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entitled 'Mineral Revenues: Data Management Problems and Reliance on 
Self-Reported Data for Compliance Efforts Put MMS Royalty Collections 
at Risk' which was released on March 11, 2008.

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Testimony: 

Before the Subcommittee on Energy and Mineral Resources, Committee on 
Natural Resources, House of Representatives: 

United States Government Accountability Office: 
GAO: 

For Release on Delivery: 
Expected at 10:00 a.m. EST: 
Tuesday, March 11, 2008: 

Mineral Revenues: 

Data Management Problems and Reliance on Self-Reported Data for 
Compliance Efforts Put MMS Royalty Collections at Risk: 

Statement of Frank Rusco, Acting Director: 
Natural Resources and Environment: 

Accompanied by: 

Jeanette Franzel, Director: 
Financial Management and Assurance: 

GAO-08-560T: 

GAO Highlights: 

Highlights of GAO-08-560T, a testimony before the Subcommittee on 
Energy and Mineral Resources, Committee on Natural Resources, House of 
Representatives. 

Why GAO Did This Study: 

Companies that develop and produce federal oil and gas resources do so 
under leases administered by the Department of the Interior (Interior). 
Interior’s Bureau of Land Management (BLM) and Offshore Minerals 
Management (OMM) are responsible for overseeing oil and gas operations 
on federal leases. Companies are required to self-report their 
production volumes and other data to Interior’s Minerals Management 
Service (MMS) and to pay royalties either “in value” (payments made in 
cash), or “in kind” (payments made in oil or gas). 

GAO’s testimony will focus on whether (1) Interior has adequate 
assurance that it is receiving full compensation for oil and gas 
produced from federal lands and waters, (2) MMS's compliance efforts 
provide a check on industry’s self-reported data, (3) MMS has 
reasonable assurance that it is collecting the right amounts of royalty-
in-kind oil and gas, and (4) the benefits of the royalty-in-kind 
program that MMS has reported are reliable. This testimony is based on 
ongoing work. When this work is complete, we expect to make 
recommendations to address these and other findings. 

To address these issues GAO analyzed MMS data, reviewed MMS, and other 
agency policies and procedures, and interviewed officials at Interior. 
In commenting on a draft of this testimony, Interior provided GAO 
technical comments which were incorporated where appropriate. 

What GAO Found: 

Interior lacks adequate assurance that it is receiving full 
compensation for oil and gas produced from federal lands and waters 
because Interior’s Bureau of Land Management (BLM) and Offshore 
Minerals Management (OMM) are not fully conducting production 
inspections as required by law and agency policies and because MMS’s 
financial management systems are inadequate and lack key internal 
controls. Officials at BLM told us that only 8 of the 23 field offices 
in five key states we sampled completed their required production 
inspections in fiscal year 2007. Similarly, officials at OMM told us 
that they completed about half of the required production inspections 
in calendar year 2007 in the Gulf of Mexico. In addition, MMS’s 
financial management system lacks an automated process for routinely 
and systematically reconciling production data with royalty payments. 

MMS’s compliance efforts do not consistently examine third-party source 
documents to verify whether self-reported industry royalty-in-value 
payment data are complete and accurate, putting full collection of 
royalties at risk. In 2001, to help meet its annual performance goals, 
MMS moved from conducting audits, which compare self-reported data 
against source documents, toward compliance reviews, which provide a 
more limited check of a company’s self-reported data and do not include 
systematic comparison to source documentation. MMS could not tell us 
what percentage of its annual performance goal was achieved through 
audits as opposed to compliance reviews. 

Because the production verification processes MMS uses for royalty-in-
kind gas are not as rigorous as those applied to royalty-in-kind oil, 
MMS cannot be certain it is collecting the gas royalties it is due. MMS 
compares companies’ self-reported oil production data with pipeline 
meter data from OMM’s oil verification system, which records oil 
volumes flowing through metering points. While analogous data are 
available from OMM’s gas verification system, MMS has not chosen to use 
these third-party data to verify the company-reported production 
numbers. 

The financial benefits of the royalty-in-kind program are uncertain due 
to questions and uncertainties surrounding the underlying assumptions 
and methods MMS used to compare the revenues it collected in kind with 
what it would have collected in cash. Specifically, questions and 
uncertainties exist regarding MMS’s methods to calculate the net 
revenues from in-kind oil and gas sales, interest payments, and 
administrative cost savings. 

To view the full product, including the scope and methodology, click on 
[hyperlink, http://www.GAO-08-560T]. For more information, contact 
Frank Rusco at (202) 512-3841 or ruscof@gao.gov. 

[End of section] 

Mr. Chairman and Members of the Subcommittee: 

We are pleased to participate in the subcommittee's hearing to discuss 
the Department of the Interior's (Interior) oversight of the collection 
of royalties paid on the production of oil and natural gas (hereafter 
oil and gas) from federal lands and waters. In fiscal year 2007, 
Interior's Minerals Management Service (MMS) collected over $9 billion 
in oil and gas royalties and disbursed these funds to federal, state, 
and tribal accounts. The federal portion of these royalties, which 
totaled $6.7 billion in fiscal year 2007, represents one of the 
country's largest nontax sources of revenue. At the same time, oil and 
gas production on federal lands and waters represents a critical 
component of the nation's energy portfolio, supplying roughly 35 
percent of all the oil and 30 percent of all the gas produced in the 
United States in 2006. The Department of Energy's (DOE) Energy 
Information Administration projects that over the next 10 years the 
portion of U.S. production from federal lands and waters will increase 
to 47 percent for oil and 37 percent for gas. In fiscal year 2007, MMS 
also transferred $322 million worth of oil to DOE as part of its 
efforts to fill the nation's Strategic Petroleum Reserve (SPR). The SPR 
currently holds nearly 700 million barrels of oil--equivalent to about 
58 days of net oil imports--that can be released at the discretion of 
the President in the event of an oil supply disruption. Recently, both 
oil prices and the demand to drill for oil and gas on federal lands 
have increased dramatically. For example, the price of West Texas 
Intermediate--a commonly used benchmark crude oil--now exceeds $100 per 
barrel, a price that, when adjusted for inflation, is the highest price 
since 1980. Moreover, Interior's Bureau of Land Management (BLM) is 
projecting substantially increased numbers of drilling permit 
applications. It received 8,351 in 2005 and anticipates receiving 
12,500 in 2008. 

Companies that develop and produce federal oil and gas resources from 
federal lands and waters do so under leases obtained and administered 
by Interior--BLM for onshore leases and MMS's Offshore Minerals 
Management (OMM) for offshore leases. Together, BLM and OMM are 
responsible for overseeing oil and gas operations on more than 28,000 
producing leases to help ensure that oil and gas companies comply with 
applicable laws, regulations, and agency policies. Among other things, 
BLM and OMM staff inspect producing leases to verify whether oil and 
gas are accounted for as required by both the Federal Oil and Gas 
Royalty Management Act of 1982[Footnote 1] and agency policies. As a 
condition of producing oil and gas under federal leases, companies are 
required to self-report monthly production volumes to MMS (as part of 
their monthly production reports).[Footnote 2] In some situations, 
several companies may be jointly involved in developing oil and gas 
from a lease or a number of adjacent leases, in which case the 
companies designate one of the companies to be the "operator." The 
operator has sole responsibility for submitting production reports for 
all oil and gas produced from the leases. 

Companies, or lessees, compensate the government for producing federal 
oil and gas resources either "in value" (royalty payments made in 
cash), or "in kind" (royalty payments made in oil or gas). In fiscal 
year 2006, 58 percent of the $9.74 billion in oil and gas royalty 
payments were made in value, while 42 percent were made in kind. Under 
the royalty-in-value program, lessees responsible for paying cash 
royalties, also called "payors," calculate the royalty payment they owe 
to the federal government using the key variables illustrated in the 
following equation: 

Royalty payment = (sales volume x sales price - deductions) x royalty 
rate[Footnote 3] 

Cash royalty payors are required to submit monthly royalty reports to 
MMS specifying the royalty amount they owe the federal government for 
the production and sale of oil and gas, and generally make the cash 
payment via an electronic fund transfer to an account at the Department 
of the Treasury (Treasury).[Footnote 4] In many instances, because 
leases are co-owned by multiple companies, multiple payors submit 
individual royalty reports for a single lease. However, in these 
situations a single company is designated the "operator" and is 
responsible for submitting the production report for that entire lease. 
As a result, MMS will often receive multiple royalty reports 
corresponding to a single production report. Royalty reports include 
the sales volume (amount sold), the sales revenue (the amount of 
revenue received from the sale), and the royalty payment due to MMS 
(royalty value less allowances taken for transportation and processing 
the gas into a marketable condition), prorated based on the share owned 
by each payor. Some of these data, as well as some of the deductible 
transportation costs, are also available from third-party sources. For 
example, individual royalty payor data on production and some 
transportation costs can be acquired from pipeline statements, which 
are essentially receipts from pipeline companies for shipping oil and 
gas. In contrast, documentation of sales revenue data, as well as data 
supporting allowable deductions, are generally available only from oil 
and gas company records. Royalty payors submit their monthly royalty 
reports through a Web-based portal. Once MMS reconciles the self- 
reported royalty payment data from the monthly royalty reports with the 
payments submitted to Treasury, MMS disburses the royalties from the 
Treasury account to the appropriate federal, state, and tribal 
accounts. The transaction information is recorded in MMS's financial 
management system.[Footnote 5] 

As a check on the accuracy of the self-reported data the payors use 
when determining cash royalty payments, among MMS's internal controls 
are audits and compliance reviews.[Footnote 6] Audits are an assessment 
of the accuracy and completeness of the self-reported production and 
royalty data compared against source documents, such as sales contracts 
and oil and gas sales receipts from pipeline companies. By contrast, 
compliance reviews deal with reasonableness--a quicker, more limited 
check of the accuracy and completeness of a company's self-reported 
data--and they do not include systematic examination of underlying 
source documentation. In addition, some states and tribes that receive 
a share of royalties collected by MMS have agreements with MMS 
authorizing them to conduct both audits and compliance reviews on 
federal and Indian producing leases within their 
jurisdictions.[Footnote 7] MMS has an annual performance goal whereby 
it evaluates the compliance group's performance on the basis of whether 
the group has conducted compliance activities--either full audits or 
compliance reviews--on a predetermined percentage of royalty payments. 

In contrast to royalties in value, when paying royalties in kind, a 
payor delivers a volume of oil or gas to MMS as determined by the 
following equation: 

Royalty volume = total production volume x royalty rate[Footnote 8] 

Once it receives the oil or gas, MMS may either sell it and disburse 
the revenues received from the sales, or transfer it to federal 
agencies for them to use. For example, MMS can transfer oil to DOE and 
DOE, in turn, can trade this oil for other oil of specific quality to 
fill the SPR. Under the Energy Policy Act of 2005,[Footnote 9] MMS is 
charged with ensuring that the revenues it receives when it sells oil 
and gas taken in-kind are at least as great as the revenues it would 
have received had it taken the royalties in value. Furthermore, MMS 
cannot sell oil and gas it takes in-kind for less than market value. As 
required, MMS routinely compares the estimated benefits of the in-kind 
program to the estimated benefits MMS would have received if the 
royalties had been taken in cash and annually reports these benefits to 
the Congress. 

MMS estimates that from fiscal years 2004 through 2006 the royalty-in- 
kind program generated about $87 million more in net value to the 
government than MMS would have collected had it received royalties in 
cash. Of this $87 million, MMS estimates that (1) $74 million came from 
selling royalty-in-kind oil and gas for more than it would have 
received in cash royalty payments, (2) $5 million came from interest 
from receiving revenues from in-kind sales earlier than cash payments 
are due, and (3) $8 million came from savings because the royalty-in- 
kind program costs less to administer than the in-value program. 

Our testimony today is based on two ongoing efforts. The first focuses 
on MMS's royalty-in-value program and addresses (1) whether Interior 
has adequate assurance that it is receiving full compensation for oil 
and gas produced from federal lands and waters and (2) the extent to 
which MMS's compliance efforts provide an adequate check on industry's 
self-reported data.[Footnote 10] The second, relating to MMS's royalty- 
in-kind program, addresses (1) the extent to which MMS has reasonable 
assurance that it is collecting the right amounts of royalty-in-kind 
oil and gas and (2) the reliability of the benefits of the royalty-in- 
kind program that MMS has reported.[Footnote 11] 

In addressing these issues, we reviewed documentation on MMS policies 
and procedures for collecting royalties; collected and assessed 
information on the sales of royalty oil and gas; and reviewed MMS 
procedures for preparing the administrative cost comparison between the 
royalty-in-value and royalty-in-kind programs. We also interviewed 
officials at offices selected from a nonprobability sample of five BLM 
field offices and the associated BLM state offices--the offices were 
selected based on the numbers of violations, oil and gas volume errors 
identified, and geographic location. In addition, we interviewed 
officials at MMS; toured oil and gas production facilities in Wyoming, 
Colorado, and the Gulf of Mexico; sent questionnaires addressing 
production and royalty data issues to the 11 state and 7 tribal members 
of the State and Tribal Royalty Audit Committee, of which 9 states and 
5 tribes responded. We assessed the reliability of the royalty-in-kind 
sales and performance data by (1) reviewing the systems that MMS has in 
place to help ensure that the data were entered and calculated 
correctly, and (2) comparing the data to aggregate performance results 
that MMS reported to the Congress for fiscal years 2004 through 2006. 
We determined that the data were sufficiently reliable for the purposes 
of this testimony. Our work is ongoing and we are continuing to assess 
information related to the objectives and findings presented in this 
testimony. We conducted this work from April 2007 to February 2008 in 
accordance with generally accepted government auditing standards. Those 
standards require that we plan and perform the audit to obtain 
sufficient, appropriate evidence to provide a reasonable basis for our 
findings and conclusions based on our audit objectives. We believe that 
the evidence obtained provides a reasonable basis for our findings and 
conclusions based on our audit objectives. 

In summary, regarding the royalty-in-value program, our work to date 
has revealed the following: 

* Interior lacks adequate assurance that it is receiving full 
compensation for oil and gas produced from federal lands and waters. 
For example, neither BLM nor OMM is meeting statutory obligations or 
agency targets for conducting inspections of meters and other equipment 
used to measure oil and gas production, which raises questions about 
the accuracy of oil and gas measurement. Further, MMS's systems and 
processes for collecting and verifying royalty data are inadequate and 
lack key internal controls. Specifically, MMS lacks an automated 
process to routinely and systematically reconcile all production data 
filed by payors (those responsible for paying the royalties) with 
production data filed by operators (those responsible for reporting 
production volumes). 

* MMS's compliance efforts do not consistently examine data from third 
parties to verify whether self-reported industry payment data are 
complete and accurate. Combined with the inadequacy of MMS's systems 
and processes for collecting and verifying royalty data and the lack of 
key internal controls, the absence of a consistent check on self- 
reported data using third-party data raises further questions about the 
accuracy of royalty payments. 

Regarding the royalty-in-kind program, our work to date has revealed 
the following: 

* MMS does not consistently check the accuracy of self-reported gas 
collection data against available third-party data, putting the 
accuracy of gas royalty collections at risk. MMS's ability to detect 
gas production discrepancies is weaker than for oil because, unlike in 
the case of oil, MMS does not use third-party gas metering data to 
verify the operator-reported production numbers. 

* The methods and assumptions MMS uses to compare the revenues it 
collects in kind with what it would have collected in cash do not 
account for all costs and do not sufficiently deal with uncertainties, 
raising significant questions about the reported financial benefits of 
the in-kind program. 

Interior's Oversight Does Not Provide Adequate Assurance That the 
Government Is Being Fully Compensated for Oil and Gas Production on 
Federal Lands and Waters: 

Interior lacks adequate assurance that it is receiving the full 
royalties it is owed because (1) neither BLM nor OMM is fully 
inspecting leases and meters as required by law and agency policies, 
and (2) MMS lacks adequate management systems and sufficient internal 
controls for verifying that royalty payment data are accurate and 
complete. With regard to inspecting oil and gas production, BLM is 
charged with inspecting approximately 20,000 producing onshore leases 
annually to ensure that oil and gas volumes are accurately measured. 
However, BLM's state Inspection and Enforcement Coordinators from 
Colorado, Montana, New Mexico, Utah, and Wyoming told us that only 8 of 
the 23 field offices in the 5 states completed both their (1) required 
annual inspections of wells and leases that are high-producing and 
those that have a history of violations and (2) inspections every third 
year on all remaining leases.[Footnote 12] According to the BLM state 
Inspection and Enforcement Coordinators, the number of completed 
production inspections varied greatly by field office. For example, 
while BLM inspectors were able to complete all of the production 
inspections in the Kemmerer, Wyoming, field office, inspectors in the 
Glenwood Springs, Colorado, field office were able to complete only 
about one-quarter of the required inspections. Officials in 3 of the 5 
field offices in which we held detailed discussions with inspection 
staff told us that they had not been able to complete the production 
inspections because of competing priorities,[Footnote 13] including 
their focus on completing a growing number of drilling inspections for 
new oil and gas wells, and high inspection staff turnover. However, BLM 
officials from all 5 field offices told us that when they have 
conducted production inspections they have identified a number of 
violations. For example, BLM staff in 4 of the 5 field offices 
identified errors in the amounts of oil and gas production volumes 
reported by operators to MMS by comparing production reports with third-
party source documents. Additionally, BLM staff from 1 field office we 
visited showed us a bypass built around a gas meter, allowing gas to 
flow around the meter without being measured. BLM staff ordered the 
company to remove the bypass. Staff from another field office told us 
of a case in which individuals illegally tapped into a gas line and 
routed gas to private residences. Finally, in one of the field offices 
we visited, BLM officials told us of an instance in which a company 
maintained two sets of conflicting production data--one used by the 
company and another reported to MMS. 

Moreover, OMM, which is responsible for inspecting offshore production 
facilities that include oil and gas meters, did not inspect all oil and 
gas royalty meters, as required by its policy, in 2007. For example, 
OMM officials responsible for meter inspections in the Gulf of Mexico 
told us that they completed about half of the required 2,700 
inspections, but that they met OMM's goal for witnessing oil and gas 
meter calibrations. OMM officials told us that one reason they were 
unable to complete all the meter inspections was their focus on the 
remaining cleanup work from hurricanes Katrina and Rita. Meter 
inspections are an important aspect of the offshore production 
verification process because, according to officials, one of the most 
common violations identified during inspections is missing or broken 
meter seals. Meter seals are meant to prevent tampering with 
measurement equipment. When seals are missing or broken, it is not 
possible without closer inspection to determine whether the meter is 
correctly measuring oil or gas production. 

With regard to MMS's assurance that royalty data are being accurately 
reported by companies, MMS's systems and processes for collecting and 
verifying these data lack both capabilities and key internal controls, 
including those focused on data accuracy, integrity, and completeness. 
For example, MMS lacks an automated process to routinely and 
systematically reconcile all production data filed by payors (those 
responsible for paying the royalties) with production data filed by 
operators (those responsible for reporting production volumes). MMS 
officials told us that before they transitioned to the current 
financial management system in 2001, their system included an automated 
process that reconciled the production and royalty data on all 
transactions within approximately 6 months of the initial entry date. 
However, MMS's new system does not have that capability. As a result, 
such comparisons are not performed on all properties. Comparisons are 
made, if at all, 3 years or more after the initial entry date by the 
MMS compliance group for those properties selected for a compliance 
review or audit. 

In addition, MMS lacks a process to routinely and systematically 
reconcile production data included by payors on their royalty reports 
or by operators on their production reports with production data 
available from third-party sources. OMM does compare a large part of 
the offshore operator-reported production data with third-party data 
from pipeline operators through both its oil and gas verification 
programs, but BLM compares only a relatively small percentage of 
reported onshore oil and gas production data with third-party pipeline 
data. When BLM and OMM do make comparisons and find discrepancies, they 
forward the information to MMS, which then takes steps to reconcile and 
correct these discrepancies by talking to operators. However, even when 
discrepancies are corrected and the operator-reported data and pipeline 
data have been reconciled, these newly reconciled data are not 
automatically and systematically compared with the reported sales 
volume in the royalty report, previously entered into the financial 
management database, to ensure the accuracy of the royalty payment. 
Such comparisons occur only if a royalty payor's property has been 
selected for an audit or compliance review. 

Furthermore, MMS's financial management system lacks internal controls 
over the integrity and accuracy of production and royalty-in-value data 
entered by companies. Companies may legally make changes to both 
royalty and production data in MMS's financial management system for up 
to 6 years after the reporting month, and these changes may necessitate 
changes in the royalty payment.[Footnote 14] However, when companies 
retroactively change the data they previously entered, these changes do 
not require prior approval by, or notification of, MMS. As a result of 
the companies' ability to unilaterally make these retroactive changes, 
the production data and required royalty payments can change over time, 
further complicating efforts by agency officials to reconcile 
production data and ensure that the proper amount of royalties was 
paid. Compounding this data reliability concern, changes made to the 
data do not necessarily trigger a review to determine their 
reasonableness or whether additional royalties are due. According to 
agency officials, these changes are not subject to review at the time a 
change is made and would be evaluated only if selected for an audit or 
compliance review. This is also problematic because companies may 
change production and royalty data after an audit or compliance review 
has been done, making it unclear whether these audited royalty payments 
remain accurate after they have been reviewed. Further, MMS officials 
recently examined data from September 2002 through July 2007 and 
identified over 81,000 adjustments made to data outside the allowable 6-
year time frame. MMS is working to modify the system to automatically 
identify adjustments that have been made to data outside of the 
allowable 6-year time frame, but this effort does not address the need 
to identify adjustments made within the allowable time that might 
necessitate further adjustments to production data and royalty payments 
due. 

Finally, MMS's financial management system could not reliably detect 
when production data reports were missing until late 2004, and the 
system continues to lack the ability to automatically detect missing 
royalty reports. In 2004, MMS modified its financial management system 
to automatically detect missing production reports. As a result, MMS 
has identified a backlog of approximately 300,000 missing production 
reports that must be investigated and resolved. It is important that 
MMS have a complete set of accurate production reports so that BLM can 
prioritize production inspections, and its compliance group can easily 
reconcile royalty payments with production information. Importantly, 
MMS's financial management system continues to lack the ability to 
automatically detect cases in which an expected royalty report has not 
been filed. While not filing a royalty report may be justifiable under 
certain circumstances, such as when a company sells its lease, MMS's 
inability to detect missing royalty reports presents the risk that MMS 
will not identify instances in which it is owed royalties that are 
simply not being paid. Officials told us they are currently able to 
identify missing royalty reports in instances when they have no royalty 
report to match with funds deposited to Treasury. However, cases in 
which a company stops filing royalty reports and stops paying royalties 
would not be detected unless the payor or lease was selected for an 
audit or compliance review. 

MMS's Compliance Efforts Do Not Consistently Use Third-Party Data to 
Check Self-Reported Royalty-in-Value Payment Data: 

MMS's increasing use of compliance reviews, which are more limited in 
scope than audits, has led to an inconsistent use of third-party data 
to verify that self-reported royalty data are correct, thereby placing 
accurate royalty collections at risk. Since 2001, MMS has increasingly 
used compliance reviews to achieve its performance goals of completing 
compliance activities--either full audits or compliance reviews--on a 
predetermined percentage of royalty payments. According to MMS, 
compliance reviews can be conducted much more quickly and require fewer 
resources than audits, largely because they represent a quicker, more 
limited reasonableness check of the accuracy and completeness of a 
company's self-reported data, and do not include a systematic 
examination of underlying source documentation. Audits, on the other 
hand, are more time-and resource-intensive, and they include the review 
of original source documents, such as sales revenue data, 
transportation and gas processing costs, and production volumes, to 
verify whether company-reported data are accurate and complete. When 
third-party data are readily available from OMM, MMS may use them when 
conducting a compliance review. For example, MMS may use available 
third-party data on oil and gas production volumes collected by OMM in 
its compliance reviews for offshore properties. In contrast, because 
BLM collects only a limited amount of third-party data for onshore 
production, and MMS does not request these data from the companies, MMS 
does not systematically use third-party data when conducting onshore 
compliance reviews. Despite conducting thousands of compliance reviews 
since 2001, MMS has only recently evaluated their effectiveness. For 
calendar year 2002, MMS compared the results of 100 of about 700 
compliance reviews of offshore leases and companies with the results of 
audits conducted on those same leases or companies. However, while the 
compliance reviews covered, among other things, 12 months of production 
volumes on all products--oil, gas, and retrograde, a liquid product 
that condenses out of gas under certain conditions--the audits covered 
only 1 month and one product. As a result of this evaluation comparing 
the results of compliance reviews with those of audits, MMS now plans 
to improve its compliance review process by, for example, ensuring that 
it includes a step to check that royalties are paid on all royalty- 
bearing products, including retrograde. 

To achieve its annual performance goals, MMS began using the compliance 
reviews along with audits. One of MMS's performance goals is to 
complete compliance activities--either audits or compliance reviews-- 
on a specified percentage of royalty payments within 3 years of the 
initial royalty payment. For example, in 2006 MMS reported that it had 
achieved this goal by confirming reasonable compliance on 72.5 percent 
of all calendar year 2003 royalties. To help meet this goal, MMS 
continues to rely heavily on compliance reviews, yet it is unable to 
state the extent to which this performance goal is accomplished through 
audits as opposed to compliance reviews. As a result, MMS does not have 
information available to determine the percentage of the goal that was 
achieved using third-party data and the percentage that did not 
systematically rely on third-party data. Moreover, to help meet its 
performance goal, MMS has historically conducted compliance reviews or 
audits on leases and companies that have generated the most royalties, 
with the result that the same leases and companies are reviewed year 
after year. Accordingly, many leases and companies have gone for years 
without ever having been reviewed or audited. 

In 2006, Interior's Inspector General (IG) reviewed MMS's compliance 
process and made a number of recommendations aimed at strengthening it. 
The IG recommended, among other things, that MMS examine 1 month of 
third-party source documentation as part of each compliance review to 
provide greater assurance that both the production and allowance data 
are accurate. The IG also recommended that MMS track the percentage of 
the annual performance goal that was accomplished through audits versus 
through compliance reviews, and that MMS move toward a risk-based 
compliance program and away from reviewing or auditing the same leases 
and companies each year. To address the IG's recommendations, MMS has 
recently revised its compliance review guidance to include suggested 
steps for reviewing third-party source production data when available 
for both offshore and onshore oil and gas, though the guidance falls 
short of making these steps a requirement. MMS has also agreed to start 
tracking compliance activity data in 2007 that will allow it to report 
the percentage of the performance goal that was achieved through audits 
versus through compliance reviews. Finally, MMS has initiated a risk- 
based compliance pilot project, whereby leases and companies are 
selected for compliance work according to MMS-defined risk criteria 
that include factors other than whether the leases or companies 
generate high royalty payments. According to MMS, during fiscal year 
2008 it will further evaluate and refine the pilot as it moves toward 
fuller implementation. 

Finally, representatives from the states and tribes who are responsible 
for conducting compliance work under agreements with MMS have expressed 
concerns about the quality of self-reported production and royalty data 
they use in their reviews. As part our work, we sent questionnaires to 
all 11 states and seven tribes that conducted compliance work for MMS 
in fiscal year 2007. Of the nine state and five tribal representatives 
who responded, seven reported that they lack confidence in the accuracy 
of the royalty data. For example, several representatives reported that 
because of concerns with MMS's production and royalty data, they 
routinely look to other sources of corroborating data, such as 
production data from state oil and gas agencies and tax agencies. 
Finally, several respondents noted that companies frequently report 
production volumes to the wrong leases and that they must then devote 
their limited resources to correcting these reporting problems before 
beginning their compliance reviews and audits. 

The MMS Royalty-in-Kind Program Is at Risk of Inaccurate Collection of 
Natural Gas Royalties because of Inconsistent Oversight: 

Because MMS's royalty-in-kind program does not extend the same 
production verification processes used by its oil program to its gas 
program, it does not have adequate assurance that it is collecting the 
gas royalties it is owed. As noted, under the royalty-in-kind program, 
MMS collects royalties in the form of oil and gas and then sells these 
commodities in competitive sales. To ensure that the government obtains 
the fair value of these sales, MMS must make sure that it receives the 
volumes to which it is entitled. Because prices of these commodities 
fluctuate over time, it is also important that MMS receive the oil and 
gas at the time it is entitled to them. As part of its royalty-in-kind 
oversight effort, MMS identifies imbalances between the volume 
operators owe the federal government in royalties and the volume 
delivered and resolves these imbalances by adjusting future delivery 
requirements or cash payments. The methods that MMS uses to identify 
these imbalances differ for oil and gas. 

* For oil, MMS obtains pipeline meter data from OMM's liquid 
verification system, which records oil volumes flowing through numerous 
metering points in the Gulf of Mexico region. MMS calculates its 
royalty share of oil by multiplying the total production volumes 
provided in these pipeline statements by the royalty rates for a given 
lease. MMS compares this calculation with the volume of royalty oil 
that the operators delivered as reported by pipeline operators. When 
the value of an imbalance cumulatively reaches $100,000, MMS conducts 
further research to resolve the discrepancy. Using pipeline statements 
to verify production volumes is a good check against companies' self- 
reporting of royalties due the federal government because companies 
have an incentive to not underreport their share of oil going into the 
pipeline because that is the amount they will have to sell at the other 
end of the pipeline. 

* For gas, MMS relies on information contained in two operator-provided 
documents--monthly imbalance statements and production reports. 
Imbalance statements include the operator's total gas production for 
the month, the share of that production that the government is entitled 
to, and any differences between what the operator delivered and the 
government's royalty share. Production reports contain a large number 
of data elements, including production volumes for each gas well. MMS 
compares the production volumes contained in the imbalance statements 
with those in the production reports to verify production levels. MMS 
then calculates its royalty share based on these production figures and 
compares its royalty share with gas volumes the operators delivered as 
reported by pipeline operators. When the value of an imbalance 
cumulatively reaches $100,000, MMS conducts further research to resolve 
the discrepancy. 

MMS's ability to detect gas imbalances is weaker than for oil because 
it does not use third-party metering data to verify the operator- 
reported production numbers. Since 2004, OMM has collected data from 
gas pipeline companies through its gas verification system, which is 
similar to its liquid verification system in that the system records 
information from pipeline company-provided source documents. Our review 
of data from this program shows that these data could be a useful tool 
in verifying offshore gas production volumes.[Footnote 15] 
Specifically, our analysis of these pipeline data showed that for the 
months of January 2004, May 2005, July 2005, and June 2006, 25 percent 
of the pipeline metering points had an outstanding discrepancy between 
self-reported and pipeline data.[Footnote 16] These discrepancies are 
both positive and negative--that is, production volumes submitted to 
MMS by operators are at times either under-or overreported. 

Data from the gas verification system could be useful in validating 
production volumes and reducing discrepancies. However, to fully 
benefit from this opportunity, MMS needs to improve the timeliness and 
reliability of these data. After examining this issue, in December 
2007, the Subcommittee on Royalty Management, a panel appointed by the 
Secretary of the Interior to examine MMS's royalty program, reported 
that OMM is not adequately staffed to conduct sufficient review of data 
from the gas verification system.[Footnote 17] We have not yet, nor has 
MMS, determined the net impact of these discrepancies on royalties owed 
the federal government. 

Significant Questions and Uncertainties Exist Regarding the Reported 
Financial Benefits of the Royalty-in-Kind Program: 

The methods and underlying assumptions MMS uses to compare the revenues 
it collects in kind with what it would have collected in cash do not 
account for all costs and do not sufficiently deal with uncertainties, 
raising doubts about the claimed financial benefits of the royalty-in- 
kind program. Specifically, MMS's calculation showing that MMS sold the 
royalty oil and gas for $74 million more than MMS would have received 
in cash payments did not appropriately account for uncertainty in 
estimates of cash payments. In addition, MMS's calculation that early 
royalty-in-kind payments yielded $5 million in interest was based on 
assumptions about payment dates and interest rates that could misstate 
the estimated interest benefit. Finally, MMS's calculation that the 
royalty-in-kind program cost about $8 million less to administer than 
an in-value program did not include significant costs that, if 
included, could change MMS's conclusions. 

Sales Revenue: 

MMS sold the oil and gas it collected during the 3 fiscal years 2004 
through 2006 for $8.15 billion and calculated that this amount exceeded 
what MMS would have received in cash royalties by about $74 million--a 
net benefit of approximately 0.9 percent. MMS has recognized that its 
estimates of what it would have received in cash payments are subject 
to some degree of error but has not appropriately evaluated or reported 
how sensitive the net benefit calculations are to this error.[Footnote 
18] This is important because even a 1 percent error in the estimates 
of cash payments would change the estimated benefit of the royalty-in- 
kind program from $74 million to anywhere from a loss of $6 million to 
a benefit of $155 million. 

Moreover, MMS's annual reports to the Congress present oil sales data 
in aggregate and therefore do not reflect the fact that, in many 
individual sales, MMS sold the oil it collected in kind for less than 
it estimates it would have collected in cash. Specifically, MMS 
estimates that, in fiscal year 2006, it sold 28 million barrels of oil, 
or 64 percent of all the oil it collected in kind, for less than it 
would have collected in cash. The government would have received an 
additional $6 million in revenue if it had taken these royalties in 
cash instead. These sales indicate that MMS has not always been able to 
achieve one of its central goals: to select, based on systematic 
economic analysis, which royalties to take in cash and which to take in 
kind in a way that maximizes revenues to the government. 

According to a senior MMS official, the federal government has several 
advantages when selling gas that it does not have when selling oil, a 
fact that helps to explain why MMS's gas sales have performed better 
than its oil sales. For example, MMS can bundle the natural gas 
production in the Gulf of Mexico from many different leases into large 
volumes that MMS can use to negotiate discounts for transporting gas 
from production sites to market centers. Because purchasers receive 
these discounts when they buy gas from MMS, they may be willing to pay 
more for gas from MMS than from the original owners. Opportunities for 
bundling are less prevalent in the oil market. Because MMS generally 
does not have this, or other, advantages when selling oil, purchasers 
often pay MMS about what they would pay other producers for oil, and 
sometimes less. Indeed, MMS's policies allow it to sell oil for up to 
7.7 cents less per barrel than MMS estimates it would collect if it 
took the royalties in cash. MMS told us that the other financial 
benefits of the royalty-in-kind program, including interest payments 
and reduced administrative costs, justify selling oil for less than the 
estimated cash payments because once these additional revenues are 
factored in, the net benefit to the government is still positive. 
However, as discussed below, we have found that there are significant 
questions and uncertainties about the other financial benefits as well. 

Interest: 

Revenues from the sale of royalty-in-kind oil are due 10 days earlier 
than cash payments, and revenues from the sale of in-kind gas are due 5 
days earlier. MMS calculates that the government earned about $5 
million in interest from fiscal years 2004 through 2006 from these 
early payments that it would not have received had it taken royalties 
in cash.[Footnote 19] We found two weaknesses in the way MMS calculates 
this interest. First, the payment dates used to calculate the interest 
revenue have the potential to over-or underestimate its value. MMS 
calculates the interest on the basis of the time between the actual 
date that Treasury received a royalty-in-kind payment and the 
theoretical latest date that Treasury would have received a cash 
payment under the royalty-in-value program. However, MMS officials told 
us that cash payments can, and sometimes do, arrive before their due 
date. As a result, MMS might be overstating the value of the early 
royalty-in-kind payments. Second, the interest rate used to calculate 
the interest revenue may either over-or understate its value because 
the rate is not linked to any market rate. From fiscal year 2004 
through 2007, MMS used a 3 percent interest rate to calculate the time 
value of these early payments. However, during this time, actual market 
interest rates at which the federal government borrowed fluctuated. For 
example, 4-week Treasury bill rates ranged from a low of 0.72 percent 
to a high of 5.18 percent during this same period. Therefore, during 
some fiscal years, MMS likely overstated or understated the value of 
these early payments. 

Administrative Cost Savings: 

MMS has developed procedures to capture the administrative costs of the 
royalty-in-kind and cash royalty programs and includes in its 
administrative cost comparison primarily the variable costs for the 
federal offshore oil and gas activities--that is, costs that fluctuate 
based on the volume of oil or gas received by MMS, such as labor costs. 
Although MMS also includes some department-level fixed costs, it 
excludes some fixed costs that it does not incur on a predictable basis 
(largely information technology [IT] costs). According to MMS, if it 
included these IT and other such costs, there would be a high potential 
of skewing the unit price used to determine the administrative cost 
savings. However, by excluding such fixed costs from the administrative 
cost comparison, MMS is not including all the necessary cost 
information to evaluate the efficacy of the royalty-in-kind program. 

MMS's administrative cost analysis compares a bundle of royalty-in-kind 
program administrative costs divided by the number of barrels of oil 
equivalent realized by the royalty-in-kind program during a 
year,[Footnote 20] with a bundle of cash royalty program administrative 
costs divided by the number of barrels of oil equivalent realized by 
that program. The difference between these amounts represents the 
difference in cost to administer a barrel of oil equivalent under each 
program. 

MMS then multiplies the difference in cost to administer a barrel of 
oil equivalent under the two programs by the number of barrels of oil 
equivalent realized by the royalty-in-kind program to determine the 
administrative cost savings. However, MMS's calculations excluded some 
fixed costs that are not incurred on a regular or predictable basis 
from the analysis. For example, in fiscal year 2006, royalty-in-kind IT 
costs of $3.4 million were excluded from the comparison. Moreover, 
additional IT costs of approximately $29.4 million--some of which may 
have been incurred for either the royalty-in-kind or the cash royalty 
program--were also excluded. Including and assigning these IT costs to 
the programs supported by those costs would provide a more complete 
accounting of the respective costs of the royalty-in-kind and royalty- 
in-value programs, and would likely impact the results of MMS's 
administrative cost analysis. 

Conclusions: 

Ultimately the system used by Interior to ensure taxpayers receive 
appropriate value for oil and gas produced from federal lands and 
waters is more of an honor system than we are comfortable with. Despite 
the heavy scrutiny that Interior has faced in its oversight of royalty 
management, we and others continue to identify persistent weaknesses in 
royalty collections. Given both the long-term fiscal challenges the 
government faces and the increased demand for the nation's oil and gas 
resources, it is imperative that we have a royalty collection system 
going forward that can assure the American public that the government 
is receiving proper royalty payments. Our work on this issue is 
continuing along several avenues, including comparing the royalties 
taken in kind with the value of royalties taken in cash, assessing the 
rate of oil and gas development on federal lands, comparing the amount 
of money the U.S. government receives with what foreign countries 
receive for allowing companies to develop and produce oil and gas, and 
examining further the accuracy of MMS's production and royalty data. We 
plan to make recommendations to address the weaknesses we identified in 
our final reports on these issues. 

We look forward to further work and to helping this subcommittee and 
the Congress as a whole to exercise oversight on this important issue. 
Mr. Chairman, this concludes our prepared statement. We would be 
pleased to respond to any questions that you or other members of the 
subcommittee may have at this time. 

GAO Contact and Staff Acknowledgments: 

For further information about this testimony, please contact either 
Frank Rusco, at 202-512-3841, or ruscof@gao.gov, or Jeanette Franzel, 
at 202-512-9406, or franzelj@gao.gov. Contact points for our 
Congressional Relations and Public Affairs may be found on the last 
page of this statement. Contributors to this testimony include Ron 
Belak, Ben Bolitzer, Lisa Brownson, Melinda Cordero, Nancy Crothers, 
Glenn C. Fischer, Cindy Gilbert, Tom Hackney, Chase Huntley, Heather 
Hill, Barbara Kelly, Sandra Kerr, Paul Kinney, Jennifer Leone, Jon 
Ludwigson, Tim Minelli, Michelle Munn, G. Greg Peterson, Barbara 
Timmerman, and Mary Welch. 

[End of section] 

Footnotes: 

[1] Federal Oil and Gas Royalty Management Act, Pub. L. No. 97-451, § 
101(a) (1983). 

[2] Companies are required to self-report monthly production volumes to 
MMS on an Oil and Gas Operations Report (OGOR) form. 

[3] The royalty rate varies somewhat but is typically in the range of 
12.5 to 18.75 percent. In other words, the federal government typically 
receives between 12.5 and 18.75 percent of revenues less allowable 
deductions for oil and gas produced on federal lands and waters. 
Allowable deductions include payments to pipeline companies and other 
shipping costs required to transport the commodity to a market center, 
as well as adjustments made for the costs of processing natural gas. 

[4] Companies are required to self-report monthly royalty payments to 
MMS on the Report of Sales and Royalty Remittance Form, Form 2014. 

[5] This system, also known as the Minerals Revenue Management Support 
System, is designed to store and support the collection, verification, 
and disbursement of royalty revenues from federal and Indian mineral 
leases. 

[6] Internal controls are a series of management actions and activities 
that occur throughout an entity's operations and include the procedures 
used to meet agency objectives. 

[7] Eleven states--Alaska, California, Colorado, Louisiana, Montana, 
New Mexico, North Dakota, Oklahoma, Texas, Utah, and Wyoming--and seven 
tribes--Blackfeet Nation, Jicarilla Apache Tribe, Navajo Nation, 
Shoshone and Arapaho Tribes, Southern Ute Indian Tribe, Ute Mountain 
Ute Tribe, and the Ute Indian Tribe--conducted compliance work under 
cooperative agreements with MMS in fiscal year 2007. 

[8] In some cases, there may be deductions to the royalty oil given MMS 
as a result of costs incurred by the payor to transport the oil to the 
point at which MMS takes possession. In addition, there may be credits 
or deductions that adjust for different qualities of oil transported on 
a pipeline. 

[9] Energy Policy Act of 2005, Pub. L. No. 109-58, § 342 (2005). 

[10] This work is being done at the request of Senator Bingaman and Mr. 
Davis, Mr. Issa, Ms. Maloney, and Mr. Rahall, House of Representatives. 

[11] This work is being done at the request of Senator Bingaman and 
Senator Wyden, and Mr. Issa and Mr. Rahall, House of Representatives. 

[12] We excluded production inspection results from three BLM field 
offices where BLM state Inspection and Enforcement Coordinators could 
not validate production inspection numbers because they felt the data 
in BLM's Automated Fluid Minerals Support System (AFMSS), the database 
used to track production inspections, were unreliable. We excluded one 
additional BLM field office because it is implementing a pilot project 
inspection program using different selection and prioritization 
criteria; therefore it is not comparable with the other BLM field 
offices. 

[13] To gain a balance of perspectives of how BLM field offices conduct 
production inspections, we chose a nonprobability sample of five field 
office locations--Meeker, Colorado; Vernal, Utah; Farmington, New 
Mexico; Buffalo, Wyoming; and Pinedale, Wyoming. We selected the field 
offices in each of these states through consideration of a number of 
criteria, ensuring that we visited BLM field offices that represented a 
range of BLM state office jurisdictional policies. While this 
nonprobability sample allowed us to learn about many important aspects 
of production inspections, it was not designed to be representative of 
all the BLM field offices production inspection activities. As such, 
the findings cannot be generalized to sites we did not visit. 

[14] The Royalty Simplification and Fairness Act of 1996, Pub. L. No. 
104-185, § 5(a) (1996), provides a 6 year adjustment window. 

[15] Onshore gas properties accounted for less than 1 percent of the 
revenue managed by the royalty-in-kind program from fiscal year 2004 
through fiscal year 2006, but this area is expected to grow in the 
future. 

[16] For purpose of this testimony, we used 4 months of data from the 
gas verification system. We chose these months (January 2004, May 2005, 
July 2005, and June 2006) because these are the months for which MMS 
has started to work to resolve the discrepancies identified between the 
production reports and pipeline data. 

[17] Subcommittee on Royalty Management, Royalty Policy Committee, 
Report to the Royalty Policy Committee: Mineral Revenue Collection from 
Federal and Indian Lands and the Outer Continental Shelf (2007). 

[18] OMB Circular A-94, "Guidelines and Discount Rates for Benefit-Cost 
Analysis of Federal Programs," suggests that such sensitivity analysis 
be done and reported. 

[19] While MMS calls this value "interest," it is not interest per se 
because the money does not go into an interest-bearing account. Rather, 
MMS argues that the government uses the early payments to cover 
expenses that it would otherwise need to borrow money to pay for. The 
interest, then, is the cost that the government avoids by deferring the 
need to borrow. 

[20] A barrel of oil equivalent is an amount of natural gas or natural 
gas liquid that contains the same heating value as a barrel of oil. 

[End of section] 

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