Oil and Gas Royalties:

Royalty Relief Will Cost the Government Billions of Dollars but Uncertainty Over Future Energy Prices and Production Levels Make Precise Estimates Impossible at this Time

GAO-07-590R: Published: Apr 12, 2007. Publicly Released: Apr 12, 2007.

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Oil and gas from federal lands and waters is critical to meeting the nation's energy needs, providing about 35 percent of all oil and 25 percent of all the natural gas produced in the United States in fiscal year 2005. Oil and gas companies that lease federal lands and waters agree to pay the federal government royalties on the resources extracted and produced from these leases. In 1995--a time when oil and natural gas prices were significantly lower than they are today--Congress passed the Outer Continental Shelf Deep Water Royalty Relief Act of 1995 (DWRRA), which authorized the Department of the Interior's (Interior) Minerals Management Service (MMS) to provide "royalty relief" on oil and gas produced in the deep waters of the Gulf of Mexico from leases issued from 1996 through 2000. This "royalty relief" waived or reduced the amount of royalties that companies would otherwise be obligated to pay. In implementing the DWRRA for leases sold in 1996, 1997, and 2000, MMS specified that royalty relief would only be applicable if oil and gas prices were below certain levels, known as "price thresholds," thereby protecting the government's royalty interests should oil and gas prices increase significantly. MMS did not include price thresholds for leases it issued in 1998 and 1999. Because oil and natural gas prices have risen significantly in recent years, the omission of price thresholds on the leases issued in 1998 and 1999 has resulted in significant foregone royalties to the federal government. In an effort to recoup some of these royalties, Interior is currently negotiating with some of the oil and gas companies that own these leases. Congress has also been considering legislative actions to recoup foregone royalty revenues on these leases or to encourage companies to negotiate with MMS. In addition to the foregone royalties on the 1998 and 1999 leases, one company, Kerr-McGee, is currently pursuing a legal challenge to the Interior's authority to place price thresholds on any deep water leases issued between 1996 and 2000 under the DWRRA. If successful, this legal challenge would lead to additional foregone royalties on leases issued in 1996, 1997, and 2000. We reported to the Senate Committee on Energy and Natural Resources in January 2007 that the royalty relief for leases issued under the DWRRA will likely cost the federal government billions of dollars, but that the final costs have yet to be determined. At that time, MMS' most recent estimates of forgone royalties were made in October 2004. In light of these findings, Congress asked us to evaluate the potential for foregone royalties resulting from the omission of price thresholds on the leases issued in 1998 and 1999. We are also reporting on the status of Kerr-McGee's legal challenge to the Interior's authority to set price thresholds for the leases issued in 1996, 1997, and 2000 under the DWRRA, and the potential implications this challenge could have on federal royalty revenues.

The absence of price thresholds in leases issued in 1998 and 1999 has already cost the government about $1 billion and MMS' most recent estimate in February 2007 indicates a range of future foregone royalties of between $6.4 billion and $9.8 billion over the lives of the leases. We believe the methodology and assumptions used by MMS to make these estimates are reasonable. However, because there is considerable uncertainty about future oil and natural gas prices and production levels, actual foregone royalties could end up being higher or lower than MMS's estimates. Our analysis shows that future foregone royalties are quite sensitive to changes in prices or in the amount of oil and natural gas produced. For example, one scenario that assumed high production levels and a price of $70 per barrel for oil and $6.50 per thousand cubic feet for natural gas--prices that are higher than those used by MMS but within the range of recent market prices--indicated that the future foregone royalties could be as high as $10.5 billion. Alternatively, a scenario that assumed low production levels and $50 per barrel for oil and $6.50 per thousand cubic feet for natural gas indicated that future forgone royalties could be as low as $4.3 billion. MMS is currently negotiating with oil and gas companies to apply price thresholds to future production from the 1998 and 1999 leases. To date, the results of these negotiations have been mixed -- 6 of the 45 companies involved have agreed to terms; others have agreed to negotiate but have not yet come to terms; and some companies have yet to agree to negotiate. With regard to the legal challenge to the Interior's authority to include price thresholds on leases issued under the DWRRA, Kerr-McGee filed suit in early 2006, but agreed to enter mediation with Interior in an attempt to resolve the issue. The mediation was unsuccessful and litigation has resumed. If the government loses this litigation it will lead to additional foregone royalty revenues from the 1996, 1997, and 2000 leases that included price thresholds. The additional foregone royalty revenues could include royalties on these leases totaling approximately $1 billion that have already been collected and which may have to be refunded as well as royalties on future production. MMS estimated in October 2004 that potential foregone royalties on future production could be up to $60 billion over the life of the leases, should the federal government lose the legal challenge. In our review of the methodology and assumptions used in MMS' estimate, we found that MMS may have over-estimated the amount of oil and natural gas that would be produced from these leases over the course of their lifetime. MMS officials agreed with this assessment and said that an updated estimate of foregone revenue from these leases might be considerably lower than the $60 billion figure but that they are not currently working to develop a revised estimate.

Recommendations for Executive Action

  1. Status: Closed - Implemented

    Comments: In fulfilling this recommendations, MMS reported in February 2008: (1) the numbers of 1998 and 1999 DWRRA leases in each status (including producing, terminated, and expired), (2) the annual amounts of royalties lost from 2000 through September 2007 from price thresholds not being in these leases, and (3) the cumulative amount of royalties lost through September 2007--about $1.4 billion.

    Recommendation: To assist the Congress in its efforts to find appropriate remedies for foregone royalty revenues or those that may be at risk, MMS should report to the Congress the status of the leases and the annual amount of royalties that have been foregone on the 1998 and 1999 DWRRA leases until the issue is resolved.

    Agency Affected: Department of the Interior: Minerals Management Service

  2. Status: Closed - Implemented

    Comments: In fulfilling this recommendations, MMS reported in February 2008: the numbers of 1996, 1997, and 2000 DWRRA leases in each status, the annual amounts of royalties lost from 1996 through September 2007 from these leases, and the cumulative amount of royalties lost through September 2007--about $1.1 billion.

    Recommendation: To assist the Congress in its efforts to find appropriate remedies for foregone royalty revenues or those that may be at risk, MMS should report to the Congress the status of the leases and the annual amount of royalties collected to date from the 1996, 1997, and 2000 DWRRA leases until the Kerr-McGee suit is resolved.

    Agency Affected: Department of the Interior: Minerals Management Service

  3. Status: Closed - Implemented

    Comments: In fulfilling this recommendations, MMS reported in February 2008 that future royalties forgone from the 1998 and 1999 leases could be from $5.3 billion to $7.8 billion and that an additional $15.7 billion to $21.2 billion could be at risk from 1996, 1997, and 2000 leases. In June 2008, we released GAO-08-792R which reviewed MMS's estimates of future forgone royalty revenues from the 1998 and 1999 leases and from the 1996, 1997, and 2000 leases and found that their estimates followed standard engineering and financial practices and were done in good faith. We also developed a number of scenarios that show that the future amount of forgone royalties is highly dependent of future oil and gas prices and future production levels. Our scenarios generally produced ranges of future forgone royalties. Our lower bounds generally agrees with MMS's lower bounds but our upper bounds are higher because we used higher oil and gas prices and assumed that reserves would grow more in the future.

    Recommendation: To assist the Congress in its efforts to find appropriate remedies for foregone royalty revenues or those that may be at risk, MMS should report to the Congress periodic estimates, as MMS resources allow, of future foregone royalties from 1998 and 1999 DWRRA leases and future royalties that may be at risk from 1996, 1997, and 2000 DWRRA leases until both of these situations are resolved.

    Agency Affected: Department of the Interior: Minerals Management Service

 

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