Royalty Payments for Natural Gas From Federal Leases in the
Outer-Continental Shelf (Correspondence, 10/24/2000, GAO/GAO-01-101R).

The determination of royalty payments for natural gas produced from
outer-continental shelf (OCS) leases falls to the Minerals and
Management Service (MMS). Gas royalty payments are determined by
multiplying the gross sales value by a royalty rate. Disagreement over
the interpretation of key values in the formula has led to several
lawsuits between MMS and the gas industry. With the deregulation of the
gas market, determining the sale of gas produced and sold from OCS
leases has become more difficult. To help resolve these pricing issues,
MMS is pilot-testing a royalty-in-kind program. Royalty-in-kind payments
mean that royalty payments are paid in the form of physical gas. MMS and
the industry believe that this is an appropriate solution to some
pricing issues, but that it is not suitable to all transactions.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GAO-01-101R
     TITLE:  Royalty Payments for Natural Gas From Federal Leases in
	     the Outer-Continental Shelf
      DATE:  10/24/2000
   SUBJECT:  Litigation
	     Natural gas prices
	     Prices and pricing
	     Royalty payments
	     Leases

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GAO-01-101R

Natural Gas Royalty Payments United States General Accounting
Office

Washington, DC 20548

October 24, 2000 The Honorable Carolyn B. Maloney House of Representatives

Subject: Royalty Payments for Natural Gas From Federal Leases in the
OuterContinental Shelf

Dear Ms. Maloney: As requested, we are providing you with information on how
the Minerals Management Service (MMS) of the Department of the Interior
determines and monitors royalty payments for gas produced from federal
Outer- Continental Shelf leases (OCS). We used the enclosed material to
brief your staff on August 25, 2000. (See enc. I.) A summary of the
information follows.

In 1998, the last year that production data were available, about 5.8
trillion cubic feet of natural gas was produced in the OCS, accounting for
about 24 percent of total U. S. natural gas production in that year.
According to MMS, OCS gas production accounted for about $1.7 billion, or 46
percent, of the total mineral royalties received by the federal government
in 1999. The Energy Information Administration projects that U. S. gas
production will increase steadily from 1998 through 2020, compared with a
slightly declining trend for oil production. Therefore, gas production from
federal OCS leases will undoubtedly continue to account for a significant
share of total federal mineral royalties.

Gas royalty payments are determined by the following calculation: the gross
sales value, or “proceeds,” from the sale of gas- after
adjusting the sales value for allowable transportation and processing costs-
is multiplied by the 16.67- percent royalty rate for gas produced from
federal OCS leases. Although this calculation is straightforward,
interpretations of “sales value” and adjustments to it are less
clear and have created disagreement and litigation between MMS and industry.

For royalty purposes, the sales value equals the unit price received for the
gas multiplied by the volume or quantity of gas produced and sold.
Determining the sale price of gas produced and sold from federal OCS leases
has become increasingly complex, as the gas market has evolved from a
regulated to a largely unregulated market. The deregulation of key aspects
of the gas industry and the resulting restructuring of the industry
increased the number and complexity of transactions among end- users,
producers, transporters, distributors, and providers of a host of related
services. As such, MMS must determine if the sale of gas by industry
involves an “arm's length” transaction- that is, a sale between
parties that are not affiliated

2 GAO- 01- 101R Natural Gas Royalty Payments

and have opposing financial interests. When such a transaction is found, MMS
accepts the sale price for royalty calculation purposes. If the sale is
“non- arm's length” (i. e., where the parties are affiliated and
have similar financial interests), MMS requires the use of benchmarks, such
as the prices under comparable arm'slength transactions in the OCS field or
area to help establish an “arm's length” price. The volume of
gas produced is measured through metering, and it is generally not an issue
between MMS and industry.

In addition to price, MMS and industry dispute what allowable costs can be
deducted from gross proceeds before royalties are paid. For example, MMS
allows companies to deduct storage costs for up to 30 days. However,
industry generally believes that it should be allowed to deduct all costs
incurred to store gas for future sales. Some of these disputes have been the
subject of litigation.

MMS monitors the accuracy of gas volumes reported by lessees by using its
Production Accounting and Auditing System and monitors the accuracy of
royalty payments through its Auditing and Financial System. Using these
systems and its audit and compliance efforts, the agency has identified and
collected about $2.2 billion in underpayments over the period 1982- 99.

To help resolve these valuation disagreements and avoid continued
litigation, the industry believes that the government should take its
royalty payments in the form of physical gas, or, as it is commonly called,
royalty- in- kind. MMS believes that royaltyin- kind payments can offer a
potential solution to the disputes, but MMS and the industry acknowledge
that these payments are not appropriate in all situations. MMS is currently
pilot- testing the royalty- in- kind program by taking about 10 percent of
the royalties for OCS gas in kind. MMS plans to assess these pilot tests for
potential broader application.

To prepare the information in this report, we interviewed officials from MMS
and relevant states, and representatives from the oil and gas industries. We
also reviewed relevant documents and analyzed data from MMS, the oil and gas
industries, and the Energy Information Administration. We did not verify the
accuracy of the data, but we provided MMS officials, including the Chief,
Royalty Valuation Division, with a draft of this report for review and
comment. We also discussed the report with MMS officials, who agreed with
the report's contents. We conducted our work from June through September
2000 in accordance with generally accepted government auditing standards.

---- Unless you publicly announce its contents earlier, we plan no further
distribution of this report until 7 days after the date of this letter. At
that time, we will send copies to interested Members of Congress and make
copies available to others on request.

3 GAO- 01- 101R Natural Gas Royalty Payments

If you have any questions about this report or need additional information,
please call me at (202) 512- 3841. Major contributors to this report
included Daniel Haas, Godwin Agbara, Paul Lacey, and Philip Farah.

Sincerely yours, Jim Wells Director, Natural Resources

and Environment Enclosure

Enclosure I 4 GAO- 01- 101R Natural Gas Royalty Payments

Briefing on Natural Gas Royalty Payments

Prepared for:

Rep. Carolyn B. Maloney August 25, 2000

Enclosure I 5 GAO- 01- 101R Natural Gas Royalty Payments

Table of Contents Objectives, Scope, and

M h d l Background How MMS Determines and Monitors

OCS Gas Royalty Payments How the Oil and Gas Companies

(L ) Determine Their Gas Royalty P Contentious Issues

What to Do?

Enclosure I 6 GAO- 01- 101R Natural Gas Royalty Payments

Objectives, Scope, and Methodology

Objectives What processes does the Minerals Management

Service (MMS) use to determine and monitor royalty payments on gas produced
from federal leases in the Outer- Continental Shelf (OCS)?

What processes are producing companies using in determining their royalty
payments for gas they produce from federal OCS leases?

Scope Review focuses primarily on federal OCS gas.

Methodology Interviewed officials from MMS, relevant states, and

representatives from the oil and gas industry. Reviewed relevant documents
and analyzed data

from MMS, oil and gas industries, and the Energy Information Administration.

GAO did not verify the accuracy of the data but discussed the contents of
these slides with MMS officials.

Enclosure I 7 GAO- 01- 101R Natural Gas Royalty Payments

Background U. S. Natural Gas Production (1998)

Source: Natural Gas Annual, 1998, EIA.

Enclosure I 8 GAO- 01- 101R Natural Gas Royalty Payments

Background Forecast of U. S. Gas and Crude Oil Production (1998- 2020)

Source: Annual Energy Outlook, 2000, EIA's.

Enclosure I 9 GAO- 01- 101R Natural Gas Royalty Payments

Background

Gas Producers and Pipeline Operators in the OCS

Gas Producers (Operators) 126 companies (operators) produced gas

in the OCS (1999) Top 5 companies produced 35% of OCS

gas Top 10 companies produced 51% of

OCS gas Top 20 companies produced 70% of

OCS gas Pipeline Operators

315 companies operated in the OCS

Enclosure I 10 GAO- 01- 101R Natural Gas Royalty Payments

Background Federal offshore royalties (1990- 99)

Source: Mineral Revenues, 1998 and 1999, MMS.

Enclosure I 11 GAO- 01- 101R Natural Gas Royalty Payments

Background Federal Mineral Royalties (1999)

Source: Mineral Revenues, 1999, MMS.

Enclosure I 12 GAO- 01- 101R Natural Gas Royalty Payments

How MMS Determines and Monitors OCS Gas Royalty Payments

Royalty Formula

Volume x price = gross proceeds

Gross proceeds allowances = net proceeds

Net proceeds x royalty rate = royalty payment

(16. 67%)

Enclosure I 13 GAO- 01- 101R Natural Gas Royalty Payments

Determining Gas Royalties

(continued)

Gross proceeds are overriding principle Volume determined by meter Price

If “arms length,” sales prices generally accepted for royalty
payment purposes

If “non- arms length,” benchmarks apply

Benchmark 1 (gross proceeds based on comparable arms- length transactions in
the area, plant, or nearby plants) Benchmark 2 (any or combination of

gross proceeds, index prices, etc.) Benchmark 3 (Net- back or other

reasonable method)

Enclosure I 14 GAO- 01- 101R Natural Gas Royalty Payments

Determining Gas Royalties

(continued)

Allowances Transportation

Lessee's actual costs to transport production from the lease to the sales
point or point of value determination

Limitation of 50% of value at each sales outlet is allowed (exceptions can
be approved by MMS)

Processing (for gas plant products) Lessee's actual costs, limited to 66.
67%

of tailgate value of each gas plant product (exceptions can be approved by
MMS)

Enclosure I 15 GAO- 01- 101R Natural Gas Royalty Payments

Monitoring Gas Royalties Two systems involved

Production Accounting and Auditing System

Used to monitor the accuracy of gas volumes reported by companies

Auditing and Financial System Used to monitor the accuracy of royalty

payments reported by companies About $2. 2 billion in underpayments

collected (1982 through 1999)

Enclosure I 16 GAO- 01- 101R Natural Gas Royalty Payments

How Oil and Gas Companies (Lessees) Determine Their Gas Royalty Payments
According to industry representatives:

Basically follow MMS' royalty formula Volume x price = Gross proceeds
allowances = net proceeds x royalty

rate = royalty payment Volume is metered Sales price used for “arms
length” Benchmark for “non- arms length” Each company
determines its own

“appropriate” benchmark Companies may use different

benchmarks even if producing in the same lease area

Enclosure I 17 GAO- 01- 101R Natural Gas Royalty Payments

Gas Market Environments Affecting Royalty Determination

Regulated Market

Enclosure I 18 GAO- 01- 101R Natural Gas Royalty Payments

Changing Gas Market Environments Affecting Royalty Determination

Deregulated Market

Enclosure I 19 GAO- 01- 101R Natural Gas Royalty Payments

Contentious Issues Volume mostly a non- issue Valuation

Price Arms length vs. non- arms length Allowances

Marketing costs Storage costs Litigation

Enclosure I 20 GAO- 01- 101R Natural Gas Royalty Payments

What to Do? Proposed negotiated regulations “REG- NEG”

published in 1995 by MMS Based, in part, on indexed pricing Included
representatives of federal

government, states, Indian tribes, and industry

Withdrawn in 1997 (not revenue neutral) Reengineering (MMS)

Will help identify areas of disagreements more expeditiously but not
necessarily resolve them

Enclosure I 21 GAO- 01- 101R Natural Gas Royalty Payments

(141473)

What to Do? (continued)

Industry strongly favors royalty in kind (RIK) (acknowledges that RIK is not
appropriate in all situations)

MMS believes RIK has a potential as a solution but not in all situations

Currently pilot- testing RIK (About 10% OCS gas royalties)
*** End of document ***