Mineral Revenues: Cost and Revenue Information Needed to Compare 
Different Approaches for Collecting Federal Oil and Gas Royalties
(16-APR-04, GAO-04-448).					 
                                                                 
In fiscal year 2003, the federal government collected $5.6	 
billion in royalties from oil and gas production on federal	 
lands. Although most oil and gas companies pay royalties in cash,
the Department of the Interior's Minerals Management Service	 
(MMS) has the option to take a percentage of the oil and gas	 
produced and sell this product-- known as "taking royalties in	 
kind (RIK)." MMS has taken royalties in kind continuously since  
1998 with the goal of achieving administrative savings while	 
maintaining revenue. GAO attempted to (1) quantify the		 
administrative savings that may be attributable to the RIK sales 
and (2) compare the sales revenues from RIK sales to what would  
have been collected in cash royalty payments.			 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-04-448 					        
    ACCNO:   A09805						        
  TITLE:     Mineral Revenues: Cost and Revenue Information Needed to 
Compare Different Approaches for Collecting Federal Oil and Gas  
Royalties							 
     DATE:   04/16/2004 
  SUBJECT:   Administrative costs				 
	     Financial analysis 				 
	     Royalty payments					 
	     Sales						 
	     Comparative analysis				 
	     Cost control					 

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GAO-04-448

United States General Accounting Office

                     GAO Report to Congressional Requesters

April 2004

MINERAL REVENUES

    Cost and Revenue Information Needed to Compare Different Approaches for
                    Collecting Federal Oil and Gas Royalties

                                       a

GAO-04-448

Highlights of GAO-04-448, a report to Representative Nick J. Rahall,
Ranking Minority Member, House Committee on Resources, and Representative
Carolyn B. Maloney

In fiscal year 2003, the federal government collected $5.6 billion in
royalties from oil and gas production on federal lands. Although most oil
and gas companies pay royalties in cash, the Department of the Interior's
Minerals Management Service (MMS) has the option to take a percentage of
the oil and gas produced and sell this product- known as "taking royalties
in kind (RIK)." MMS has taken royalties in kind continuously since 1998
with the goal of achieving administrative savings while maintaining
revenue. GAO attempted to (1) quantify the administrative savings that may
be attributable to the RIK sales and (2) compare the sales revenues from
RIK sales to what would have been collected in cash royalty payments.

GAO reported on MMS's RIK Program in 2003 and recommended that MMS
identify and acquire key information to monitor and evaluate the RIK
Program prior to expanding the program further. While MMS has made some
progress, it has yet to implement these recommendations. Should the
Congress seek more assurance of the level of success of the RIK Program,
it might consider directing MMS to establish a systematic evaluation of
the revenue impacts of all future sales and to quantify overall changes in
the administration of royalty collections. In commenting on the draft
report, Interior generally agreed with GAO's observations.

www.gao.gov/cgi-bin/getrpt?GAO-04-448.

To view the full product, including the scope and methodology, click on
the link above. For more information, contact Jim Wells at (202) 512-3841
or [email protected].

April 2004

MINERAL REVENUES

Cost and Revenue Information Needed to Compare Different Approaches for
Collecting Federal Oil and Gas Royalties

Although data on administrative savings are limited, there are substantial
audit savings attributable to RIK sales, but there are no quantified
savings in the overall administration of royalty collections. MMS has
anticipated savings in auditing and litigation expenses. While MMS data
showed that auditing costs for RIK sales were less than auditing costs for
cash sales on a per lease basis, MMS redirected the resources it saved to
auditing additional leases. At this time, MMS cannot quantify the benefit
from additional auditing. The costs of litigation, which the Solicitor's
Office in the Department of the Interior performs for MMS, are not
tracked. However, officials with the Solicitor's Office were unable to
attribute any savings in litigation to the increased use of RIK and said
that future litigation costs are difficult to predict. Finally, MMS must
weigh these benefits against additional costs required to conduct RIK
sales.

Despite limitations in MMS's analyses and revenue data that prevented a
more comprehensive assessment of all RIK sales, our estimate of the
revenue impacts from RIK sales in three areas indicates a mixed
performance. Specifically, RIK oil sales in Wyoming increased revenues by
2.6 percent, for a gain of $967,000 on sales of $37 million. RIK oil sales
in the Gulf of Mexico decreased revenues by $7.2 million, for a loss of
5.5 percent on sales of $131 million. RIK gas sales in the Gulf increased
revenues by $4 million, for a gain of 2 percent on revenues of $210
million. However, these sales only represent 11 percent of the gas and 57
percent of the oil that MMS took in kind from inception of the pilots
through November 2003. MMS does not analyze all sales because there is no
requirement to do so, staff considers existing information on sales
sufficient, few staff are assigned to analyzing sales, and MMS management
has a lengthy review process for finalizing sales analyses.

Actual and Projected RIK Gas Sales in the Gulf of Mexico

Contents

  Letter

Results in Brief
Background
Savings in Auditing RIK Occur, but Overall Impact on Royalty

Administration Costs Cannot Be Completely Quantified The Revenue Impact of
RIK Sales Is Mixed Conclusions Matters for Congressional Consideration
Agency Comments and Our Evaluation

1 3 4

6 11 20 21 21

Appendixes

Appendix I:

Appendix II: Appendix III:

Objectives, Scope, and MethodologyEUR

Wyoming Oil
Gulf of Mexico Oil
Gulf of Mexico Gas
Other Factors May Affect Revenue Analysis

Comments from the Department of the InteriorEUR

GAO Comments

GAO Contacts and Staff AcknowledgmentsEUR

GAO Contacts
Acknowledgments

23 24 28 30 31

32 36

38 38 38

                               Figures Figure 1:

Figure 2:

Figure 3:

Comparison of Weighted Average Monthly Sales Prices
Obtained from Wyoming Severance Tax Database and
MMS's Financial System for Selected Asphaltic
Properties Subsequently Included in RIK Sales 26
Comparison of Weighted Average Monthly Sales Prices
Obtained from Wyoming Severance Tax Database and
MMS's Financial System for Selected General Sour
Properties Subsequently Included in RIK Sales 27
Comparison of Weighted Average Monthly Sales Prices
Obtained from Wyoming Severance Tax Database and
MMS's Financial System for Selected Sweet Properties
Subsequently Included in RIK Sales 28

Contents

AbbreviationsEUR

ABC activity-based cost
DOE Department of Energy
GAO General Accounting Office
MMBtu one million British thermal units
MMS Minerals Management Service
MOPS Matagorda Offshore Pipeline System
MRM Minerals Revenue Management
NYMEX New York Mercantile Exchange
RIK royalty in kind
SPR Strategic Petroleum Reserve

This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
its entirety without further permission from GAO. However, because this
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copyright holder may be necessary if you wish to reproduce this material
separately.

A

United States General Accounting Office Washington, D.C. 20548

April 16, 2004

The Honorable Nick J. Rahall Ranking Minority Member Committee on
Resources House of Representatives

The Honorable Carolyn B. Maloney House of Representatives

In fiscal year 2003, the Department of the Interior's Minerals Management
Service (MMS) collected about $5.6 billion in royalties from oil and gas
production on federal lands. MMS traditionally accepts the federal
government's oil and gas royalties in cash. Under the Mineral Leasing Act
of 1920 and the Outer Continental Shelf Lands Act, MMS also has the
authority to take a portion of the actual oil and gas produced, referred
to as "taking royalties in kind." MMS then sells this oil and gas to the
highest bidders at competitive auctions. MMS established Royalty-in-Kind
(RIK) pilot sales with the intent of testing whether MMS can (1) decrease
the cost of administering royalties and (2) maintain or increase royalty
revenues. MMS began to evaluate the use of federal royalty oil as an
alternative to cash royalty payments through a series of pilot sales in
Wyoming beginning in 1998. In addition, MMS has conducted pilot sales for
gas and oil in the Gulf of Mexico. We estimate that revenue from RIK pilot
sales was about $682 million in fiscal year 2003. Based on MMS estimates
for further expansion of RIK sales, MMS could be collecting between $1.5
billion and $2.5 billion per year in revenue from RIK pilot sales by 2008.

To address MMS progress toward a more systematic evaluation of MMS's RIK
efforts, you asked us to (1) quantify any savings in administering royalty
collections that are attributable to the RIK pilots and (2) compare sales
revenues from RIK pilots to what would have been collected under cash
royalty payments.

In responding to the objectives, we discussed the RIK sales program with
MMS officials and oil and gas marketers who are active in Wyoming and the
Gulf of Mexico, where MMS has conducted almost all of its RIK pilot sales.
We initially reviewed documents analyzing RIK sales and the costs to
administer these sales. However, we found at the start of our review that
MMS had only released two draft reports that analyzed the impact of RIK
sales, and these reports and other informal studies only addressed the
revenue impacts associated with 9 percent of the royalty oil sold through

July 2002 and about 44 percent of the royalty gas sold through March 2002.
The reports remained in draft until approved by management in March 2004.
While the two studies asserted that RIK sales produce administrative
savings, the studies did not conclusively quantify any savings. Given the
nature of MMS's limited analysis of administrative cost and revenue
impacts, we attempted to address the objectives by acquiring and analyzing
additional MMS data. However, in the course of our analysis, we found that
sufficiently detailed administrative cost information necessary to compare
RIK to cash royalties does not exist, leaving us unable to completely
assess the administrative impacts.

In evaluating the revenue impact of RIK sales, we obtained royalty data
from MMS's financial data system. However, this system was designed to
collect and disburse revenues and not to specifically analyze the revenue
impacts of RIK sales; therefore it was not suitable for doing a
comprehensive evaluation of the RIK sales. In addition, some erroneous and
missing data required time-consuming inspections of the royalty data to
ensure their reliability and integrity. As a result, we were only able to
assess the revenue impacts in case studies representing parts of three RIK
pilot sales areas: Wyoming oil, Gulf of Mexico oil, and Gulf of Mexico
natural gas. The sales we analyzed represented about 57 percent of the
royalty oil and 11 percent of the royalty gas MMS took in kind from
inception of these pilots through November 2003. We performed significance
tests on the results of our case studies and found them to be
statistically significant at the 5 percent level. However, it was not
possible to project the total revenue impact of all the RIK pilot sales
from these case studies because the difference between RIK revenues and
cash royalty revenues can vary greatly over time and because the case
studies are not representative samples of all RIK sales. In addition, we
were unable to obtain data that would have enabled us to measure the
effects of audits on revenues from RIK and cash sales, which adds
uncertainty to our estimates in the case studies. Therefore, we are unable
to determine conclusively how well the RIK pilot sales have done compared
to what would have been expected from cash sales over the long term.

We conducted our work from February 2003 through March 2004 in accordance
with generally accepted government auditing standards. For a more detailed
discussion of the scope and methodology of our review, see appendix I.

Results in Brief	There are substantial administrative savings in auditing
royalty collections that are attributable to the RIK pilots, but there are
no quantified savings in the overall administration of royalty
collections. MMS has stated that the RIK pilots should create savings
primarily by reducing the costs of auditing royalty payments and by
decreasing overall litigation. RIK royalty auditing costs are
substantially less than cash royalty auditing costs on a per-lease basis,
but MMS simply redirected any resources it saved to auditing more cash
payments. Although more audits of these cash payments could result in
higher revenue collections if the audits identified royalty underpayments,
MMS is not currently able to determine this benefit because the auditing
of cash payments takes several years to complete. Similarly, the
Department of the Interior's Solicitor's Office could not identify any
change in the amount of litigation attributable to the RIK pilots or
predict the extent to which RIK would affect its future litigation
workload. MMS did incur other administrative costs under RIK that it would
not have incurred by accepting cash royalty payments. For example, it
incurred $1.7 million in direct costs to conduct the RIK pilot sales
during fiscal year 2003 and one-time costs of $13 million to purchase
information systems that, among other things, were intended to bill,
collect, and report revenues from the RIK pilots.

Our analysis of the revenue impacts from three case studies of RIK pilots
indicated a mixed performance when compared to cash royalty payments.
Specifically, we estimated that (1) RIK sales in Wyoming increased
revenues by about 2.6 percent, for a gain of $967,000 on sales of about
$37 million; (2) a 6-month oil sale in the Gulf of Mexico decreased
revenues by 5.5 percent, for a loss of $7.2 million on sales of about $131
million; and (3) natural gas sales in the Gulf of Mexico increased
revenues by about 2 percent, for an estimated gain of about $4 million on
sales of about $210 million. These sales represented about 11 percent of
the gas and 57 percent of the oil that MMS took in kind from inception of
the pilots through November 2003. Limitations in MMS's data and a lack of
MMS analyses of RIK sales precluded us from comprehensively analyzing the
revenue impact of more RIK sales in a timely manner. Currently, MMS is not
required to analyze sales or document them, the staff responsible for
conducting sales considers the information on sales results sufficient,
few staff are assigned to analyzing sales, and MMS management has not
placed a priority on the time-consuming review of sales results.

In January 2003, we reported to the Congress that MMS had not developed
sufficient management control over its RIK sales, including the collection

of the data necessary to quantify the revenue impacts and the
administrative savings attributable to the RIK program.1 In our report, we
recommended that the Secretary of the Interior instruct the appropriate
managers in MMS to identify and acquire key information to monitor and
evaluate the RIK program prior to expanding the program. We recommended
that such information include the revenue impacts of all RIK sales and the
administrative costs and savings attributable to RIK. MMS generally agreed
with our recommendations and emphasized their current efforts and future
plans to improve the evaluation of RIK. We recognized MMS's progress in
establishing management control and documenting the results of its RIK
sales. However, as RIK sales have continued to grow, it is still difficult
to completely quantify the administrative cost and revenue impact of the
RIK program. As MMS looks to continue to expand the use of RIK, we are
suggesting that if the Congress wants to ensure a systematic and timely
evaluation of RIK efforts, the Congress may want to consider directing MMS
to conduct an evaluation of all future RIK sales and to quantify any
changes in the administrative cost and revenue impact on royalty
collections as a result of RIK.

Background	In general, royalty rates for onshore federal oil and gas
leases are 12-1/2 percent of the value of the oil and the gas produced,
whereas royalty rates for offshore leases are generally 16-2/3 percent.
MMS also administers programs under which royalties are reduced or
suspended to encourage exploration and production. The administration of
cash royalty payments has been challenging for MMS. MMS relies upon
royalty payors to selfreport the amount of oil and gas they produce, the
value of this oil and gas, and the cost of transportation and processing
that they deduct from cash royalty payments. With 22,000 producing leases
and often several companies paying royalties on each lease each month, the
auditing of these cash royalty payments has become a formidable task. In
addition, payors and MMS often disagree over the value of the oil and gas
and the transportation and processing deductions, leading to
time-consuming and costly appeals and litigation for those disagreements
that they cannot resolve. MMS claims that compared to cash royalty
payments, RIK can substantially simplify the administration of royalties
because it reduces these disagreements and the time that MMS must spend
resolving them. While RIK offers the promise of simplified administration,
MMS must also

1U.S. General Accounting Office, Mineral Revenues: A More Systematic
Evaluation of the Royalty-in-Kind Pilots Is Needed, GAO-03-296
(Washington, D.C.: Jan. 9, 2003).

consider the revenue impact of RIK. The Mineral Leasing Act of 1920 and
the Outer Continental Shelf Lands Act authorize taking royalties in kind.
These two acts directed the Secretary of the Interior to obtain fair
market value for the oil and gas taken in kind.2 The Outer Continental
Shelf Lands Act defined "fair market value" as the average unit price for
the mineral sold either from the same lease or, if such sales did not
occur, in the same geographic area. Moreover, the fiscal years 2001
through 2004 Appropriation Acts for Interior and related agencies directed
MMS to collect at least as much revenue from RIK sales as MMS would have
collected from traditional cash royalty payments.

In recent years, MMS conducted three major RIK pilots involving (1) oil in
Wyoming, (2) oil in the Gulf of Mexico, and (3) natural gas in the Gulf of
Mexico. For oil in Wyoming, MMS has taken royalties in kind since October
1998. Although the amount of royalty oil that MMS takes in kind in Wyoming
is less than 1 percent of all federal royalty oil, MMS has gained valuable
experience during these sales. MMS has also taken royalty oil in kind in
the Gulf of Mexico in two 6-month sales between November 2000 and March
2002. Unlike in Wyoming, the amount of royalty oil that MMS took in the
Gulf approached 20 percent of all federal royalty oil during the second
6-month sale from October 2001 through March 2002. MMS's RIK oil pilot in
the Gulf was put on hold when the president directed that MMS use royalty
oil to fill the nearby Strategic Petroleum Reserve (SPR). Finally, for
natural gas in the Gulf of Mexico, MMS has consistently taken natural gas
in kind since December 1998. MMS currently takes about 19 percent of total
federal royalty gas in pilots conducted in the Gulf of Mexico, and this
program continues to grow.

2The Mineral Leasing Act uses the term "market price" not "fair market
value." The requirement to obtain market price does not cover competitive
sales, which by their very nature, provide some protection to the federal
government.

Savings in Auditing RIK Occur, but Overall Impact on Royalty
Administration Costs Cannot Be Completely Quantified

While there are substantial administrative savings in auditing royalty
collections that are attributable to the RIK pilots, there are no
quantified savings in the overall administration of royalty collections.
MMS's overall budget to administer royalties has declined slightly as MMS
increased the use of RIK, but the development of many other changes in
royalty administration during the same time makes it difficult to assess
the relative impact of RIK. MMS only began collecting detailed
administrative cost information starting in fiscal year 2003, so it is not
possible to attribute costs to the different royalty administration
activities before then. MMS's development of a more specific cost
information system in 2003 may help with future impact assessments, but
will not allow any comparison to the past. MMS claims that the
administrative cost savings from using RIK comes primarily from a
reduction in audit and litigation activities that would have occurred
under cash royalty collections. Information collected by MMS starting in
2003 has supported MMS's assertion that RIK pilots can create savings by
reducing the costs of auditing royalty payments. While MMS has redirected
auditing resources it saved to auditing more cash payments, it is not yet
able to determine the benefit of this increased audit effort on overall
royalty collection. Regarding litigation savings, no litigation cost
information has been collected nor have any savings been identified.
Finally, these potential savings must be weighed against additional
specific costs that would otherwise not be incurred under cash royalties,
such as operating costs in fiscal year 2003 of $1.7 million to conduct the
RIK sales. MMS also incurred a capital investment of $13 million to
purchase information systems.

MMS's Budget to Administer Royalty Collections Has Declined Slightly, but
the Impact of RIK Is Not Clear

In October 2001, MMS reorganized and created the Minerals Revenue
Management organization (MRM) within MMS to collect, disburse, and audit
royalty revenues. Since its creation, MRM's budget has declined by about 7
percent, from $86.5 million in fiscal year 2002 to $80.4 million in fiscal
year 2004. Approximately 41 percent of MRM's budget over this period
supported financial management, including the collection and disbursement
of royalty revenues. Nearly all of the remaining 59 percent of the budget
supported compliance asset management, a major function of which is the
auditing of oil and gas royalty revenues. Budget documents indicate that
MRM has maintained about 572 full-time personnel from fiscal years 2002
through 2004, of which 184 were assigned to financial management and 388
were assigned to compliance asset management. An official within the
Department of the Interior added that the actual number of employees on
board was 558 in 2004, with some of this difference due to

a decrease in the number of personnel assigned to compliance asset
management. Within compliance asset management is the RIK Office that
oversees RIK pilot sales, the Small Refiners Program, and the filling of
the SPR.

Other developments in the administration of royalty collection have made
it difficult to attribute changes in the MRM budget to RIK activities.
Whereas RIK sales significantly change the processes for collecting
royalty revenues, other developments, including the substantial change in
the duties of the personnel responsible for auditing oil and gas revenues
and for ensuring compliance with applicable rules and regulations, have
ultimately affected the way MMS deploys its personnel-a major component of
MRM's budget. For example, in June 2000 MMS implemented new oil valuation
regulations that provide more specific guidance on what prices companies
must report to MMS on the sales of oil to their affiliates, and this
should decrease discrepancies between MMS auditors and royalty payors.
Similarly, MMS's increased willingness to write formal agreements on these
prices is also expected to decrease such disagreements. The change in the
way MMS audits oil and gas revenues since its reorganization is also
expected to decrease its workload. For example, MMS auditors no longer
routinely compare all production volumes reported by the operators of oil
and gas leases against all sales volumes reported by royalty payors to
search for possible underpayments. Instead, MMS auditors now perform this
activity on a case-by-case basis as needed. MMS auditors are also
increasingly selecting the property as the entity to audit rather than
selecting an individual company. Finally, when MMS does select a company
to audit, there are fewer companies to select because of the recent
mergers of the large oil and gas companies.

Prior to fiscal year 2003, MMS lacked the necessary data to conclusively
quantify the difference in administrative costs under different royalty
collection methods. Under Interior's agencywide initiative, MMS
implemented an activity-based cost (ABC) management system in fiscal year
2003. The system identifies specific work activities in order to measure
their costs, monitor and evaluate program performance and results, and
improve the way MMS does its work. In essence, MMS personnel record the
hours spent on specific work activities, such as RIK audits, and convert
these hours into labor costs. These labor costs are then added to nonlabor
costs, such as travel and materials costs, to produce total direct costs
for the identified work activities. MMS has captured the costs of the work
activities included in the collection and auditing of royalty revenues
during fiscal year 2003. Such information may help MMS

compare the costs of administering the RIK sales to the costs of
administering cash royalty collections; however, there is no way to make
this comparison prior to fiscal year 2003.

RIK Reduces Audit Costs, But Overall Impact on Royalty Collection Is Not
Quantified

According to MMS, the auditing and compliance effort is significantly
reduced under RIK because MMS and the RIK purchaser agree to a contractual
price before the sale and because transportation deductions are no longer
an issue when MMS sells the oil or gas at the lease. MMS further explained
that auditing RIK leases can be done within as little as 120 days after
the sale because it has all the necessary price information at that time,
while up to 3 years transpire before MMS initiates an audit of cash
royalty payments. During such cash royalty audits, MMS personnel must
physically collect and inspect collaborative pricing and transportation
documents, often at the payors' offices, while similar pricing information
for RIK sales is instantly available in MMS's information systems.

The data from MMS's newly implemented ABC management system does support
MMS's assertion that the auditing of certain RIK sales revenues is less
costly on a per-lease basis than the auditing of comparable cash royalty
payments. A review of the auditing and compliance costs for oil and gas
leases in the Gulf of Mexico and Wyoming-two locations in which MMS
received both cash and in-kind royalty payments during fiscal year 2003-
showed that the costs to audit cash sales per lease were substantially
higher than the costs to audit in-kind royalties in both areas. In the
Gulf of Mexico, MMS reported spending $6,765,000 to audit cash sales from
242 oil and gas leases, or $27,956 per lease, while spending $458,000 to
audit all 297 gas leases included in the RIK pilot sales, or $1,542 per
lease. Similarly, MMS reported spending $820,000 to audit cash royalties
from 912 oil and gas leases in Wyoming, or $899 per lease, while spending
$38,000 to audit all 580 RIK oil leases in Wyoming, or $66 per lease.

While the ABC data suggest that the auditing costs for RIK sales revenues
are less than the auditing costs for cash royalty payments, this
difference does not necessarily mean that MMS is spending less money as it
moves more leases into its RIK sales. MMS explained that instead of
decreasing its audit budget, it has used these freed-up resources to audit
additional cash royalty payments that it would not have otherwise audited.
In addition, MMS has stated that auditing additional cash royalty payments
could result in the collection of additional revenues. For fiscal year
2000, the latest year for which audit data are available, MMS reported
that its audit activities, together with state and tribal audits of
federal royalty revenues, generated

about $219 million (or 5 percent) on royalty revenues of about $4.6
billion. However, MMS will not know the results of auditing additional
cash royalty payments for several years because it takes time to select
leases for audit, conduct the audits, and resolve related appeals and
litigation. In the future, it is possible that MMS may experience
different rates of revenue increase, either upwards or downwards, as it
expands its audit coverage because of the different leases it selects for
audit.

Litigation Costs Are Not Tracked

MMS's new ABC system provided costs associated with taking royalties in
kind during fiscal year 2003, but it did not capture the costs associated
with specific types of litigation performed by others for MMS. Litigation
sometimes arises after MMS or state and tribal auditing efforts identify a
discrepancy that cannot be resolved by MMS and the payors. Such
discrepancies commonly involve the value of oil and gas or the costs of
transporting this oil and gas to market. MMS has maintained that the
taking of royalties in kind reduces litigation. However, the savings that
could result from avoiding litigation cannot be quantified by MMS because
MMS does not conduct the litigation. Instead MMS relies primarily upon the
Department of the Interior's Solicitor's Office, which does not track
specific types of litigation costs for MMS. Officials in the Solicitor's
Office reported that since fiscal year 1999, between two and four of their
attorneys worked full-time on MMS royalty issues. In addition, these
officials said that attorneys within the Department of Justice represent
MMS in court. Officials in the Solicitor's Office could not attribute any
decrease in litigation to an increase in the use of RIK. They also stated
that the nature of the royalty litigation could change as a result of RIK;
while litigation over valuation and transportation deductions may
decrease, litigation over RIK contracts and discrepancies over volumes
sold may increase. They also cautioned that future litigation over
administrative decisions and rule making is impossible to predict.
Finally, regardless of the volume of RIK sales, they cautioned that as
long as MMS receives some cash royalty payments, there would always be the
potential for litigation on valuation issues and transportation
allowances.

RIK Sales Require The administration of the RIK pilot sales includes
additional activities that Additional Costs Not are not necessary when
accepting cash royalty payments and therefore add Incurred When Collecting
to the cost of collecting royalties in kind. Such activities include
identifying

properties from which to sell oil and gas, calculating minimum
acceptableCash Royalties bids, awarding and monitoring contracts, billing
purchasers, negotiating transportation rates, and reconciling
discrepancies in volumes. In fiscal

year 2003, MMS's preliminary ABC data showed direct costs of $1.7 million
to conduct activities for the RIK pilot sales that it would not have
incurred had it accepted cash royalty payments.3 Of this $1.7 million, MMS
reportedly spent $475,000 to identify properties, calculate minimum
acceptable bids, and conduct sales; $464,000 to market the royalty oil and
gas; $176,000 to monitor the credit worthiness of purchasers; $496,000 for
auditing leases and reconciling volumes; and $127,000 for policy
compliance and legal support.

MMS also incurred one-time costs of more than $13 million to acquire three
information systems, part of whose functions are to bill, collect, and
report on revenues from the RIK pilots. When fully implemented, these
systems may help address the management control weakness that we
previously identified involving the manual entry of data into unlinked
computer spreadsheets.4 The first of these systems, the gas information
system, is wholly dedicated to the administration of the RIK gas pilot
sales and cost $7.3 million. Implemented in January 2003, the system
automates the billing, collecting, and reporting functions. MMS's second
system, the liquids information system, cost almost $5 million and was
implemented in June 2003. Like the gas system, it is designed to automate
the billing, collecting, and reporting functions, but unlike the gas
system it is not wholly dedicated to the RIK pilot sales, but also
supports the Small Refiners Program and the filling of the SPR. MMS's
third system, the Risk and Performance Management System, cost about $0.9
million and is designed to measure the results of the RIK gas sales and
the Small Refiners Program for periods during 2003. In addition, MMS's
preliminary ABC data shows that MMS incurred direct costs of $682,000 in
fiscal year 2003 to develop and maintain these information systems. MMS
will also incur additional costs in future years to operate and maintain
these systems.

3We relied upon the direct costs identified by MMS-costs that MMS defines
as directly supporting its mission. We regarded the RIK direct costs as
being most indicative of the incremental costs to administer the RIK
pilots. We did not analyze indirect costs-those costs that MMS defines as
sustaining the organization, normally referred to as overhead, including
information technology support, general management, and general
administrative support. Indirect costs are allocated back to the
mission-supporting activities based on the ratio of the labor cost
contained in each direct work activity to the total labor cost in all
direct work activities.

4U.S. General Accounting Office, Mineral Revenues: A More Systematic
Evaluation of the Royalty-in-Kind Pilots is Needed, GAO-03-296
(Washington, D. C.: Jan. 9, 2003).

The Revenue Impact of RIK Sales Is Mixed

Our analysis of sales in three RIK pilots indicates a mixed performance
when comparing RIK sales revenue to what might have been collected under
cash royalty payments. Specifically, (1) RIK sales in Wyoming increased
revenues by about 2.6 percent, for an estimated gain of $967,000 on sales
of about $37 million; (2) a 6-month oil sale in the Gulf of Mexico
decreased revenues by 5.5 percent, for an estimated loss of $7.2 million
on sales of about $131 million; and (3) natural gas sales in the Gulf of
Mexico produced more revenues than would have been collected from cash
royalty payments-an increase of about 2 percent, for an estimated gain of
$4 million on revenues of $210 million. These sales represented about 11
percent of the gas and 57 percent of the oil that MMS took in kind from
inception of the pilots through November 2003. Our attempts to review the
revenue impact of more RIK sales were precluded by specific limitations in
MMS financial data and the availability of only two independent MMS draft
reports.5 As we observed in our January 2003 report, MMS continues to
expand its RIK pilots without analyzing and documenting the revenue
impacts of all its RIK sales. MMS is making some progress in this area,
but still has not demonstrated that it has received fair market value, or
at least as much as it would have received in cash royalty payments.

RIK Oil Sales in Wyoming Increased Revenues by About 2.6 Percent

MMS chose to conduct its first RIK oil sales in Wyoming because of the
state's active oil markets and the cooperative spirit of state officials.
MMS offered for sale the federal government's royalty share of oil
together with the state of Wyoming's royalty oil that was for 6-month
periods beginning in October 1998.6 Bidders offered a fixed amount of
money either more or less than published market prices, such as Wyoming
posted prices, Canadian posted prices, and the oil futures contract on the
New York Mercantile Exchange (NYMEX). 7 The winning bidders, which
included companies that

5Staff independent of the MMS RIK sales staff conducted draft studies for
18 months of the Wyoming oil sales and 19 months of the Gulf of Mexico gas
sales. See Wyoming Oil Royalty In Kind Pilot, Evaluation Report (June 1,
2002) and Texas General Land Office/Minerals Management Service 8(g) Gas
Royalty In Kind Pilot, A Report (March 27, 2002).

6Wyoming participated in all but the first 6-month sale.

7A NYMEX futures contract is an agreement through the New York Mercantile
Exchange for a future purchase or sale of 1,000 barrels of sweet crude
oil, similar in quality to West Texas Intermediate oil. While most NYMEX
contracts result in a financial gain or loss, rather than the delivery and
receipt of oil, parties to the agreement can exchange oil at Cushing,
Oklahoma, where several oil pipelines intersect and where storage
facilities exist.

market, refine, transport and/or produce oil in Wyoming and adjacent
states, accepted delivery of the oil at the lease. Although MMS's RIK
sales in Wyoming accounted for only about 1 percent of total federal
royalty oil, MMS acquired significant knowledge on how to conduct sales
and market oil onshore. For example, MMS determined that companies more
commonly bid on royalty oil from properties that are connected to
pipelines and prefer flexibility in choosing a specific price upon which
to base their bid. In addition, MMS learned in 2002 that it was not
profitable to transport the volumes from many scattered leases to one
central location for sale.

In a draft report issued in March 2001, updated in June 2002, and
finalized in March 2004, MMS estimated that it received slightly more
revenue in its first three RIK sales than it would have received in cash
royalty payments. Specifically, MMS reported that it collected $810,000
more from RIK sales than it would have received in cash royalty payments,
or an increase of about 2.9 percent on sales of $27.66 million from
October 1998 through March 2000. MMS based its conclusion on a comparison
of winning RIK bids to severance taxes that producers reported and paid to
the state of Wyoming. State severance taxes are calculated as a percentage
of the value of all oil that companies sell, regardless of whether the oil
is produced from federal, state, or private lands. Because the state of
Wyoming's oil valuation statutes are similar to how the federal government
values oil, MMS assumed that the price that companies reported for state
severance taxes on RIK properties was equal to the price that the
government would have received in cash royalty payments. However, MMS did
not demonstrate that the average sales prices for cash royalty payments
were equal to the average sales prices used to calculate Wyoming severance
taxes, initially creating some uncertainty about MMS's revenue
calculations.

To address the uncertainty in MMS's assumption about the relationship
between cash royalty payments and severance tax prices, we analyzed the
relationship. For nine federal properties8 that accounted for about 47
percent of the oil that MMS sold in Wyoming during the first seven RIK
sales, we compared Wyoming severance tax data with MMS's financial data
for the 33-month period prior to the RIK sales and concluded that Wyoming
severance tax prices are a reasonable proxy for cash royalty payments.
Therefore, based on Wyoming severance tax data, we estimated that MMS

8Properties consist of one or more leases. In Wyoming, producing
properties often contain more than one contiguous lease.

collected $967,000 more from the RIK sales from October 1998 through March
2002 than it would have collected in cash royalty payments-an increase of
about 2.6 percent on sales of about $37 million. The results of our
analysis of selected Wyoming RIK sales are consistent with MMS's
conclusion that the RIK sales that it analyzed resulted in slightly more
revenue that it would have realized if it had accepted cash royalty
payments. A more detailed discussion of our analysis appears in appendix
I.

Six Months of RIK Oil Sales in the Gulf of Mexico Decreased Revenues by
About 5.5 Percent, But Long Term Impacts Could Differ

Although MMS has a long-standing history of selling royalty oil through
the Small Refiners Program, MMS did not sell offshore royalty oil directly
to other qualified purchasers until November 2000. MMS sold, through two
separate 6-month sales, up to 20 percent of the federal government's
royalty share of oil in the offshore Gulf of Mexico to all purchasers
meeting predetermined financial qualifications, whether they were small
refiners, large refiners, producers, or marketers.9 Winning bidders
offered a fixed amount of money that was more than or less than a formula
based on one of two widely published oil prices-Koch's published price for
West Texas Intermediate oil in the first sale and the NYMEX futures
contract in the second sale. During the first sale, MMS offered about
39,000 barrels of oil per day, but awarded contracts for only about 7,600
barrels per day. Only two companies submitted bids. MMS attributed the
lack of interest to the delivery points for the oil being at market
centers onshore rather than offshore near the lease. During the second
sale, which commenced in October 2001, MMS offered and awarded
approximately 48,000 barrels of oil from six major pipeline systems.
Nearly all of the oil consisted of two types, referred to as the Mars and
Eugene grades, produced in water depths up to about 4,000 feet. The
delivery point for the oil was offshore near the lease, and competition
was robust. MMS terminated the Gulf RIK oil pilots after the second sale
when ordered by a Presidential directive to transfer oil from these
properties to the SPR.

As of July 2003, MMS had not evaluated the revenue impacts of either sale.
Because of the larger amount of oil sold during the second sale, we chose
to analyze this sale and estimated that MMS received about $7.2 million
less in revenues than it would have received had it accepted cash royalty
payments-a 5.5 percent loss on sales of about $131 million. We selected 13

9The first sale was automatically extended for another 5 months.

of the 26 leases included in the second sale that collectively accounted
for about 89 percent of the oil offered and sold. For the 16-month period
prior to the start of the second oil sale, we compared the average monthly
sales price for oil from each lease to the price as prescribed by MMS's
oil valuation regulations for sales between affiliated parties
(transactions not at arm's-length).10 We then computed a weighted average
difference in the monthly prices for the entire 16-month period and
assumed that this weighted average difference would have persisted over
the 6-month RIK sales period had royalties been paid in cash. A detailed
explanation of our analysis appears in appendix I.

Because revenue from RIK sales and from cash sales can differ considerably
in any given month, a longer period of evaluation is needed to determine
whether a specific type of RIK sales can generate at least as much royalty
revenue as cash sales. The reason that RIK and cash sales revenues differ
month to month is that they are generally based on different sets of
market prices. For example, the formula that MMS used to award RIK bids in
the second Gulf of Mexico sale differs from the formula prescribed in the
oil valuation regulations primarily in two ways: (1) the bidding formula
relies on prices from a period that is almost a month earlier than that
prescribed by the oil valuation regulations, thereby creating a timing
difference and (2) the bidding formula relied on an adjustment to NYMEX
futures price, referred to as "the roll." The roll is an adjustment that
compensates for differences in oil futures prices for subsequent months.
If futures prices for the next three trade months trend downward, the roll
is a positive adjustment. If futures prices trend upward for the next
three trade months, the roll is a negative number. Rising oil futures
prices that accompanied uncertainty in the financial markets after the
September 11 terrorist attacks resulted in generally lower-thananticipated
RIK royalties caused by the timing differential and a negative roll,
thereby contributing significantly to the negative performance of the
second sale.

MMS officials agree that a 6-month term is an insufficient period of time
during which to evaluate a sales methodology. Specifically, MMS added that
it had intended to continue the oil sales in the Gulf of Mexico but that
the President directed that royalty oil be used to fill the SPR, and
royalty oil

10We chose MMS's valuation regulations for transactions not at
arm's-length for comparison because these regulations rely upon readily
available published oil prices at market centers through which the oil
must flow.

from the leases included in the pilot sales was the only feasible source.
Although MMS generally agrees with the magnitude of the revenue impact
that we identified during the 6-month period of the second sale, MMS
believes that we should have examined a longer period of time, even though
the oil that was sold during this sale was thereafter transferred to the
SPR. After learning of our analysis, MMS conducted its own evaluation of
many of the same leases. MMS combined the results of the 6-month second
sale with the following 12 months during which oil from these same leases
was transferred to the SPR. MMS estimated that during this combined
18-month period, its sales methodology increased revenues by $4.9 million.
This estimate, however, does not mean that MMS collected $4.9 million more
than it would have collected in cash royalty payments. MMS's estimate is
based on combining cash collections from RIK sales in the first 6 months
with market index prices at the time that MMS transferred the oil to the
Department of Energy (DOE) for filling of the SPR. MMS estimated that it
lost $6 million in cash during the first six months and that the value of
the oil transferred to DOE was $10.9 million more than it would have
received in cash royalties had the RIK pilot sales continued for the next
12 months.

We do not believe that MMS's evaluation of the SPR program is necessarily
indicative of how the RIK program would have performed had it been allowed
to continue. The SPR program does not generate royalty income for the
federal government in the same way as the RIK program does. In the SPR
program, the royalty oil, or an equivalent amount from another source, is
pumped into the reserve, and revenues will only be generated upon its
removal and sale at some unspecified period in the future. In addition,
the data that MMS used in estimating the revenue impacts of its Gulf of
Mexico oil sales was problematic in several ways. First and most
important, MMS did not adjust its revenue estimate by quality bank
adjustments. Quality bank adjustments are either positive or negative
adjustments to sales revenues that pipeline companies compute because the
royalty oil is of either better or worse quality than the average quality
of oil in the pipeline. Payors either add or subtract these adjustments
from both their cash and in-kind royalty payments to MMS. Quality bank
adjustments can be substantial-during the second RIK sale, they lowered
MMS's revenues on the leases we examined by $2.5 million. Second, MMS did
not use the actual transfer volumes to the SPR in its financial database,
opting instead to use volumes recorded in its production database or to
use estimates of these volumes, adding uncertainty to the accuracy of its
revenue calculations. For example, we examined the production volumes for
8 of the 13 leases we reviewed during the 6-month sale and found
significant discrepancies

between these volumes and the volumes in its financial database.
Similarly, independent auditors performing an audit of MMS's fiscal year
2002 financial statements noted that MMS's use of estimated volumes did
not ensure an accurate calculation of the SPR amounts transferred to DOE.
Third, we identified some minor discrepancies in the prices MMS used to
calculate the value of the SPR transfers, such as using an index other
than that used during the 6-month sale and assuming that companies bid
exactly the same on the SPR transfers as they did in the 6-month sale, but
it is unclear as to whether these discrepancies would significantly alter
MMS's calculations.

Sales of Royalty Gas from Two Pipelines in the Gulf of Mexico Generated
Higher Revenues Than Would Have Been Expected from Cash Royalties

After initial experimentation with selling royalty gas in 1995 and
simultaneously with the contracting of gas marketers in 1999, MMS
established sales procedures for offshore royalty gas similar to those in
2003. Beginning in June 1999, MMS tested the sale of offshore royalty gas
from 11 federal offshore leases. Production from these leases flowed
through the Matagorda Offshore Pipeline System or through the Blessing
Pipeline System.11 MMS entered a cooperative agreement with the Texas
General Land Office to conduct the RIK sales because under section 8(g) of
the Outer Continental Shelf Lands Act, royalty revenues for federal leases
located in coastal waters are to be shared with the state. MMS sold the
royalty gas for 1-month periods at competitive auctions, during which
purchasers who met minimum financial qualifications bid an increment or
decrement relative to applicable published gas indexes. Several months
into the pilot, MMS started dividing the gas into two separate packages-a
larger package (base volume), for which MMS guaranteed that it would
deliver the specified volume at a fixed first-of-the-month price, and a
smaller package (swing volume), for which MMS did not guarantee the volume
delivered and which MMS offered at published prices that varied daily.
Beginning in 2000, MMS began combining its monthly gas sales into two
sales periods for administrative reasons. MMS now conducts gas sales for
delivery from April through October, corresponding to the period during
which natural gas is used extensively for air conditioning, and for
delivery from November through March, corresponding to the period during
which natural gas is used extensively for heating.

11Although not technically named the Blessing Pipeline System, GAO and MMS
refer to it by this name because the pipelines terminate at a gas plant in
Blessing County, Texas.

In accordance with its cooperative agreement with the Texas General Land
Office, MMS issued a draft report in March 2002 on the analysis of its gas
sales from the Blessing and the Matagorda Offshore Pipeline Systems from
June 1999 through December 2000. The report stated that the RIK sales
increased revenues by nearly $1 million over what it would have collected
in cash royalties-an increase of about 1 percent on sales of almost $100
million. MMS obtained this estimate by comparing RIK sales revenues to
cash royalty sales from 18 other leases located in the same geographic
area. However, because of limitations with its financial data, MMS did not
subtract the costs of transporting the gas to its sales points onshore,
comparing gross unit prices rather than prices net of transportation
allowances.

After reviewing MMS's study and conducting our own analysis, we reached
conclusions similar to those of MMS-that revenues from the sale of RIK gas
from the Blessing and Matagorda Offshore Pipeline Systems were higher than
MMS would have received in cash royalty payments. We included additional
RIK leases in our analysis, excluded some cash royalty payments that MMS
later identified as not coming from leases on the same pipeline systems,
and extended the time frame of our study to December 2001. We estimated
that, including the cost to transport the RIK gas to its onshore sales
points, revenues were increased by about 2 percent. Hence, we estimate
that MMS realized about $4 million more than it would have collected in
cash royalties, or a gain of about 2 percent on sales of about $210
million. A more detailed description of our analysis appears in appendix
I.

Data Limitations Prevent a More Comprehensive Analysis of RIK Sales

In analyzing RIK sales, we identified specific limitations in MMS's
financial data that inhibited our analysis and precluded us from
conducting a comprehensive computer-based assessment of all RIK sales. A
small amount of erroneous, missing, and improperly coded financial data,
together with other anomalous but legitimate financial data, required
timeconsuming inspections of these data and complex edit checks to ensure
data reliability and integrity. For example, in our analysis of the three
RIK pilot sales, we analyzed almost 60,000 financial transactions,
followed at times by a line-by-line inspection of some of these data,
discussions with MMS personnel, and manual checks of source documents. MMS
staff confirmed that the financial data in their raw form were unreliable
in assessing program performance; in some instances, MMS staff chose to
use contract prices or production volumes in lieu of the financial data
because they lacked confidence in the available financial data. In
addition, the lack

of a systematic method to electronically combine data in its financial
database with well, pipeline, product quality, and market center data also
prevented us from analyzing the revenue impacts of all offshore RIK sales.
Although MMS obtains and records these data for individual properties
included in its RIK sales, MMS personnel must manually obtain these data
for each property through time-consuming phone calls and searches of
industry databases. According to its procedures, MMS performs these data
collection efforts each time it expands the RIK program into new areas.
However, MMS's unsystematic collection and recording of these data may
slow the development of benchmarks against which to compare RIK sales in
the future.

In 2001, MMS took steps to improve its collection and management of
royalty data and to develop the means to identify and correct erroneous
financial data. For example, MMS began to develop a more consistent coding
of RIK transactions, and MMS personnel in the RIK Office began to take a
more active role in entering RIK transactions for the purpose of ensuring
data reliability. In October 2001, MMS revised its electronic form for
collecting royalty data in an attempt to correct erroneous data. More
recently, MMS sought external assistance in developing software to
identify erroneous data that can then be corrected or eliminated. While
some of the data problems may have been resolved by MMS, other problems
continue to be evident. Specifically, the misallocation of SPR volumes to
some individual leases and the aggregating of sales from multiple gas
leases will continue to complicate future analyses unless these problems
are corrected. MMS says that it plans to correct these deficiencies as it
further refines its newly acquired oil and gas information systems. See
appendix I for more detailed information on data problems.

Lacking Formal Requirements, Many RIK Sales Remain Unanalyzed

Our ability to assess the revenue impact of RIK sales was further limited
by the failure of MMS to analyze and document the results of its sales. We
reported in January 2003 that MMS quantified the revenue impacts of only 9
percent of the 15.8 million barrels of federal royalty oil that it sold
from October 1998 through July 2002 and about 44 percent of the 241
billion cubic feet of federal royalty gas that it sold from December 1998
through March 2002. MMS has since sold an additional 201 billion cubic
feet of gas in the Gulf of Mexico and an additional 1.4 million barrels of
oil in Wyoming through November 2003, but has not published an analysis of
the revenue impacts of these sales. In total, we estimate that MMS has
analyzed only 8 percent of the 17.2 million barrels of royalty oil and 24
percent of the 442 billion cubic feet of royalty gas sold during RIK pilot
sales through

November 2003. This limited analysis of revenue impacts could be a
significant issue as RIK sales expand in the future. Based on MMS's
estimates for further expansion of the program, we estimate that MMS could
be collecting between $1.5 billion and $2.5 billion per year in revenue
from the RIK pilot sales by 2008.

MMS has not systematically analyzed and documented the results of all its
RIK sales for four main reasons. The first and most significant reason is
that MMS has no requirement that all sales results be analyzed and
documented. Although the Congress directs MMS to (1) obtain fair market
value and (2) collect at least as much revenue from the RIK sales as MMS
would have collected from traditional cash royalty payments, MMS is not
required to document how this directive is met. While MMS does analyze
factors that will affect the revenues of upcoming sales, MMS lacks a
systematic process for analyzing the final results of each of its sales.
Second, staff responsible for conducting sales already believe that they
have enough information on sales results. For example, MMS staff cited the
second 6-month oil sale in the Gulf of Mexico in which market conditions
unexpectedly moved in a manner that resulted in revenue collections that
were less for this period than what would have been expected from cash
royalty collections. MMS stated that they had enough information on the
market conditions that drove the sales results even before completion of
the 6-month sale. Third, insufficient staff is available for analyzing
sales. We observed that staff who conduct sales are busy with identifying
properties for inclusion in sales, establishing minimum acceptable bids,
evaluating bids, and expanding the program. MMS has only one staff member
independent of the RIK Program whose duties involve selectively analyzing
RIK sales results at the direction of MMS management. To ensure proper
management control and to remove the appearance of a conflict of interest,
it is best to segregate the responsibility of a program's operation from
the responsibility of reviewing the program, which MMS correctly did when
it reviewed the Wyoming oil and the Gulf of Mexico gas sales. Fourth, a
lengthy management review process limits the usefulness of analyses that
are conducted. For example, MMS's report on the Wyoming pilot sales dated
March 2001 and its report on gas sales in the Gulf of Mexico dated March
2002 remained in draft form pending final management approval until March
2004. In addition, a study of subsequent gas sales in the Gulf of Mexico,
completed in April 2003, is still being reviewed and modified under the
direction of MMS management.

MMS Has Recently Taken Steps to Address Deficiencies in Analyzing Sales
Results and Quantifying Administrative Efficiency

Since our last report, MMS has hired an industry consulting group to
develop a strategic plan to guide the transition of the RIK pilots through
the end of 2008. MMS intends to develop a 5-year business plan based
largely upon the consulting group's plan. The consulting group, among
other things, has proposed that MMS (1) develop benchmarks that are
indicative of fair market value; (2) develop a consistent process for
monitoring RIK sales at regular time periods against these benchmarks; (3)
develop a consistent process for deciding whether to accept cash royalty
payments or to take RIK; (4) track administrative efficiency expressed as
the cost per unit of royalty oil and gas sold; and (5) measure the amount
of time it takes to collect, report, audit, and reconcile RIK revenue
collections. The consulting group intends that the benchmarks satisfy
MMS's congressional mandates that RIK sales achieve fair market value and
generate at least what would have been collected in cash royalty payments.
The consulting group has developed a timetable for MMS to develop
benchmarks for fair market value by March 2004 and benchmarks for
administrative efficiency by March 2005.

While much of the data collection for developing benchmarks will remain a
manual process, MMS anticipates that overall calculation of RIK Program
performance will be facilitated by MMS's newly acquired RIK information
systems. MMS stated that while data on RIK sales are available in less
than 30 days after the sales month, RIK purchasers continue to submit data
on quality adjustments and volume imbalances after these sales, and MMS
must enter these data into its financial systems and audit the final
figures. MMS believes that 120 days after an RIK sale, it will have
completed these audits and has set this 120-day period as a formal
objective. Within 180 days, MMS stated that it would be able to report on
the results of these sales. However, many RIK sales only have a length of
about 180 days or less, so obtaining performance results 180 days after a
sale is not timely enough to use these results to modify the next sale.
Recognizing this limitation, the consulting group recommended that
performance be measured on a monthly or quarterly basis, and MMS believes
this will be possible with its newly acquired RIK information systems.

Conclusions	RIK can be an important tool for managing the collection of
royalty revenues from federal oil and gas leases. In light of the
possibility of revenue collections from RIK sales approaching $1.5 billion
to $2.5 billion by 2008, it is important that MMS measure and document the
revenue impact and costs of administering RIK relative to cash royalty
payments, to

ensure itself and the public that royalties are collected in the most
efficient manner. In doing so, MMS may be able to conclusively show that
it has reduced overall administrative costs or collected more than
traditional cash royalty payments. MMS has made some progress in analyzing
the revenue impacts of some of its sales, but many sales remain
unanalyzed, and MMS has yet to implement a more systematic and timely
approach to analyzing these sales. Also, completely quantifying the
administrative efficiency of these RIK sales continues to be a challenge.
While key data from MMS's new activity-based cost management system have
shed some light on the difference in costs to administer RIK and cash
royalties, MMS has been unable to quantify any overall benefit that may
arise from shifting resources to auditing more cash royalty payments and
from changes in litigation due to RIK. Unless steps are taken to quantify
the impacts of these changes, MMS and the Congress will be unable to
determine the efficiency of RIK. Because MMS has not systematically
assessed and documented the overall administrative cost and revenue
impacts of many RIK sales, knowledge of MMS's RIK Program is insufficient
to determine whether MMS should expand or contract the use of RIK.

Matters for Should the Congress seek a more systematic and timely
evaluation of RIK

efforts, the Congress may want to consider directing MMS to implement
aCongressional systematic process for evaluating all future RIK sales in a
timely manner Consideration and to quantify any changes in the
administrative cost and revenue impact

on royalty collections as a result of RIK.

Agency Comments and 	We provided the Department of the Interior with a
draft of this report for review and comment. Interior generally agreed
with our observations and

Our Evaluation	emphasized the steps that they are taking to improve their
measurement of RIK sales performance. Interior said that the insights and
conclusions contained in the report are timely and will be valuable in
their efforts to improve the RIK Program. Their comments and our response
to these comments are reproduced in appendix II.

As agreed with your offices, and unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days from
the date of this letter. At that time, we will send copies of this report
to the Secretary of the Interior; the Director of the Office of Management
and Budget; and other interested parties. We will also make copies
available to

others upon request. This report will be available at no charge on GAO's
Web site at http://www.gao.gov.

If you have any questions about this report, please call Mark Gaffigan or
me at (202) 512-3841. Key contributors to this report are listed in
appendix III.

Jim Wells Director, Natural Resources and Environment

Appendix I

                       Objectives, Scope, and Methodology

To determine the administrative cost savings associated with RIK, we first
examined MMS's two draft studies on RIK sales-Wyoming Oil Royalty In Kind
Pilot, Evaluation Report (June 1, 2002) and Texas General Land
Office/Minerals Management Service 8(g) Gas Royalty In-Kind Pilot, A
Report (March 27, 2002). We reviewed MMS's logic and assumptions in these
reports concerning the quantification of administrative savings and
benefits attributable to RIK. We used the data in these reports, MMS's
budgetary data, and testimonial evidence from MMS officials to identify
which aspects of administrative savings and benefits to investigate. We
then obtained data from the activity-based cost (ABC) management system
for the entire fiscal year 2003 and solicited MMS's assistance in
understanding the individual activities and in identifying which direct
costs were attributable to RIK sales and which were attributable to cash
royalty collections. We also obtained one-time expenditures for MMS's new
information systems from MMS officials and supporting documentation since
not all of these costs were reflected in the fiscal year 2003 ABC data. To
calculate costs for auditing cash royalty payments and RIK sales revenue
on a per-lease basis, we used ABC data, together with the numbers of the
different types of leases that MMS audited in fiscal year 2003, as
supplied by MMS. We obtained data on additional royalty revenue obtained
through auditing and compliance activities from MMS's report entitled

Report of Royalty Management and Delinquent Account Collection Activities,
Fiscal Year 2000. We interviewed MMS personnel on the costs of appeals,
and we interviewed attorneys in the Department of the Interior's
Solicitor's Office to obtain information on the impact of RIK sales on
litigation. Finally, we audited revenue from all RIK sales during fiscal
year 2002 to determine the benefit of early collections.

To evaluate all of MMS's RIK pilot sales, we planned to compare RIK sales
revenues with cash royalties from comparable federal leases. We started
with sales in the Gulf of Mexico by attempting to identify comparable
leases through the electronic matching of attributes, such as type of oil,
sulfur content, market center, well location, pipeline available for
shipment, and distance to the nearest market center. To do so necessitated
combining data on these attributes in MMS's offshore geographic
information system with data on sales values, sales volumes, royalty
values, royalty volumes, transportation deductions, and quality bank
adjustments in MMS's financial system. We examined data from January 1997
through July 2003, but we did not independently verify the integrity of
MMS's financial database. Unfortunately, we could not perform the intended
analysis because of two reasons: (1) we were unable to link the data in
the financial system with data in the offshore geographic

               Appendix IEURObjectives, Scope, and MethodologyEUR

information system, and (2) we identified many data anomalies in MMS's
financial database. We were unable to link the financial data with data in
the offshore geographic information system because the common link-the
lease number-had been compromised during some RIK gas sales. Specifically,
MMS personnel who entered these data had combined RIK sales revenue from
multiple leases and entered these data under a new lease number referred
to as a "dummy lease number." We also found that some data that would be
helpful in identifying comparable oil leases, such as the quality of oil
and the sulfur content, were not present in MMS's geographic information
system. Upon examination of the financial data, we discovered many data
anomalies that prevented us from reliably and easily aggregating the
monthly transactions to the same lease and payor. Within the data
aggregated to the month-lease-payor level, anomalies included negative
sales volumes, missing sales values, negative sales values, and missing
quality measures for gas prior to fiscal year 2002. Some of these
anomalies were obvious errors, but many more appeared to be correct and
legitimate data entries. With no explanations in the financial data
documentation to indicate which anomalies were accurate and which were
not, resolving the anomalies required line-by-line inspection of the data
and, in some cases, manual checks with other documentation. As a result of
the large number of data anomalies and the time-consuming process required
to correct and verify the royalty data, we undertook case studies of MMS's
RIK pilots in three sales areas: (1) RIK oil sales in Wyoming, (2) RIK oil
sales in the Gulf of Mexico, and (3) RIK gas sales on two pipelines in the
Gulf of Mexico.

Wyoming Oil	In analyzing the integrity and reliability of MMS's financial
data that we used to evaluate RIK oil sales in Wyoming, we selected nine
properties that provided about 47 percent of the oil sold during the RIK
sales we analyzed. We selected properties that produced the three
different types of crude oil that MMS sold in its RIK sales-asphaltic,
general sour, and Wyoming sweet oils. We obtained MMS's financial data for
all nine properties from January 1996 through March 2002 and aggregated
these 32,823 financial transactions to the property-month level rather
than the lease level because we anticipated that the financial impact of
the smaller leases would not be as significant. We found that 3.3 percent
of property months contained erroneous or missing data, but we were able
to correct or obtain these data.

Appendix IEURObjectives, Scope, and MethodologyEUR

To estimate the revenue impact of Wyoming RIK oil sales, we attempted to
determine if Wyoming severance tax1 prices were a good proxy for what MMS
would have received in cash royalty payments. We first obtained the state
of Wyoming's severance tax data for the same nine properties. We then
proceeded to examine the average sales price per barrel and the number of
barrels produced from each property during each of the 33 months
immediately preceding the first RIK sale. The Bureau of Land Management,
which leased the nine federal properties in Wyoming, grouped federal
leases into these properties based on the geological boundaries of the oil
fields. Personnel with the state of Wyoming, however, group producing
leases into clusters for tax purposes. At our request, a Wyoming state
official attempted to match these clusters as closely as possible to the
federal properties. However, some clusters included additional state or
private leases that they could not segregate, and in some instances, the
state official could not precisely match the properties. We then graphed
the volumes reported to the state of Wyoming for severance taxes and the
volumes reported to MMS for cash sales for each of the nine properties.
The graphs suggested that seven state properties contained many of the
same federal leases. We then graphed the state severance tax prices and
MMS's cash royalty prices for each property. We determined that the
severance tax prices and MMS's cash royalty prices are essentially the
same for eight properties. The severance tax prices for the ninth property
were on average about 50 cents higher than MMS's cash royalty prices. See
figures 1, 2, and 3 for graphs of these prices that aggregate properties
according to type of oil.

1Severance taxes are levied by the state as a percentage of the value of
the oil or gas that is produced, regardless of whether the lease is for
federal, state, or private lands.

Appendix IEURObjectives, Scope, and MethodologyEUR

Figure 1: Comparison of Weighted Average Monthly Sales Prices Obtained
from Wyoming Severance Tax Database and MMS's Financial System for
Selected Asphaltic Properties Subsequently Included in RIK Sales

Dollars 25.00

20.00

15.00

10.00

5.00

0.00

96-

Jan-96 Mar

y-96 JuMa

9-

6 Sep-96 No

                                v-96 Jan-97 Mar

97-

                          7 7 Sep-97 Nov-97 Jan-98 Mar

7-98

y-98 JaM

8l-9u

ep-98S

y-9Ma

l-9uJ

                                   MMS prices

        WY prices Source: GAO analysis of MMS and state of Wyoming data.

Appendix IEURObjectives, Scope, and MethodologyEUR

Figure 2: Comparison of Weighted Average Monthly Sales Prices Obtained
from Wyoming Severance Tax Database and MMS's Financial System for
Selected General Sour Properties Subsequently Included in RIK Sales

Dollars 25.00

20.00

15.00

10.00

5.00

0.00

Jan-96 Mar

                                ep-98 MMS prices

        WY prices Source: GAO analysis of MMS and state of Wyoming data.

               Appendix IEURObjectives, Scope, and MethodologyEUR

Figure 3: Comparison of Weighted Average Monthly Sales Prices Obtained
from Wyoming Severance Tax Database and MMS's Financial System for
Selected Sweet Properties Subsequently Included in RIK Sales

Dollars

                                  30.00 25.00

                                     20.00

                                     15.00

                                     10.00

                                      5.00

                                      0.00

96-

Jan-96 Mar

y-96 JuMa

9-

6 Sep-96 No

                                v-96 Jan-97 Mar

97-

                          7 7 Sep-97 Nov-97 Jan-98 Mar

7-98

y-98 JaM

8ul-9

ep-98S

y-9Ma

l-9uJ

                                   MMS prices

                                   WY prices

             Source: GAO analysis of MMS and state of Wyoming data.

Gulf of Mexico Oil	To evaluate the integrity and reliability of MMS's
financial data that we used to evaluate the second RIK oil sale in the
Gulf of Mexico, we examined MMS's financial data from January 1997 through
March 2002 for 16 of the 26 leases in the sale. We removed all
transactions involving the SPR and small refiners so that we could compare
sales from the second RIK sale to cash royalty payments only. We found
this initial task difficult because MMS inconsistently used transaction
codes for sales to small refiners and for transfers to the SPR during the
time frame of our study. We aggregated 7,725 transactions to the
payor-lease-month level and found that 1.9 percent of the
payor-lease-months contained erroneous or missing data, and about 9
percent of the aggregated data was compromised by payors using multiple
payor codes. Payors also inconsistently reported or did not report royalty
volumes when reporting transportation deductions prior to October 2001 and
inconsistently reported or did not report sales values when reporting
quality bank adjustments. We subsequently reduced the period of our
analysis to June 2000 through March 2002, reduced our leases to the 13

Appendix IEURObjectives, Scope, and MethodologyEUR

that accounted for about 89 percent of the oil sold during the sale, and
corrected the single significant error that we found in this data set.

To estimate the revenue impact of the October 2001 through March 2002 RIK
oil sale in the Gulf of Mexico, we first chose a sample of leases included
in the RIK sale and determined the relationship of their cash sales prices
before the RIK sale to the prices as prescribed by MMS's royalty valuation
regulations for sales to affiliated companies (also known as transactions
not at arm's length). We analyzed only those leases that produced Mars and
Eugene Island sweet oil because these two oil grades collectively
accounted for 96 percent of the production. We then selected only the Mars
and Eugene Island leases that had cash royalty sales during at least 8 of
the 16 months between June 2000-the first month that the current oil
valuation regulations became effective, and September 2001- the month
immediately preceding the RIK sale. These selection criteria produced the
13 leases for our detailed analysis. Eleven of the 13 leases had cash
royalty sales during all 16 months. For each of the 13 leases, we then
calculated the average monthly cash sales price (net of any transportation
allowances and quality bank adjustments) from data in MMS's financial
database for each of the 16 months preceding the RIK sale. Next, we
obtained the average monthly price from MMS for Mars and Eugene Island
sweet oils as prescribed in MMS's oil valuation regulations for sales not
at arm' length at the market center for the same time period. We then
subtracted these monthly prices from the average monthly cash prices and
multiplied this difference by the barrels of oil sold each month to yield
monthly revenue for each lease relative to MMS's regulations. Next, we
summed these monthly revenues and divided the sum by the total barrels of
oil sold to obtain a weighted average difference per barrel for the entire
16month period. This value, -$1.36, indicates that MMS received on average
$1.36 less than the market center price for each barrel of royalty oil
produced from these 13 leases from June 2000 through September 2001. We
attribute most of this difference to the payors' costs of transporting the
oil to market. Finally, for the 6-month term of the RIK sale, we
calculated a weighted average difference per barrel between the RIK sales
price and the price as prescribed by MMS's valuation regulations for
transactions not at arm's length. This value, -$2.24, indicates that MMS
received on average $2.24 less than the average market center price for
each barrel of oil that MMS sold during its RIK sale from October 2001
through March 2002. We then assumed that if MMS had not conducted this RIK
sale, it would have received cash royalty payments that on average would
have been $1.36 less than the market center price as we previously
computed. We subtracted $2.24 from $1.36 to estimate that MMS lost on
average $0.88 on every barrel

               Appendix IEURObjectives, Scope, and MethodologyEUR

that MMS sold during this RIK sale. Since MMS sold 8.2 million barrels
during this sale, MMS lost approximately $7.2 million.

Gulf of Mexico Gas	In analyzing MMS's financial data on gas sales in the
Gulf of Mexico, we discussed with MMS officials the financial data
limitations that they identified while conducting their analysis of RIK
gas sales-limitations that prompted MMS personnel to use invoice prices
rather than the sales data in MMS's financial database. We then obtained
19,211 financial transactions for all the cash and RIK sales on the
Blessing and Matagorda Offshore Pipeline Systems (MOPS) from January 1997
through December 2001. Upon aggregating these data to the
payor-lease-month level and researching anomalous data, we found that 6
percent of the RIK summary data remained anomalous. Consequently, we
decided to use the RIK invoice data, adjusted for transportation costs, to
compute net unit prices for the RIK transactions.

To estimate the revenue impacts of RIK gas sales in the Gulf of Mexico, we
relied on financial data aggregated to the lease-month for all cash sales
on the Blessing Pipeline System and on MOPS from January 1997 through
December 2001.2 On each of the pipeline systems, MMS determined that the
leases from which it received cash royalty payments were comparable to the
leases from which it collected RIK. For each lease connected to the
Blessing Pipeline System, we calculated the average cash sales price net
of all reported transportation costs per MMBtu for each month and
subtracted it from the average RIK sales price net of all transportation
costs per MMBtu for each month.3 We then multiplied these figures by the
quantity of royalty gas (in MMBtu) sold in kind each month to obtain the
monthly revenue impacts, and we then summed the monthly revenue impacts to
yield total revenue impacts of the RIK sales on the Blessing Pipeline
System. To determine the revenue impacts of RIK sales on MOPS, we followed
the same procedure as that on the Blessing Pipeline System, using data
specific to sales on that pipeline. We then summed the revenue impacts
from RIK sales on both systems to yield the total estimated revenue gain
of about $4 million on sales of about $210 million.

2Unlike RIK transactions, data from cash sales could be manually reviewed
and adjusted to achieve an anomalous financial data rate of less than 1
percent.

3MMBtu (one million British thermal units) is a measure of the heating
quality of the gas equal to 1,000 cubic feet of gas at a Btu quality of
1,000.

               Appendix IEURObjectives, Scope, and MethodologyEUR

Other Factors May Affect Revenue Analysis

Our case studies did not include other overall factors that may affect
revenues from RIK sales. First, differences in the timing of royalty
collections can affect total revenue collections because an earlier
collection of these revenues allows the Treasury to earn interest on the
funds collected. Revenues from the sale of royalty oil are due 10 days
earlier than cash royalties, while revenues from the sale of gas are due 5
days earlier than cash royalties. We reviewed MMS's revenue collections
from all RIK pilot sales during fiscal year 2002 and determined that 98
percent of the oil and 92 percent of the gas revenues were collected
according to this early schedule. For fiscal year 2002, we calculated the
combined benefit to be about $128,500, or about 0.03 percent on a total of
$454 million collected in RIK pilot sales.4 MMS may have also realized
relatively small amounts of money from interest on those revenues that
were late. Future benefits will depend upon the amount of oil and gas sold
in kind, interest rates, and the sales prices of oil and gas. Secondly,
during the time frame of our revenue analysis, data were not available on
a leaseby-lease basis that would enable us to estimate how much additional
revenue had accrued to MMS as the result of the audit process. Hence, we
could not determine whether any additional funds collected as a result of
auditing were included in MMS's financial data. For example, Wyoming state
auditors who audit the federal leases in Wyoming that we included in our
revenue analysis stated that they audited some of these leases for some of
the time frame. While any additional audit collections would be expected
to affect unit prices in both MMS's financial database and the state's
severance tax database, additional collections were not necessarily
recorded for every lease. We did not examine how any additional
collections resulting from audits were recorded for oil and gas leases in
the Gulf of Mexico because of the difficulty in accessing individual
leases in the information system that tracks auditing efforts. In
addition, some of the time frame that we included in our revenue analyses
had not yet been audited by MMS when we initiated our work.

4To make this calculation, we used the federal funds rate, which is the
rate that banks charge each other for short-term loans during the Federal
Reserve Bank check clearing process.

Appendix II

Comments from the Department of the Interior

Note: GAO comments supplementing those in the report text appear at the
end of this appendix.

Appendix IIEURComments from the Department of theEURInteriorEUR

Appendix IIEURComments from the Department of theEURInteriorEUR

                                 See comment 1.

                                 See comment 2.

Appendix IIEURComments from the Department of theEURInteriorEUR

See comment 3.

See comment 1. Now on page 6.

See comment 1.

See comment 1. Now on p. 10.

See comment 4. Now on p. 19.

See comment 5.

        Appendix IIEURComments from the Department of theEURInteriorEUR

The following are GAO's comments on the Department of the Interior's
letter dated April 5, 2004.

GAO Comments 1.

2.

3.

4.

5.

We clarified our report to reflect these comments.

We included the costs of $496,000 for auditing leases and reconciling
volumes because MMS reported it as a direct cost of the RIK pilot sales,
and because it is unknown how many of these leases would have been
selected for auditing if they had not been in the RIK Program.

We acknowledge that there are considerable costs for systems that support
financial and compliance activities. However, the financial system
supports both the collection of cash royalty payments and RIK payments, so
its costs are incurred regardless of whether royalties are collected in
cash or in kind. We acknowledge MMS's observation that the compliance
system has associated costs and that these costs are incurred
predominantly with the collection of cash royalties. However, it was not
our intent to compare systems costs under different methods of collecting
royalties. We intended only to mention the incremental costs associated
with collecting royalties in kind because MMS will continue to incur costs
associated with collecting cash royalty payments.

We clarified the report by stating that there is only one staff
independent of the RIK Program whose duties involve analyzing RIK sales
results. We acknowledge that additional RIK Program staff and managers
analyze sales results. However, we believe that proper management controls
require that staff independent of the RIK Program should analyze sales
results for MMS management. We also acknowledge and state in this report
that an independent contractor has assisted with developing a strategy for
analyzing sales. We believe that this is a significant step towards
comprehensively and systematically analyzing RIK sales results.

MMS's technical comments on its Gulf oil sale related to two issues: (1)
removing the effect of quality bank adjustments and (2) the validity of
extending its analysis for an additional 12 months. Because of the
variability of quality bank adjustments, MMS stated that it is necessary
to remove these adjustments before conducting an analysis, and MMS
believes that it has done so. We acknowledge the variability of quality
bank adjustments and also note that transportation allowances

Appendix IIEURComments from the Department of theEURInteriorEUR

associated with the leases that we reviewed are also variable, albeit to a
lesser degree. However, when we conducted our analysis, there was
insufficient data on quality bank adjustments for the time period prior to
the second RIK sale to effectively remove their effect from our analysis.
To compensate for the variability of both quality bank adjustments and
transportation allowances among the 13 leases we examined, we chose to
establish our relationship between cash royalty payments and MMS's royalty
valuation regulations for a relatively long time period prior to the
6-month RIK sale. We assumed that the effects of variability would be
minimized over the 16-month period for which we established our
relationship. Concerning the validity of extending the time period of
analyzing the Gulf of Mexico oil sale, MMS restated its belief that
analyzing the transfer of oil to the SPR during the subsequent 12 months
is a valid technique. We already discussed the limitations of using this
technique in the report.

Appendix III

                     GAO Contacts and Staff Acknowledgments

GAO Contacts	Jim Wells (202) 512-3841 Mark Gaffigan (202) 512-3168

Acknowledgments	In addition to those named above, Ron Belak, Robert
Crystal, Art James, Lisa Knight, Jonathan McMurray, Franklin Rusco, Dawn
Shorey, and Maria Vargas made key contributions to this report.

GAO's Mission	The General Accounting Office, the audit, evaluation and
investigative arm of Congress, exists to support Congress in meeting its
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