Oil and Gas Royalties: Litigation over Royalty Relief Could Cost 
the Federal Government Billions of Dollars (05-JUN-08,		 
GAO-08-792R).							 
                                                                 
Oil and gas production from federal lands and waters is critical 
to meeting the nation's energy needs. This production provided	 
about 31 percent of all oil and 29 percent of all natural gas	 
produced in the United States in fiscal year 2007. Every five	 
years, the federal government decides the areas in the offshore  
waters of the United States it will offer for leasing and	 
establishes a schedule for individual lease sales. The Department
of the Interior's Minerals Management Service (MMS) has conducted
these sales at least once per year for at least the past 30	 
years. During the sales, oil and gas companies bid for the rights
to explore and develop the oil and gas resources on these leases 
and also agree to pay the federal government royalties on the	 
resources produced. In 1995, a time when oil and natural gas	 
prices were significantly lower than they are today, Congress	 
passed the Outer Continental Shelf Deep Water Royalty Relief Act 
(DWRRA), which authorized MMS to provide "royalty relief" on oil 
and gas produced in the deep waters of the Gulf of Mexico from	 
certain leases issued from 1996 through 2000. This "royalty	 
relief" waived or reduced the amount of royalties that companies 
would otherwise be obligated to pay on the initial volumes of	 
production from leases, which are referred to as "royalty	 
suspension volumes." The DWRRA also authorized the Secretary of  
the Interior to provide royalty relief to promote oil and gas	 
development or to increase production from leases in the Gulf of 
Mexico. In implementing the DWRRA for leases sold in 1996, 1997, 
and 2000, MMS specified that royalty relief would be applicable  
only if oil and gas prices were below certain levels, known as	 
"price thresholds," with the intention of protecting the	 
government's royalty interests if oil and gas prices increased	 
significantly. MMS did not include these same price thresholds	 
for leases it issued in 1998 and 1999, and this action raised	 
Congressional concerns that the federal government would lose	 
billions of dollars in forgone revenues. We reported in April	 
2007 that MMS's failure to include price thresholds on leases	 
issued in 1998 and 1999 under the DWRRA would likely cost the	 
federal government billions of dollars in forgone royalties, but 
precise costs were impossible to determine because of uncertain  
future prices and production levels. In light of the recent rise 
of oil prices to more than $100 per barrel and natural gas to $8 
per thousand cubic feet and the recent judgment against 	 
MMS-imposed price thresholds, you asked us to: (1) update our	 
scenario that illustrates the potential loss of royalties because
of the absence of price thresholds in leases issued in 1998 and  
1999 and (2) provide an update of the possible consequences of	 
Kerr-McGee's legal challenge on royalties already collected and  
evaluate the potential for additional forgone royalties if price 
thresholds no longer apply to future production from the 1996,	 
1997, and 2000 DWRRA leases.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-08-792R					        
    ACCNO:   A82271						        
  TITLE:     Oil and Gas Royalties: Litigation over Royalty Relief    
Could Cost the Federal Government Billions of Dollars		 
     DATE:   06/05/2008 
  SUBJECT:   Cost analysis					 
	     Federal legislation				 
	     Future budget projections				 
	     Gas leases 					 
	     Gas resources					 
	     Leases						 
	     Litigation 					 
	     Losses						 
	     Mineral leases					 
	     Natural gas					 
	     Natural gas prices 				 
	     Oil leases 					 
	     Prices and pricing 				 
	     Regulatory agencies				 
	     Royalty payments					 
	     Cost estimates					 

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GAO-08-792R

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Cost the Federal Government Billions of Dollars' which was released on 
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GAO-08-792R: 

United States Government Accountability Office: 
Washington, DC 20548: 

June 5, 2008: 

Congressional Requesters: 

Subject: Oil and Gas Royalties: Litigation over Royalty Relief Could 
Cost the Federal Government Billions of Dollars: 

Oil and gas production from federal lands and waters is critical to 
meeting the nation's energy needs. This production provided about 31 
percent of all oil and 29 percent of all natural gas produced in the 
United States in fiscal year 2007. Every five years, the federal 
government decides the areas in the offshore waters of the United 
States it will offer for leasing and establishes a schedule for 
individual lease sales. The Department of the Interior's Minerals 
Management Service (MMS) has conducted these sales at least once per 
year for at least the past 30 years. During the sales, oil and gas 
companies bid for the rights to explore and develop the oil and gas 
resources on these leases and also agree to pay the federal government 
royalties on the resources produced. 

In 1995, a time when oil and natural gas prices were significantly 
lower than they are today, Congress passed the Outer Continental Shelf 
Deep Water Royalty Relief Act (DWRRA), which authorized MMS to provide 
"royalty relief" on oil and gas produced in the deep waters of the Gulf 
of Mexico from certain leases issued from 1996 through 2000. [Footnote 
1] This "royalty relief" waived or reduced the amount of royalties that 
companies would otherwise be obligated to pay on the initial volumes of 
production from leases, which are referred to as "royalty suspension 
volumes."[Footnote 2] The DWRRA also authorized the Secretary of the 
Interior to provide royalty relief to promote oil and gas development 
or to increase production from leases in the Gulf of Mexico. 

In implementing the DWRRA for leases sold in 1996, 1997, and 2000, MMS 
specified that royalty relief would be applicable only if oil and gas 
prices were below certain levels, known as "price thresholds," with the 
intention of protecting the government's royalty interests if oil and 
gas prices increased significantly. MMS did not include these same 
price thresholds for leases it issued in 1998 and 1999, and this action 
raised Congressional concerns that the federal government would lose 
billions of dollars in forgone revenues.[Footnote 3] In addition, the 
Kerr-McGee Corporation--which was active in the Gulf of Mexico and is 
now owned by Anadarko Petroleum Corporation--filed suit challenging the 
Department of the Interior's authority to include price thresholds in 
DWRRA leases issued from 1996 through 2000. Recently, the U.S. District 
Court for the Western District of Louisiana granted summary judgment in 
favor of Kerr-McGee concerning the application of price thresholds to 
those leases.[Footnote 4] The court held that the DWRRA did not provide 
MMS with the authority to impose price thresholds on production below 
the royalty suspension volumes for leases issued under the DWRRA from 
1996 through 2000. Interior officials disagree with the court's 
decision, and in December 2007 the Department of Justice filed notice 
to appeal this decision. In response to the possible loss of future 
royalty revenues on these leases, Congress has been considering 
legislative action. 

We reported in April 2007 that MMS's failure to include price 
thresholds on leases issued in 1998 and 1999 under the DWRRA would 
likely cost the federal government billions of dollars in forgone 
royalties, but precise costs were impossible to determine because of 
uncertain future prices and production levels.[Footnote 5] However, we 
developed a number of scenarios to illustrate how different prices and 
production levels will influence these costs. We determined that, in 
addition to the $1 billion that had already been forgone, future costs 
could range between $4.3 billion and $10.5 billion over about 25 years, 
depending on the future prices of gas and oil and the volumes produced 
on these leases. MMS also estimated that the Department of the Interior 
faced losing an additional $60 billion in forgone royalties if it lost 
legal challenges to its application of price thresholds in all the 
DWRRA leases issued in 1996, 1997, and 2000. We noted, however, that 
MMS made this estimate in October 2004 and that this estimate may have 
included overly optimistic assumptions about the amount of oil and gas 
production that could occur over the lifetime of the leases. In light 
of the recent rise of oil prices to more than $100 per barrel and 
natural gas to $8 per thousand cubic feet and the recent judgment 
against MMS-imposed price thresholds, you asked us to: (1) update our 
scenario that illustrates the potential loss of royalties because of 
the absence of price thresholds in leases issued in 1998 and 1999 and 
(2) provide an update of the possible consequences of Kerr-McGee's 
legal challenge on royalties already collected and evaluate the 
potential for additional forgone royalties if price thresholds no 
longer apply to future production from the 1996, 1997, and 2000 DWRRA 
leases. 

To update our scenario illustrating the potential loss of royalties 
from leases issued in 1998 and 1999, we increased the upper bounds of 
oil and gas prices to $100 per barrel and $8 per thousand cubic feet, 
respectively, well above the levels of our high-price scenario in the 
April 2007 report. We did not, however, revise our lower bounds for 
prices. To update the consequence of the Kerr-McGee challenge to 
royalties already collected, we interviewed MMS officials, reviewed 
legal documents, and reviewed MMS's estimate on royalties paid to date. 
To evaluate the potential for forgone royalties on future production 
from the 1996, 1997, and 2000 leases, we reviewed estimates made by MMS 
in October 2004 and its more recent estimates released in February 
2008. Specifically, we reviewed the methodology and assumptions MMS 
used to estimate the amount of future oil and natural gas production 
from DWRRA leases. To assess the likelihood of future oil and gas 
discoveries on DWRRA leases, we reviewed statistical data on field 
sizes, discovery success rates, and the availability of drilling rigs 
in the deep waters of the Gulf of Mexico. We determined that the data 
were sufficiently reliable for the purposes of this report. We also 
developed a series of scenarios to illustrate the uncertainty of prices 
and future production and their effect on the amount of future forgone 
royalties. A more detailed description of our scope and methodology is 
provided in enclosure 1. We conducted our review primarily from 
November 2007 through April 2008 in accordance with generally accepted 
government auditing standards. These standards require that we plan and 
perform the audit to obtain sufficient, appropriate evidence to provide 
a reasonable basis for our findings and conclusions based on our audit 
objectives. We believe the evidence we obtained provides a reasonable 
basis for our findings and conclusions based on our audit objectives. 

Summary: 

Regarding the 1998 and 1999 leases, which included no price thresholds, 
the cost to the federal government could be significantly more than the 
upper bound we reported in April 2007 if higher oil and natural gas 
prices are sustained over the lives of these leases. In April 2007, we 
developed scenarios that illustrated the federal government could 
sustain losses of between $4.3 billion and $10.5 billion, depending on 
production levels and oil and gas prices over about the next 25 years. 
Assuming similar oil production levels but higher oil and natural gas 
prices of $100 per barrel and $8 per thousand cubic feet, respectively-
-prices that are closer to current prices than the maximum prices used 
in our 2007 scenarios--the upper bound of these scenarios could climb 
to as high as $14.7 billion, a 40 percent increase. There are no 
guarantees, however, about what future prices will be. For example, oil 
prices have topped $130 per barrel since we did the analysis for this 
report, but it is also possible that prices could fall below our lower 
price assumptions. Thus, these scenarios should not be viewed as 
probabilistic estimates of what actual forgone royalties will be, or 
even firm boundaries within which forgone royalties will fall. Rather, 
the scenarios reflect reasonable possibilities based on recent 
experience and possible future prices. 

With regard to the 1996, 1997, and 2000 leases, because the U.S. 
District Court for the Western District of Louisiana ruled in October 
2007 that price thresholds do not apply to DWRRA leases, the federal 
government may have to refund over $1.13 billion in royalties that have 
already been collected from DWRRA leases issued in 1996, 1997, and 
2000, if the government loses on appeal. The government also faces 
forgoing additional royalty revenues, which will likely be in the 
billions of dollars, on future production from these leases. We 
developed a number of scenarios that illustrate the magnitude of 
possible forgone royalties at different price levels. For example, our 
scenarios ranged from $15.1 billion of lost revenue for a low 
production scenario with $70 per barrel of oil and $6.50 per thousand 
cubic feet of gas to as high as $38.3 billion for high production 
levels and prices of $100 per barrel of oil and $8 per thousand cubic 
feet of natural gas over about the next 25 years. The same caveats 
apply to interpreting these scenarios as those for the 1998 and 1999 
leases. 

Overall, our work illustrates that the value of future forgone 
royalties is highly dependent upon oil and gas prices, production 
levels, and the ultimate outcome of litigation over price thresholds. 
Assuming that the District Court's ruling in the Kerr-McGee case is 
upheld, future forgone royalties from all the DWRRA leases issued from 
1996 through 2000 could range widely--from a low of about $21 billion 
to a high of $53 billion. The $21 billion figure assumes low production 
levels and oil and gas prices that average $70 per barrel and $6.50 per 
thousand cubic feet over the lives of the leases. The $53 billion 
figure assumes high production levels and oil and gas prices that 
average $100 per barrel and $8 per thousand cubic feet over the lives 
of the leases. 

Not Including Price Thresholds in 1998 and 1999 Leases Could Cost the 
Government More in Forgone Royalty Payments Should Recent Increases in 
Oil and Natural Gas Prices Be Sustained: 

In February 2007, MMS estimated that in addition to the $1 billion in 
revenues already forgone the range of future forgone revenues is 
between $6.4 billion and $9.8 billion from not including price 
thresholds in leases issued in 1998 and 1999. MMS calculated these 
estimates under a range of assumptions about oil and natural gas prices 
and future production levels. MMS used two price assumptions--one 
employing a constant price of $45 per barrel of oil equivalent and the 
other using the Office of Management and Budget's (OMB) projected oil 
and gas prices, which escalate through time.[Footnote 6] For future 
production volumes from the 1998 and 1999 leases, MMS made low and high 
estimates. The low estimate did not allow for expected growth in oil 
and natural gas reserves, while the high estimate included expected 
growth in reserves based on past experience with oil and natural gas 
leases in the Gulf of Mexico.[Footnote 7] Reserves are the amount of 
oil and natural gas that is believed to be economically recoverable 
with current technology and prices. Reserve growth is the tendency of 
the initial reserve estimates to increase in the future as more becomes 
known about the oil and gas field. We reviewed MMS's assumptions and 
methodology for estimating the potential forgone revenue from 1998 and 
1999 leases and found them to be reasonable. 

In order to provide further perspective on just how much these future 
costs may vary, we developed and analyzed different scenarios in April 
2007 that illustrate how the cost to the federal government is 
sensitive to changes in both oil and natural gas prices and future 
production volumes.[Footnote 8] Accordingly, our scenarios used a range 
of values for oil and natural gas prices and future production volumes 
to illustrate the uncertainty surrounding future forgone federal 
royalty revenues.[Footnote 9] Because oil and natural gas prices have 
historically been volatile, at the time we made our initial estimates 
we selected a variety of prices, including $50 and $70 per barrel of 
oil and $6.50 per thousand cubic feet of natural gas. In our analyses, 
we assumed that price thresholds would rise 2.1 percent per year, based 
on their average annual increase over the past 12 years. Similarly, our 
scenarios included low and high volume estimates for future oil and 
natural gas production from these leases. In these scenarios, the 
estimated forgone royalty revenues vary significantly. For example, an 
oil price of $50 per barrel and a natural gas price of $6.50 per 
thousand cubic feet and low production volumes resulted in $4.3 billion 
in forgone royalties.[Footnote 10] Alternatively, with $70 per barrel 
of oil and $6.50 per thousand cubic feet of natural gas, the high 
production volume assumption yielded $10.5 billion. 

In June 2007, MMS also provided an update on the loss of potential 
royalties from not including price thresholds on the leases issued in 
1998 and 1999. MMS used oil and natural gas prices cited within OMB's 
Economic Assumptions for the 2008 Budget. Based on an average oil price 
of $60.78 per barrel and an average natural gas price of $7.52 per 
thousand cubic feet, MMS estimated that between $5.3 billion and $7.8 
billion may be lost in future royalties. The low estimate assumes that 
reserves do not grow, and the high estimate assumes that reserves do 
grow over time. 

Because oil and natural gas prices increased substantially since the 
study we completed in 2007, we developed an additional scenario with 
higher oil and natural gas prices. We used the same methodology as that 
in our April 2007 study, updating only the oil and natural gas prices. 
[Footnote 11] At an oil price of $100 per barrel and a natural gas 
price of $8 per thousand cubic feet, a low production level yields 
potential losses of $8.7 billion. With the same prices and a high 
production level, potential losses climb to $14.7 billion. It is 
important to note, however, that there is no assurance these recent 
high oil and natural gas prices will be sustained over the lives of the 
leases, about 25 more years. For more information on this scenario, see 
enclosure II. 

Kerr-McGee's Challenge of Interior's Authority to Include Price 
Thresholds in DWRRA Leases Could Result in Refunding Royalty Payments: 

As of September 30, 2007, leases issued under the DWRRA in 1996, 1997, 
and 2000 have generated $1.13 billion in royalties for the U.S. 
government, according to MMS. If the Kerr-McGee decision is upheld on 
appeal and is applied to all 1996, 1997, and 2000 DWRRA leases, the 
federal government may be required to refund these royalties. As of 
November 2007, 57 of the leases issued in 1996, 1997, and 2000 under 
the DWRRA have produced oil and natural gas upon which royalties have 
been paid. Only eight of the leases issued in 1996, 1997, and 2000 are 
expected to produce oil and gas in excess of their royalty suspension 
volumes. The amount of this excess production is expected to be about 
14 percent of the total production from all the leases issued in 1996, 
1997, and 2000 that are producing or expected to produce. 

In early 2006, Kerr-McGee filed the suit challenging the Department of 
the Interior's authority to include price thresholds in its DWRRA 
leases. In effect, this suit sought to remove price thresholds from 
leases issued in 1996, 1997, and 2000 because Interior did not include 
price thresholds on leases issued in 1998 and 1999. In June 2006, Kerr- 
McGee agreed to enter into mediation with Interior in an attempt to 
resolve the issue; however, the mediation was unsuccessful and 
litigation resumed. In October 2007, the U.S. District Court for the 
Western District of Louisiana ruled in favor of Kerr-McGee. 

The court held that price thresholds in leases issued under the DWRRA 
from 1996 through 2000 to Kerr-McGee for oil and gas production below a 
threshold volume were unlawful. According to the court, "The Interior 
has no discretion to enact a price threshold requirement that applies 
to volumes below the minimum volume of royalty-free production." The 
DWRRA specifies that royalties are not due on certain amounts of 
production, referred to in the ruling as "the minimum volume of royalty-
free production" and referred to by others as royalty suspension 
volumes. The court agreed with Kerr-McGee's interpretation that the 
section of the DWRRA that requires mandatory royalty relief prevents 
Interior from enacting price thresholds for volumes below the royalty 
suspension volumes. 

Senior Interior officials and many congressional leaders disagree with 
the decision. They believe that Congress intended for royalty relief to 
apply only during times of low oil and natural gas prices and that the 
DWRRA grants Interior the authority to set price thresholds for new 
leases. In December 2007, the Department of Justice filed a notice to 
appeal the decision. 

Congressional leaders are seeking legislative remedies for the absence 
of price thresholds in DWRRA leases issued in 1998 and 1999. Sections 
7502 and 7504 of H.R. 3220, the New Direction for Energy Independence, 
National Security and Consumer Protection Act, would provide 
legislative avenues for addressing the absence of price thresholds. 
Section 7502 proposes that holders of leases issued in 1998 and 1999 
under the DWRRA can request the Secretary of the Interior to amend 
these leases to include price thresholds. This would formally allow 
Interior and the lessees to renegotiate these leases. Interior and some 
companies began negotiations in late 2006 to apply price thresholds to 
future production from 1998 and 1999 leases. To date, 6 companies have 
formally agreed to terms, but 44 have not agreed to terms. Section 7504 
would exclude parties that hold an interest in DWRRA leases issued from 
1996 through 2000 from acquiring new oil and gas leases in the Gulf of 
Mexico unless the party renegotiates the leases to include price 
thresholds. This section would also impose a fee on oil and gas 
production from the Outer Continental Shelf lands in the Gulf of Mexico 
if these leases are not subject to price thresholds. Section 223 of S. 
701, the Strategic Energy Fund Act of 2007, contains an identical 
provision, as do H.R. 2809 and several other bills. 

Kerr-McGee's Challenge Could Also Cost the Government Billions in 
Future Forgone Royalty Payments: 

If the Kerr-McGee ruling is upheld on appeal and applied to all DWRRA 
leases issued in 1996, 1997, and 2000, the potential loss of royalties 
from future production is likely to be in the billions of dollars, but 
the exact amount will depend on future energy prices and production 
levels. MMS estimated in October 2004 that forgone royalties on the 
1996, 1997, and 2000 leases could be as high as $60 billion. In 2006, 
we reviewed MMS's assumptions and methodology for estimating the 
potential forgone revenue and found them to be reasonable. However, 
because much has been learned about the productivity of the leases 
since that initial estimate and because oil and natural gas price 
expectations have changed, we believe that this estimate needed to be 
updated. In particular, we found that estimates for reserve growth were 
overly optimistic in light of a more recent MMS study on reserve growth 
in the Gulf of Mexico. MMS's 2004 estimates on the size and number of 
future discoveries also appeared overly optimistic, given historical 
statistics on field size, a 2006 assessment of the availability of 
drilling rigs in the Gulf of Mexico, and a smaller number of leases 
available to drill in 2008 than were available in 2004. MMS concurred 
with our observations. 

In February 2008, MMS released an update on its October 2004 estimate 
of potential losses from the 1996, 1997, and 2000 leases. MMS estimated 
a range of potential future forgone revenue between $15.7 billion and 
$21.2 billion, based on assumptions about oil and natural gas prices 
and future production levels. MMS used OMB's prices of $80.92 per 
barrel of oil and $8.70 per thousand cubic feet of natural gas, as 
cited in OMB's Economic Assumptions for the 2009 Budget. For future 
production levels, MMS made low and high estimates. The low estimate 
did not allow for expected growth in oil and natural gas reserves, 
while the high estimate included expected growth in reserves. We 
reviewed these assumptions and the methodology and found them to be 
reasonable. 

Nonetheless, in order to provide further perspective on just how much 
these future costs may vary, we developed and analyzed different 
scenarios that illustrate how the cost to the federal government is 
sensitive to changes in both oil and natural gas prices and future 
production volumes. These scenarios are similar to those we used to 
illustrate forgone royalty revenue from the 1998 and 1999 leases. To 
illustrate the uncertainty surrounding potential forgone federal 
royalty revenues, our scenarios use a range of values for oil and 
natural gas prices and future production volumes. Because oil and 
natural gas prices have been volatile and high during 2007 and 2008, we 
selected oil prices of $70 and $100 per barrel of oil and $6.50 and $8 
per thousand cubic feet of natural gas. In our analyses, we assumed 
that price thresholds would rise 2.1 percent per year, based on their 
average annual increase over the past 12 years. Similarly, our 
scenarios included low and high volume estimates for future oil and 
natural gas production from these leases. In these scenarios, as might 
be expected, the estimated forgone royalty revenues vary significantly. 
For example, an oil price of $70 per barrel and a natural gas price of 
$6.50 per thousand cubic feet and low production volumes result in 
$15.1 billion in forgone royalties. With the same prices but higher 
production volumes, this estimate increases to $27.2 billion. 
Alternatively, with $100 per barrel of oil and $8 per thousand cubic 
feet of natural gas, the low production volume assumption yields 
forgone royalties of $21.2 billion and the high production volume 
assumption yields $38.3 billion. For more detailed information on each 
of the scenarios and the estimated potential forgone royalty revenue, 
see enclosure III. 

Of the 84 leases issued in 1996, 1997, and 2000 that are currently 
producing or are capable of producing in the future, 76 do not appear 
capable of producing amounts of oil and gas that will exceed the 
royalty suspension volumes. The total amount of oil and gas for these 
76 leases below the royalty suspension volumes represents about 86 
percent of the estimated amounts that the1996, 1997, and 2000 leases 
will collectively produce over their productive lives. Thus, only about 
14 percent of the production from leases issued in 1996, 1997, and 2000 
would be royalty bearing should Interior lose on appeal and the ruling 
in the Kerr-McGee suit is applied to DWRRA leases issued from 1996 
through 2000. In addition to the impact on receiving fewer royalties in 
the future from the 1996, 1997, and 2000 leases, losing the appeal 
could also adversely affect the government's negotiation of price 
thresholds for the 1998 and 1999 leases. Some companies have suspended 
or delayed negotiations, pending outcome of the Kerr-McGee suit. 

Agency Comments: 

We provided a draft of this report to the Department of the Interior 
and the Minerals Management Service (MMS) for review and oral comments. 
In commenting on the report, they generally agreed with GAO's 
methodology and conclusions. In response to their comments, we added 
clarification as to why the potential for future forgone royalties from 
the 1996, 1997, and 2000 leases with grown reserves appeared higher 
than they anticipated. We also incorporated their technical comments as 
appropriate. 

We are sending copies of this report to appropriate congressional 
committees, the Secretary of the Interior, the Director of the Minerals 
Management Service, the Director of the Office of Management and 
Budget, and other interested parties. We will also make copies 
available to others upon request. In addition, the report will be 
available at no charge on GAO's Web site at [hyperlink, 
http://www.gao.gov]. 

If you or your staffs have any questions about this report, please 
contact me at (202) 512-3841 or [email protected]. GAO staff who made 
contributions to this report include Ron Belak, Glenn C. Fischer, Mark 
Gaffigan, Dan Haas, and Barbara Timmerman. 

Signed by: 

Frank Rusco:
Acting Director, Natural Resources and Environment: 

Enclosures: 

[End of correspondence] 

List of Requesters: 

The Honorable Jeff Bingaman:
Chairman:
Committee on Energy and Natural Resources:
United States Senate: 

The Honorable Carl Levin:
Chairman:
The Honorable Norm Coleman:
Ranking Member:
Permanent Subcommittee on Investigations:
Committee on Homeland Security and Governmental Affairs:
United States Senate: 

The Honorable Ron Wyden:
Chairman:
Subcommittee on Public Lands and Forests:
Committee on Energy and Natural Resources:
United States Senate: 

The Honorable Nick J. Rahall:
Chairman:
Committee on Natural Resources:
House of Representatives: 

The Honorable Darrell E. Issa:
Ranking Member:
Subcommittee on Domestic Policy:
Committee on Oversight and Government Reform:
House of Representatives: 

The Honorable Daniel K. Akaka:
United States Senate: 

The Honorable Maria Cantwell:
United States Senate: 

The Honorable Thomas R. Carper:
United States Senate: 

The Honorable Byron L. Dorgan:
United States Senate: 

The Honorable Richard J. Durbin:
United States Senate: 

The Honorable Russell D. Feingold:
United States Senate: 

The Honorable Dianne Feinstein:
United States Senate: 

The Honorable Tim Johnson:
United States Senate: 

The Honorable John F. Kerry:
United States Senate: 

The Honorable Jon Kyl:
United States Senate: 

The Honorable Frank R. Lautenberg:
United States Senate: 

The Honorable Robert Menendez:
United States Senate: 

The Honorable Barbara A. Mikulski:
United States Senate: 

The Honorable Patty Murray:
United States Senate: 

The Honorable Barack Obama:
United States Senate: 

The Honorable Jack Reed:
United States Senate: 

The Honorable Ken Salazar:
United States Senate: 

The Honorable Charles E. Schumer:
United States Senate: 

The Honorable Carolyn B. Maloney:
House of Representatives: 

[End of section] 

Enclosure I: Scope and Methodology: 

To update our scenario that illustrates the potential loss of royalties 
from leases issued in 1998 and 1999, we revised oil and gas prices 
upward to $100 per barrel and $8 per thousand cubic feet. The 
methodology is similar to that described below for leases issued in 
1996, 1997, and 2000 under the Outer Continental Shelf Deep Water 
Royalty Relief Act of 1995 (DWRRA).[Footnote 12] 

To determine the fiscal impacts of price thresholds that may no longer 
apply to oil and gas leases issued in 1996, 1997, and 2000 under the 
DWRRA, we first met with Minerals Management Service (MMS) personnel in 
the Economics Division in Herndon, Virginia. We reviewed their October 
2004 estimate of royalties that could be forgone if price thresholds 
did not apply to 1996, 1997, and 2000 DWRRA leases. We concluded that 
they followed standard engineering and financial practices and that 
they had generated the estimate in good faith. Since this estimate, 
however, additional information became available, and we believed their 
estimate needed to be updated. MMS concurred. Differences between our 
current estimates and MMS's 2004 estimate are due to changes in oil and 
gas prices, updated information on the size of deep water oil and gas 
fields that have been discovered but are not yet producing, the growth 
of oil and gas reserves over time, and the availability of drilling 
rigs in the Gulf of Mexico. MMS updated its 2004 estimate to address 
these issues and released this updated estimate in February 2008. We 
also reviewed this estimate and similarly found that it followed 
standard engineering and financial practices and was done in good 
faith. During the course of our work, we visited MMS's Gulf of Mexico 
regional office in New Orleans and interviewed engineers and geologists 
about technical aspects of oil and gas production in the deep waters of 
the Gulf of Mexico. In addition, we contacted industry representatives 
for their opinions on oil and gas exploration and development in the 
deep waters of the Gulf of Mexico. 

Within MMS's Technical Information Management System (TIMS), we 
identified all 3,401 leases issued under the DWRRA, 2,369 of which were 
issued in 1996, 1997, and 2000. From this database, we were able to 
identify the status of these leases, the extent to which they had been 
explored and developed, and the production that had occurred on some of 
them. As of April 2008, a total of 94 of the leases issued in 1996, 
1997, and 1999 have produced, are currently producing, or are expected 
to produce oil and gas in the future under DWRRA provisions. Ten of the 
94 leases have either stopped producing or appear to be no longer 
capable of producing significant amounts, 47 are still producing, and 
37 are expected to commence production at some future time. As of 
January 1, 2008, we estimate that about 135 of the additional 1996, 
1997, and 2000 leases were still active but had not yet been tested for 
oil and gas. We also collected pertinent information from TIMS, current 
through September 2006, on the estimated reserves of leases that are 
currently producing and leases capable of producing but not yet 
connected to infrastructure (producible leases). We interviewed MMS 
personnel in New Orleans to better understand how these reserve 
estimates were made. For producing and producible leases, we 
corroborated lease information in TIMS with MMS's final bid results. We 
also obtained recent information on reserve growth for each producing 
or producible lease and obtained monthly oil and gas production volumes 
through July 2006 from MMS's Oil and Gas Operations Reports (OGOR). We 
updated these production data with additional production amounts 
through December 2007 when these data became available. We reviewed 
production data for characteristic decline patterns, questioned MMS 
personnel on how they verified these data and on reasons for periods of 
time with zero production (predominantly the result of hurricane 
activity), and compared each lease's cumulative production with reserve 
estimates in TIMS. We found the data in TIMS and in OGOR to be 
sufficiently reliable for the purposes of our analysis. 

We considered the timing of future production to identify and exclude 
from our analysis the possible production volumes that will be royalty 
free when sales prices drop below anticipated price thresholds in the 
future. However, because only the sales price of $6.50 for natural gas 
is expected to fall below price thresholds during the time frame of our 
scenarios, this time is projected to be January 2024, and royalty 
revenue from gas production after January 2004 is anticipated to be 
less than 1 percent of total gas royalty revenue, we did not adjust 
production volumes. 

To project production from future discoveries on 1996, 1997, and 2000 
leases, we examined MMS projections for future drilling activity, 
historic discovery rates, average field sizes, and anticipated lease 
expiration dates for DWRRA leases in waters deeper than 800 meters, 
where MMS anticipates all the future DWRRA discoveries will occur. 
First, we assumed that the range for the number of possible untested 
leases drilled in all of the deep waters of the Gulf of Mexico would be 
between 30 and 60. This assumption was based on the availability of 
rigs to drill exploratory wells in waters deeper than 800 meters and 
MMS projections in the 2006 deep water report. Second, we assumed the 
success rate of future deep water lease discoveries would be the same 
for such deep water leases drilled from 1974 through 1995, which was 28 
percent. Third, we scheduled the expiration dates of the 1996, 1997, 
and 2000 leases for each year through 2010 and calculated for each of 
these years the percentage of all untested deep water leases below 800 
meters that would be 1996, 1997, and 2000 leases. We assumed that there 
would be 3,700 total active deep water leases each year. Fourth, we 
assumed that each new field discovery would consist of two leases 
because 97 percent of the existing 198 fields in Gulf of Mexico waters 
deeper than 800 meters are composed of from one to four leases, with 
two leases being the average field size. Finally, for 2008 through 
2010, we assumed the number of field discoveries on 1996, 1997, and 
2000 leases would be between zero and five. This assumption was derived 
by multiplying the estimated range of untested leases that could be 
drilled in all Gulf of Mexico deep waters (30 to 60 per year) by an 
estimated percentage of all deep water leases that will be active 
untested 1996, 1997, and 2000 leases, and by also multiplying by the 
assumed historical success rate of 28 percent. We doubled this number 
in order to account for the average field consisting of two leases and 
rounded the resulting high number to five. For these new discoveries, 
we converted these numbers into oil and gas production volumes by 
multiplying them by the average of the reserves for all producing and 
producible DWRRA leases. 

With these assumptions, we developed several scenarios that illustrate 
that the potential for forgone royalties is highly dependent upon 
prices and production volumes. We chose prices of $70 for oil and $6.50 
for gas because these were in the range of common prices during late 
2007. We also chose prices of $100 for oil and $8 for gas because these 
prices are close to prices common in early 2008. We did not escalate 
oil and gas prices over the time period of our scenario. To illustrate 
the impact of changing production volumes on forgone royalties from 
producing and producible leases, we assumed low and high production 
levels. Our low production assumption is equal to MMS's estimated 
reserves, which we corrected in several instances when cumulative 
production through December 2007 exceeded estimated reserves projected 
in July 2006. Our high production assumption is equal to the sum of the 
estimated reserves for each lease multiplied by its corresponding 
growth factor. To illustrate the impact of changing production volumes 
on forgone royalties from future discoveries, we also selected low and 
high assumptions. Our low production assumption is zero discoveries, 
and our high assumption is five discoveries. We did not multiply 
production assumptions from future discoveries by growth factors, but 
such growth is possible. 

[End of section] 

Enclosure II: Scenario Illustrating the Sensitivity of Forgone 
Royalties to Changes in Future Production Volumes from 1998 and 1999 
DWRRA Leases at High Oil and Natural Gas Prices: 

Scenario 1 illustrates possible forgone federal royalty payments 
resulting from MMS's omission of price thresholds in leases issued in 
1998 and 1999 when oil and natural gas prices exceed price thresholds. 
This scenario updates the upper limit of prices chosen for our previous 
scenarios that we published in April 2007. In those scenarios, we used 
oil prices of $36, $50, and $70 per barrel and natural gas prices of 
$4.50 and $6.50 per thousand cubic feet. 

Scenario 1 uses an oil price of $100 per barrel and a natural gas price 
of $8 per thousand cubic feet and retains these prices over the lives 
of the leases (see table 1). We illustrate the forgone royalties with 
both low and high volume estimates of future oil and gas production. In 
this scenario, the productive time frame is from August 2006 through 
the lives of the leases, which are about 25 years. In the low 
production volume estimate, we use MMS's "ungrown reserve" estimates 
and assume five additional leases are discovered to be productive in 
the future. Our scenario results in $8.7 billion in forgone royalties. 
This estimate increases to $14.7 billion in the high production volume 
case, which uses MMS's "grown reserves" and 10 future discoveries. 

Table 1: Scenario 1 Assumes That from 1998 and 1999 Leases, Oil Would 
Be Sold for $100 per Barrel and Natural Gas Would Be Sold for $8 per 
Thousand Cubic Feet. 

Forgone royalties on future production from producing and producible 
leases: 
Ungrown reserves and five future discoveries: $7.3 billion; 
Grown reserves and 10 future discoveries: $11.3 billion. 

Additional forgone royalties on future production from leases with new 
discoveries: 
Ungrown reserves and five future discoveries: $1.4 billion; 
Grown reserves and 10 future discoveries: $3.4 billion. 

Total forgone royalties: 
Ungrown reserves and five future discoveries: $8.7 billion; 
Grown reserves and 10 future discoveries: $14.7 billion. 

Source: GAO. 

[End of table] 

[End of section] 

Enclosure III: Scenarios Illustrating the Sensitivity of Forgone 
Royalties to Changes in Oil and Natural Gas Prices and Future 
Production Volumes from DWRRA Leases Issued in 1996, 1997, and 2000: 

The following two scenarios illustrate the range of possible forgone 
royalties that could result if price thresholds are no longer 
applicable to leases issued in 1996, 1997, and 2000. 

Scenario 2 illustrates possible future forgone federal royalty payments 
if price thresholds are no longer applicable to these leases during 
times when oil and natural gas prices exceed the price thresholds (see 
table 2).[Footnote 13] Specifically, we selected an oil price of $70 
per barrel and a natural gas price of $6.50 per thousand cubic feet to 
illustrate the forgone royalties with both low and high volume 
estimates of future oil and gas production. In this scenario, the 
production time frame is from January 2008 through the lives of the 
leases, which is about 25 years. In the low production volume estimate, 
we use MMS's "ungrown reserve" estimates and assume that no additional 
leases are discovered in the future. This scenario results in $15.1 
billion in forgone royalties. The estimate increases to $27.2 billion 
in the high production volume case, which uses MMS's "grown reserves" 
and five future discoveries. 

Table 2: Scenario 2 Assumes That from 1996, 1997, and 2000 Leases, Oil 
Would Be Sold for $70 per Barrel and Natural Gas Would Be Sold for 
$6.50 per Thousand Cubic Feet. 

Forgone royalties on future production from producing and producible 
leases: 
Ungrown reserves and no future discoveries: $15.1 billion; 
Grown reserves and five future discoveries: $26.2 billion. 

Additional forgone royalties on future production from leases with new 
discoveries: 
Ungrown reserves and no future discoveries: $0; 
Grown reserves and five future discoveries: $1.0 billion. 

Total forgone royalties: 
Ungrown reserves and no future discoveries: $15.1 billion; 
Grown reserves and five future discoveries: $27.2 billion. 

Source: GAO. 

[End of table] 

Scenario 3 illustrates possible forgone royalties with higher oil and 
natural gas prices. Using similar assumptions on production volumes as 
in Scenario 2, $100 per barrel of oil and $8 per thousand cubic feet of 
natural gas yield $21.2 billion in forgone future royalties for the low 
production estimate and $38.3 billion in forgone future royalties for 
the high production estimate (see table 3). 

Table 3: Scenario 3 Assumes That from 1996, 1997, and 2000 Leases, Oil 
Would Be Sold for $100 per Barrel and Natural Gas Would Be Sold for $8 
per Thousand Cubic Feet. 

Forgone royalties on future production from producing and producible 
leases: 
Ungrown reserves and no future discoveries: $21.2 billion; 
Grown reserves and five future discoveries: $36.9 billion. 

Additional forgone royalties on future production from leases with new 
discoveries: 
Ungrown reserves and no future discoveries: $0; 
Grown reserves and five future discoveries: $1.4 billion. 

Total forgone royalties: 
Ungrown reserves and no future discoveries: $21.2 billion; 
Grown reserves and five future discoveries: $38.3 billion. 

Source: GAO. 

[End of table] 

The $36.9 billion in forgone royalties on future production in table 3 
is $15.7 billion greater than MMS's highest estimate of $21.2 billion 
released in February 2008. About half of this difference is attributed 
to the higher oil and gas prices we used in table 3. The other half of 
the difference is because we anticipate greater reserve growth than 
MMS. 

[End of section] 

Footnotes: 

[1] These leases are covered under Section 304 of the act, which 
applies to leases issued between November 28, 1995 and November 28, 
2000. However, since no leases were issued in 1995, we refer to these 
leases as DWRRA leases issued from 1996 through 2000. 

[2] Royalty suspension volumes establish cumulative production volumes 
above which royalty relief no longer applies. Royalty suspension 
volumes vary according to depth, ranging from a minimum of 17.5 million 
barrels of oil equivalent in water depths of 200 to 400 meters to a 
minimum of 87.5 million barrels of oil equivalent in water depths 
greater than 800 meters. 

[3] By forgone royalties, we mean royalties that would be payable if 
Congress had not authorized royalty relief under the DWRRA. 

[4] Kerr-McGee Oil and Gas Corp. v. Allred, No. 2: 06-CV-0439, 2007 
U.S. Dist., Lexis 83424 (W.D. La. Oct. 18, 2007). 

[5] GAO, Oil and Gas Royalties: Royalty Relief Will Cost the Government 
Billions of Dollars but Uncertainty Over Future Energy Prices and 
Production Levels Make Precise Estimates Impossible at this Time, 
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-590R] (Washington, 
D.C.: Apr. 12, 2007). 

[6] One barrel of oil equivalent equals one barrel of oil or 5.62 
thousand cubic feet of natural gas. 

[7] As oil and gas reserves are developed and more knowledge of the 
field is obtained, proven reserves generally experience some growth. 

[8] These scenarios are not probabilistic estimates of what may 
actually happen with royalty revenue. Rather, they are illustrative 
examples using estimates of future oil and natural gas production that 
we believe are reasonable based on the history of leases in the Gulf of 
Mexico and using oil and gas prices that are within the range of prices 
that have existed in the past 3 years. As such, we believe the 
scenarios are reflective of plausible possibilities, but we do not 
assign any probabilities to any of the scenarios. 

[9] The royalty rate for DWRRA leases in less than 400 meters of water 
is 16.67 percent, and the royalty rate for leases in waters greater 
than 400 meters is 12.5 percent. 

[10] It should be noted that if prices were to fall and remain at or 
below $36.40 per barrel for oil and $4.68 per thousand cubic feet for 
natural gas in real 2007 dollars, no royalties would be due even if the 
price thresholds that were imposed on the 1996, 1997, and 2000 leases 
were applied to the 1998 and 1999 leases. 

[11] See enclosure II in Oil and Gas Royalties: Royalty Relief Will 
Cost the Government Billions of Dollars but Uncertainty Over Future 
Energy Prices and Production Levels Make Precise Estimates Impossible 
at this Time, GAO-07-590R. 

[12] See [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-590R], 
enclosure 1, page 8. 

[13] In scenario 2, gas prices drop below price thresholds in the 
latter years of the producing lives of the leases, but this revenue is 
anticipated to be less than 1 percent of total gas royalty revenue. 

[End of section] 

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