Federal Oil Valuation: Efforts to Revise Regulations and an Analysis of
Royalties in Kind (Letter Report, 08/19/98, GAO/RCED-98-242).

Pursuant to a congressional request, GAO reviewed the Minerals
Management Service's (MMS) efforts to revise its regulations for valuing
oil from federal leases, focusing on: (1) the information used by MMS to
justify the need for revising its oil valuation regulations; (2) how MMS
has addressed concerns expressed by the oil industry and states in
developing these regulations; and (3) the feasibility of the federal
government's taking its oil and gas royalties in kind, as indicated by
existing studies and programs.

GAO noted that: (1) in justifying the need to revise its oil valuation
regulations, MMS relied heavily on the findings and recommendations of
an interagency task force--composed of representatives from MMS and the
Departments of Commerce, Energy, Justice, and the Interior--assembled in
1994 by Interior to study the value of oil produced from federal leases
in California; (2) the task force concluded that the major oil
companies' use of posted prices in California to calculate federal
royalties was inappropriate and recommended that the federal oil
valuation regulations be revised; (3) MMS subsequently determined that
in other parts of the country as well, posted prices should not be used
as the basis to calculate royalties on oil from federal leases; (4)
beginning in 1995, MMS solicited public comments on the proposed
regulations in five Federal Register notices; it solicited comments in
each notice and revised its proposed regulations three times in response
to the comments received; (5) however, the agency did not agree with all
the comments it received and in these cases provided reasons for not
incorporating the suggested changes, noting that it planned to seek
input on this issue through other means; (6) in total, the agency asked
for comments on 39 major issues and received 183 letters from states,
representatives of the oil industry, and other parties; (7) on its most
recent revision of the proposed regulations, the agency received 34
comments but has not yet publicly addressed them; (8) information from
studies of royalties in kind, as well as specific royalty-in-kind
programs operated by various entities, indicates that it would not be
feasible for the federal government to take its oil and gas royalties in
kind except under certain conditions; (9) these conditions include
having relatively easy access to pipelines to transport the oil and gas,
leases that produce relatively large volumes of oil and gas, competitive
arrangements for processing gas, and expertise in marketing oil and gas;
(10) however, these conditions are currently lacking for the federal
government and for most federal leases; and (11) specifically, the
federal government does not currently have relatively easy access to
pipelines, has thousands of leases that produce relatively low volumes,
has many gas leases for which competitive processing arrangements do not
exist, and has limited experience in oil and gas marketing.

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

 REPORTNUM:  RCED-98-242
     TITLE:  Federal Oil Valuation: Efforts to Revise Regulations and an 
             Analysis of Royalties in Kind
      DATE:  08/19/98
   SUBJECT:  Gas leases
             Intergovernmental fiscal relations
             Petroleum industry
             Public lands
             Royalty payments
             Oil leases
IDENTIFIER:  Dept. of the Interior Royalty Management Program
             California
             Alaska
             Alaskan North Slope Oil
             
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Cover
================================================================ COVER


Report to Congressional Requesters

August 1998

FEDERAL OIL VALUATION - EFFORTS TO
REVISE REGULATIONS AND AN ANALYSIS
OF ROYALTIES IN KIND

GAO/RCED-98-242

Federal Oil Valuation and Royalties in Kind

(141168)


Abbreviations
=============================================================== ABBREV

  ANS - Alaska North Slope
  GAO - General Accounting Office
  MMS - Minerals Management Service
  NYMEX - New York Mercantile Exchange

Letter
=============================================================== LETTER


B-280547

August 19, 1998

The Honorable Ralph Regula
Chairman, Subcommittee on Interior
 and Related Agencies
Committee on Appropriations
House of Representatives

The Honorable Barbara Boxer
United States Senate

The Honorable Carolyn Maloney
House of Representatives

In fiscal year 1997, the Department of the Interior's Minerals
Management Service (MMS) collected about $4.1 billion in royalties
from approximately 22,000 oil and gas leases on federal lands.  By
law, the states in which these leases are located receive a share of
the royalties collected, which are calculated as a percentage of the
value of the oil or gas that is produced. 

The value of much of the oil from federal leases has been based on
posted prices--offers by purchasers to buy oil from a specific area. 
However, recent evidence indicates that oil is now often sold for
more than the posted prices, suggesting that the value of the oil
from federal leases and the amount of federal royalties should both
be higher.  On the basis of this evidence, in 1995 MMS began revising
its regulations for valuing oil from federal leases and in February
1998 issued its most recent revision.\1 The proposed regulations
would reduce the use of posted prices to value much of the oil from
federal leases and would instead generally require that other, and
oftentimes higher, prices be used.  By requiring that higher prices
be used to value much of the oil from federal leases, the proposed
regulations would increase federal royalties by as much as $66
million annually, according to MMS. 

Although states that receive distributions of these royalties
generally support the proposed regulations, oil industry
representatives generally oppose them, believing that oil companies
should not pay royalties on higher prices and that they would suffer
increased administrative requirements.  As an alternative, the oil
industry has suggested that MMS instead be required to accept, as the
federal government's royalties, a percentage of the actual oil and
gas produced from federal leases (known as royalties in kind), rather
than cash royalties based on the value of that oil and gas.  MMS
would then sell this oil and gas to generate revenues.  Legislation
mandating that MMS accept federal oil and gas royalties in kind has
been introduced in both the U.S.  Senate and the House of
Representatives. 

Interested in the increased revenues that would result from the
proposed regulations, as well as the oil industry's opposition to
them, you asked us to address the following:  (1) the information
used by MMS to justify the need for revising its oil valuation
regulations; (2) how MMS has addressed concerns expressed by the oil
industry and states in developing these regulations; and (3) the
feasibility of the federal government's taking its oil and gas
royalties in kind, as indicated by existing studies and programs. 


--------------------
\1 MMS has addressed gas valuation in separate regulations. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

In justifying the need to revise its oil valuation regulations, the
Minerals Management Service relied heavily on the findings and
recommendations of an interagency task force--composed of
representatives from the Minerals Management Service and the
departments of Commerce, Energy, Justice, and the Interior--assembled
in 1994 by Interior to study the value of oil produced from federal
leases in California.  The task force concluded that the major oil
companies' use of posted prices in California to calculate federal
royalties was inappropriate and recommended that the federal oil
valuation regulations be revised.  The Minerals Management Service
subsequently determined that in other parts of the country as well,
posted prices should not be used as the basis to calculate royalties
on oil from federal leases. 

Beginning in 1995, the Minerals Management Service solicited public
comments on the proposed regulations in five Federal Register
notices; it solicited comments in each notice and revised its
proposed regulations three times in response to the comments
received.  For example, the proposed regulations now include a
separate valuation system for oil from federal leases in certain
Rocky Mountain states in response to comments that the oil market in
these states is geographically isolated from other markets.  However,
the agency did not agree with all the comments it received and in
these cases provided reasons for not incorporating the suggested
changes; for example, it did not change the proposed regulations to
include the oil industry's comment that the federal government should
accept its royalties in kind, noting that it planned to seek input on
this issue through other means.  In total, the agency asked for
comments on 39 major issues and received 183 letters from states,
representatives of the oil industry, and other parties.  On its most
recent revision of the proposed regulations, the agency received 34
comments but has not yet publicly addressed them. 

Information from studies of royalties in kind, as well as specific
royalty-in-kind programs operated by various entities, indicates that
it would not be feasible for the federal government to take its oil
and gas royalties in kind except under certain conditions.  These
conditions include having relatively easy access to pipelines to
transport the oil and gas, leases that produce relatively large
volumes of oil and gas, competitive arrangements for processing gas,
and expertise in marketing oil and gas.  However, these conditions
are currently lacking for the federal government and for most federal
leases.  Specifically, the federal government does not currently have
relatively easy access to pipelines, has thousands of leases that
produce relatively low volumes, has many gas leases for which
competitive processing arrangements do not exist, and has limited
experience in oil and gas marketing. 


   BACKGROUND
------------------------------------------------------------ Letter :2

The Minerals Management Service (MMS), an agency of the Department of
the Interior, collected about $2.5 billion in royalties for gas sold
from leases on federal lands and about $1.6 billion in royalties for
oil sold from leases on federal lands in fiscal year 1997.  There are
approximately 22,000 federal oil and gas leases, which are located in
30 states, off the shore of California, and in the Gulf of Mexico. 
The federal government distributes about half of the royalties
collected from federal leases located in states back to those states
(although Alaska receives 90 percent) and shares a smaller portion of
the royalties collected from leases off the shore of California and
in the Gulf of Mexico with California and the Gulf states.  About 78
percent of the federal leases are located in nine western states, but
they produce relatively small amounts of oil and gas.  In 1996, the
most recent year for which data were available, these leases provided
less than 13 percent of the total federal royalties; leases in the
Gulf of Mexico provided about 83 percent of the total federal
royalties (and leases in the rest of the country and off the shore of
California provided the remaining 4 percent). 

Oil and gas royalties are calculated as a percentage (usually 12-1/2
percent for onshore federal leases and 16-2/3 percent for federal
leases off the shore of California and in the Gulf of New Mexico) of
the value of production, less certain allowable adjustments
(reflecting, e.g., the cost of transporting oil to markets).  The
value of production is generally determined by multiplying the volume
produced (which is measured in barrels of oil and in cubic feet of
gas) by the sales price. 


      OIL PRICING
---------------------------------------------------------- Letter :2.1

Contracts under which domestic oil is sold specify one of three types
of sales prices:  (1) posted prices, which are offers made by
purchasers to buy oil from a specific area; (2) spot prices, under
which the buyer and seller agree to the delivery of a specific
quantity of oil in the following month; and (3) prices of crude oil
futures contracts that are sold on the New York Mercantile Exchange
(NYMEX).  Posted prices can change frequently, and contracts using
posted prices frequently specify that an additional premium be paid. 
Spot prices can change daily; two commonly cited spot prices are the
prices paid for Alaska North Slope (ANS) and West Texas Intermediate
crude oil.\2 NYMEX futures contracts each establish a price for the
future delivery of 1,000 barrels of sweet crude oil (similar in
quality to West Texas Intermediate oil) at Cushing, Oklahoma, where
several major oil pipelines intersect and storage facilities exist. 

When oil is bought and sold by parties with competing economic
interests, the exchange is said to be "at arm's length" and the price
paid establishes a market value for the oil.  Roughly one-third of
the oil from federal leases is sold at arm's length; the remaining
two-thirds is exchanged between parties that do not have competing
economic interests under terms that do not establish a price or
market value.  For example, oil companies that both produce and
refine oil may transport the oil they produce to their own refineries
rather than sell it.  These oil companies may also exchange similar
quantities of oil with other oil companies--rather than sell it--to
physically place oil closer to their refineries and thereby reduce
their costs of transporting it.  Other oil companies that do not
refine oil (often referred to as independent producers) may sell the
oil they produce to marketing subsidiaries or to other companies with
which they share economic interests. 

The value of oil from a federal lease is determined by the price paid
in a sale "at the lease,"\3 which is how independent producers
traditionally sold their oil.  Since the collapse of world oil prices
in 1986, however, independent producers have employed marketers and
traders to transport their oil from their leases to market centers
and to refineries, where the oil is sold at higher prices.  Under
these circumstances, federal regulations provide that the price paid
at the actual point of sale can be adjusted to approximate the price
that would have been paid if the oil had been sold at the lease and
that federal royalties can be paid on the adjusted price. 


--------------------
\2 Domestic oil is described by the location of its origin (e.g.,
western Texas) and often by its relative weight (either light,
intermediate, or heavy); it may also be referred to as "sweet," which
means it contains relatively little sulfur and requires less
refining, or "sour," which means it contains substantial sulfur and
requires more refining. 

\3 In a sale that occurs at the lease, the buyer pays the seller to
physically take the oil at the geographic location of the lease. 


      ROYALTIES IN KIND
---------------------------------------------------------- Letter :2.2

While oil and gas royalties are most often paid in cash, they may
instead be paid with a portion of the actual oil or gas that is
produced (e.g., the lessor, who receives the royalties, would take
12-1/2 barrels of oil from every 100 barrels of oil that is
produced).  This practice of taking royalties in kind is uncommon
because few lessors can or want to store oil or gas or market and
sell it.  However, some lessors accept royalties in kind under
certain circumstances because they can sell the oil or gas for more
than they would have received if the royalties had been paid in cash. 
Paying royalties in kind rather than in cash eliminates the need to
determine the sales price of the production because royalties in kind
are calculated only on the basis of the volume of oil or gas that is
produced. 

Representatives of the oil industry have suggested that the federal
government accept some or all of its oil and gas royalties in kind
and have testified before the Congress supporting a federal
royalty-in-kind program.  Legislation has been introduced in the
Congress that would require the federal government to accept all its
oil and gas royalties in kind (a recent amendment to the legislation
would exempt certain wells).  MMS has estimated that this legislation
would cost the federal government between about $140 million and $367
million annually. 


      OIL VALUATION REGULATIONS
---------------------------------------------------------- Letter :2.3

MMS promulgated the oil valuation regulations that are currently in
effect in 1988.  These regulations define the price of oil sold in
arm's-length transactions, for the purpose of determining federal
royalties, as all financial compensation accruing to the seller. 
This compensation, known as gross proceeds, includes the quoted sales
price and any premiums the buyer receives.  For other transactions
(i.e., those not at arm's length), the price of the oil is defined as
the higher of either the gross proceeds or the amount arrived at by
the first applicable valuation method from the following list of five
alternatives:  (1) the lessee's posted or contract prices, (2)
others' posted prices, (3) others' arm's-length contract prices, (4)
arm's-length spot sales or other relevant matters, and (5) a
netback\4

or any other reasonable method.  The first two alternatives, and to a
lesser extent the third, can rely on posted prices in establishing
value. 

Under the revised oil valuation regulations that are currently
proposed, MMS would continue to require that, for the purpose of
determining federal royalties, gross proceeds be used to establish
the price of oil that is sold in arm's-length transactions.  For
transactions that are not at arm's length, however, the proposed
regulations substantially change the means for determining the price
of the oil, no longer relying on the use of posted prices and instead
relying on spot prices. 

To determine federal royalties, the proposed regulations define the
price of oil not sold in arm's-length transactions differently in
each of three domestic oil markets:  (1) Alaska and California
(including leases off the shore of California); (2) the six Rocky
Mountain states of Colorado, Montana, North Dakota, South Dakota,
Utah, and Wyoming; and (3) the rest of the country, including the
Gulf of Mexico.  These regions are depicted in figure 1.  Appendix I
contains additional information on each of these oil markets. 

   Figure 1:  Three Domestic Oil
   Markets Identified by MMS

   (See figure in printed
   edition.)

Source:  Based on information provided by MMS. 

In Alaska and California, the price of oil not sold in arm's-length
transactions is defined in the proposed regulations as the ANS spot
price, adjusted for the location of the lease and the quality of the
oil.  In the six Rocky Mountain states, this price is defined by the
first applicable valuation method from the following list of four
alternatives:  (1) an MMS-approved tendering program (akin to an
auction) conducted by the lessee; (2) the weighted average of the
lessee's arm's-length purchases and sales from the same oil field, if
they exceed 50 percent of the lessee's purchases and sales in that
specific oil field; (3) NYMEX prices, adjusted for the location of
the lease and the quality of the oil; or (4) a method established by
the MMS Director.  For the rest of the country, the price of oil is
defined as local spot prices, adjusted for the location of the lease
and the quality of the oil.  MMS estimates that its proposed
regulations would increase federal royalties by $66 million annually. 


--------------------
\4 A netback involves adjusting a price that is established for a
sale occurring away from the lease site to approximate a sales price
that would have been paid at the lease, by taking deductions
reflecting the transportation costs and the quality of the oil sold. 


   INFORMATION USED BY MMS TO
   JUSTIFY REVISED REGULATIONS
------------------------------------------------------------ Letter :3

MMS' decision to revise the oil valuation regulations relied on the
findings of an interagency task force that examined whether the use
of posted prices for the purpose of determining federal royalties in
California was appropriate.  The task force concluded that posted
prices were inappropriately used for this purpose and recommended
that MMS revise its oil valuation regulations.  MMS also relied on
additional studies, for which it had contracted, that concluded that
posted prices did not reflect market value in other areas of the
country as well.  In addition, various states supplied MMS with
information on legal settlements they had reached with major oil
companies concerning the undervaluation of oil from state leases. 


      FINDINGS OF THE INTERAGENCY
      TASK FORCE
---------------------------------------------------------- Letter :3.1

By 1991, the City of Long Beach, California, reached an agreement
with six of seven major oil companies to accept $345 million to
settle a lawsuit it had filed years earlier.  Although the lawsuit
and settlement included issues other than the valuation of oil, one
of the major issues was whether the companies' use of posted prices
represented the market value of oil produced from leases owned by the
city and the state.  After conducting a preliminary assessment of the
implication of the settlement for federal oil leases in California
and consulting with state officials, in June 1994 the Department of
the Interior assembled an interagency task force with representatives
from MMS, Interior's Office of the Solicitor, the departments of
Commerce and Energy, and the Department of Justice's Antitrust
Division.  MMS also initiated audits of two of the seven major oil
companies that produced oil from federal leases in California. 

The task force examined documents submitted by the companies in the
lawsuit that had formerly been sealed by the court, reviewed the
results of MMS' audits, and employed consultants to analyze the
market for oil in California.  The market studies noted that the
seven major oil companies dominated the oil market in California by
controlling most of the facilities that produce, refine, and
transport oil in the state--that is, most of these transactions were
not at arm's length--and that this domination in turn suppressed
posted prices.  According to one of the studies, transactions
involving ANS crude oil were at arm's length however--although ANS
oil is refined in California, it is transported into the state by a
company that does not own any refineries in California, and it is
actively traded.  As a result, ANS oil commanded substantial premiums
over California oil that was comparable in quality.  The task force
concluded that the major oil companies in California inappropriately
calculated federal royalties on the basis of posted prices, rather
than include the premiums over posted prices that they paid or
received.  The task force estimated that the companies should have
paid between $31 million and $856 million in additional royalties
(the wide range reflects the use of different methodologies and
different treatments of accrued interest) for the period 1978 through
1993.  In its final report issued in 1996, the task force recommended
that MMS revise its oil valuation regulations to reduce reliance on
the use of posted prices for valuing oil for royalty purposes. 


      STUDIES OF OIL MARKETS
---------------------------------------------------------- Letter :3.2

MMS contracted for additional studies to determine the extent to
which posted prices were used to value oil from federal leases in
California and in other areas and whether their use accurately
reflected market value.  These studies provided MMS with information
on how oil is exchanged, marketed, and sold, as well as information
on the relevance of posted prices, spot markets, and NYMEX futures
prices in oil markets.  The studies concluded that posted prices do
not represent the market value of oil, citing situations in which oil
is bought and sold at premiums above posted prices throughout the
country.  The studies cited the common practice of oil traders' and
purchasers' quoting a posted price plus a premium, in what is known
as the P-plus market, as additional evidence that posted prices are
less than market value. 


      STATES' LEGAL SETTLEMENTS
---------------------------------------------------------- Letter :3.3

Several states provided information to MMS about their experiences in
resolving disputes with oil companies regarding the valuation of oil
from leases on state lands.  In general, the states disputed the oil
companies' use of posted prices as the basis for determining
royalties paid to the states, and the disputes were settled by using
spot prices and NYMEX prices.  For example: 

  -- Alaska reported settling a lawsuit filed against three major oil
     companies for about $1 billion.  These companies produced oil
     and transported it directly to their refineries, paying state
     royalties based on prices the companies had themselves
     calculated.  The state contended that these transactions from
     1977 through 1990 were not at arm's length and that the
     calculated prices were less than the market value of the oil. 
     The amount of the settlement was determined using a complicated
     formula that was based on an average of spot prices; in
     addition, two of the companies agreed to use ANS spot prices to
     value subsequent transactions.

  -- A major oil company agreed to pay Texas $17.5 million to settle
     allegations that between 1986 and 1995 it had paid royalties on
     prices for oil from state leases that were less than market
     value.  The company also agreed that it would subsequently value
     oil from state leases on the basis of NYMEX futures prices.

  -- Louisiana reported it settled 10 disputes involving oil
     companies that owned their own refineries and paid state
     royalties on posted prices from 1987 through 1998; these
     companies agreed to collectively pay about $6 million to settle
     these claims and to make future royalty payments based on
     average spot prices in the Louisiana oil market.

  -- New Mexico reported two settlements with a major oil company
     that used its own posted prices as a basis for state royalties
     from 1985 through 1995.  The company paid the state about $2
     million and agreed to calculate royalties based on higher NYMEX
     prices and higher posted prices offered by a nearby refinery. 


   HOW MMS HAS ADDRESSED
   INDUSTRY'S AND STATES' CONCERNS
------------------------------------------------------------ Letter :4

From December 1995 through June 1998, in five Federal Register
notices and in 14 meetings throughout the country, MMS solicited
public comments on its proposal to change the way oil from federal
leases is valued for royalty purposes, and it has revised the
proposed regulations three times in response to the comments
received.  Comments submitted by states were often at odds with
comments provided by the oil industry:  States generally support the
proposed regulations because MMS anticipates that royalty
revenues--which are shared with the states--will increase; the oil
industry, on the other hand, generally opposes the proposed
regulations because they would increase oil companies' royalty
payments and administrative burden.  When MMS disagreed with a
comment received, the agency provided reasons for not revising the
proposed regulations as suggested.  In total, MMS solicited comments
on 39 major issues and received 183 letters in response.  MMS has
received 34 letters on its most recent revision of the proposed
regulations but has not yet publicly addressed these comments. 


      FIRST FOUR FEDERAL REGISTER
      NOTICES
---------------------------------------------------------- Letter :4.1

In its first Federal Register notice, published in December 1995, MMS
announced that it was considering revising its oil valuation
regulations because it had acquired evidence indicating that posted
prices no longer represented market value.  MMS solicited comments on
seven major issues and received 25 letters.  In response,
representatives of the oil industry generally commented that they
opposed any changes to the current regulations but that pending
litigation prevented them from offering specific comments on the
issues identified by MMS.  Several states, on the other hand,
commented that they believed that posted prices no longer reflected
market value, provided evidence supporting their position, and
recommended that MMS adopt spot prices or NYMEX futures prices for
valuing oil from federal leases that was not sold at arm's length. 

MMS' second Federal Register notice, published in January 1997,
contained the proposed regulations and asked for comments on 10
specific issues.  The proposed regulations retained the use of gross
proceeds for valuing federal oil sold at arm's length--but reduced
the number of oil companies that could use this method by restricting
its applicability to those companies that had not sold oil in the
past 2 years--and eliminated the use of posted prices for oil not
sold at arm's length.  For these sales, MMS proposed that the value
of oil from federal leases in Alaska and California would be based on
ANS spot prices and that the value of oil from other federal leases
would be based on NYMEX futures prices.  Both the ANS and NYMEX
prices would be adjusted for differences in the location of the
leases and the quality of the oil. 

MMS received 70 written responses to this second notice.  The oil
industry generally opposed the proposed regulations, commenting that
they were burdensome, that ANS and NYMEX prices did not reflect the
market value of oil, that adjustments to these prices were burdensome
and inadequate, and that the government should take its oil royalties
in kind if it was dissatisfied with the current valuation
regulations.  Independent oil producers also commented that NYMEX
prices should not be applied to the Rocky Mountain states because
this oil market is geographically separate from the rest of the
country.  The states generally supported the proposed regulations,
but individual states differed in their opinions on the applicability
of NYMEX prices to value oil from federal leases and offered
suggestions on the price adjustments for location and quality.  The
oil industry and several states opposed the proposed 2-year
limitation on the use of the gross proceeds methodology, believing it
was unnecessarily restrictive. 

In its third Federal Register notice, published in July 1997, MMS
responded to the comments received by revising its proposed
regulations:  It deleted the proposed limitation on the use of the
gross proceeds methodology, specifically asked for alternative
suggestions for valuing oil not sold in arm's-length transactions,
and solicited comments on six additional issues.  MMS received 28
written responses.  Independent oil producers supported the deletion
of the limitation on the use of the gross proceeds methodology. 
However, they also suggested an alternative system to value oil not
sold at arm's length by identifying and using a series of valuation
methods based on comparable sales or purchases at the lease. 

In its fourth Federal Register notice, published in September 1997,
MMS reopened the comment period on the proposed regulations and
solicited comments on eight additional issues, including the
independent producers' suggestion to identify and use a series of
alternative methods to value oil not sold at arm's length, a
suggestion to value such oil using spot prices, and the need for a
separate valuation system for the Rocky Mountain states.  MMS
disagreed with and dismissed the oil industry's suggestion to
initiate a royalty-in-kind program as an alternative to the proposed
regulations, stating that the agency would seek input on this issue
through other avenues.  MMS received 28 letters in response to this
notice.  The oil industry generally supported the suggestion to use a
series of methods to value oil not sold at arm's length but offered
no consensus on the nature of these valuation methods or their
relative order; supported establishing a separate valuation
methodology for the Rocky Mountain states, agreeing that this market
is geographically isolated; and again suggested that the federal
government take its royalties in kind. 


      CURRENT STATUS OF THE
      PROPOSED REGULATIONS
---------------------------------------------------------- Letter :4.2

MMS published its fifth and most recent Federal Register notice in
February 1998, in which it again revised its proposed regulations. 
The regulations currently propose a separate system for valuing oil
not sold at arm's length in the Rocky Mountain states, thereby
identifying three different domestic oil markets.  The proposed
regulations also eliminate the use of NYMEX prices in the rest of the
country (but retain them as a last alternative for valuing oil not
sold at arm's length in the Rocky Mountain states), offer a
definition of an oil company's affiliate (transactions with
affiliated companies are not considered to be at arm's length), and
adopt spot prices as a basis for valuing oil not sold at arm's length
outside Alaska, California, and the Rocky Mountains.  MMS also made
other modifications and sought comments on seven more issues; it
received 34 letters in response. 

Although states generally support the proposed regulations,
respondents from the oil industry continue to oppose them.  The oil
industry opposes the proposed identification of three oil markets,
saying that this situation would be burdensome and would require oil
companies to maintain three separate accounting systems. 
Representatives from the oil industry and two Rocky Mountain states
further commented that the proposed valuation system for oil not sold
at arm's length in the Rocky Mountain states is unworkable because of
the nature of the Rocky Mountain oil market.  The oil industry also
opposes MMS' proposed definition of an affiliate, stating that it is
too broad and would cause many sales that occur at arm's length to be
valued inappropriately. 

MMS has not yet publicly addressed the comments it received in
response to its fifth Federal Register notice.  In May 1998, in an
amendment to the 1998 Emergency Supplemental Appropriations Act for
the Department of Defense, the Congress directed MMS to not use any
appropriated funds to publish final oil valuation regulations before
October 1, 1998.  MMS was in the process of responding to the
comments but ceased its efforts as a result of this directive. 


      ADDITIONAL EFFORTS MADE BY
      MMS
---------------------------------------------------------- Letter :4.3

In addition to publishing five notices in the Federal Register, MMS
held 14 meetings around the country to further explain the proposed
regulations and to solicit additional comments on them.  In April
1997, the agency held public meetings in Houston, Texas, and
Lakewood, Colorado.  In May 1997, it met with representatives from
the oil industry and Louisiana to solicit views on the first draft of
the regulations.  Following its September 1997 Federal Register
notice, MMS held public meetings in Washington, D.C.; Lakewood,
Colorado; Houston, Texas; Bakersfield, California; Casper, Wyoming;
and Roswell, New Mexico.  In February and March 1998, MMS also held
public meetings on its current version of the proposed regulations in
Houston, Texas; Washington, D.C.; Lakewood, Colorado; Bakersfield,
California; and Casper, Wyoming. 

MMS also placed the five Federal Register notices, all 183 letters it
received in response to these notices, and additional information
concerning the proposed oil valuation regulations on the Internet
home page of its Royalty Management Program.  We found this site easy
to use. 


   FEASIBILITY OF A
   ROYALTY-IN-KIND PROGRAM
------------------------------------------------------------ Letter :5

Although most oil and gas lessors take their royalties in cash,
several limited programs exist in the United States and Canada under
which lessors accept their royalties in kind:  Oil royalty-in-kind
programs are currently operated by MMS,\5 the Canadian Province of
Alberta, the City of Long Beach, the University of Texas, and the
states of Alaska, California, and Texas; gas royalty-in-kind programs
are also currently operated by Texas and the University of Texas. 
(App.  II provides more information on these programs.) According to
information from studies and the programs themselves, royalty-in-kind
programs seem to be feasible if certain conditions are present.  In
particular, the programs seem to be most workable if the lessors have
(1) relatively easy access to pipelines to transport the oil or gas
to market centers or refineries, (2) leases that produce relatively
large volumes of oil or gas, (3) competitive arrangements for
processing gas, and (4) expertise in marketing oil or gas.  However,
these conditions do not exist for the federal government or for most
federal leases:  The federal government does not currently have
relatively easy access to pipelines, has thousands of leases that
produce relatively low volumes, has many gas leases for which
competitive processing arrangements do not exist, and has limited
experience in oil or gas marketing. 


--------------------
\5 The purpose of MMS' royalty-in-kind program is to supply oil to
small refineries that may otherwise not be able to obtain oil at
competitive prices; it currently provides oil from 170 leases to
several small refineries. 


      EASY ACCESS TO PIPELINES
---------------------------------------------------------- Letter :5.1

Once produced from a lease, oil or gas generally becomes more
valuable (i.e., can be sold for higher prices) the closer it is moved
to a market center or refinery, and pipelines are often the only
cost-effective means of transporting it.  Several of the entities
operating royalty-in-kind programs told us that having relative ease
of access to pipelines is a key component of their programs because
it assures them that they can transport their production when they
need to at a relatively low cost.  For example, Alberta uses its
regulatory authority to direct its lessees to deliver the province's
oil royalties, using extensive pipelines that transport the oil to
centrally located storage tanks, where oil marketers who are under
contract with Alberta sell the oil.  In Texas, state law mandates
that all gas pipelines in the state accept and transport gas from the
state's gas royalty-in-kind program.  Representatives of the oil
royalty-in-kind programs in the City of Long Beach, the states of
California and Texas, and the University of Texas reported that
because oil from certain leases could be transported on only one
pipeline charging high fees, they were unable to accept royalties in
kind from these leases or incurred losses in selling this oil because
of the high transportation fees. 

The federal government does not currently have the statutory or
regulatory authority over pipelines that would ensure relative ease
of access for transporting oil and gas from federal leases.  In
addition, some pipelines are privately owned, and the owners are free
to set their own transportation fees.  In some areas of the country,
oil from federal leases can be transported on just a single pipeline,
and the owner of that pipeline may charge substantial fees.  In 1995,
MMS conducted a limited royalty-in-kind program on federal leases in
the Gulf of Mexico, collecting gas royalties in kind and offering gas
for sale near the leases.  Because purchasers had to transport the
gas and pay transportation fees to use the privately owned pipelines,
the purchase bids that MMS received were relatively low.  MMS
estimated that this program lost about $4.7 million (about 7 percent)
when compared to the revenues the agency would have received if it
had taken its gas royalties in cash.  Oil and gas marketers we
contacted confirmed that the federal government would need to
transport any royalties in kind it received to market centers or
refineries in order to increase its revenues. 


      LARGE VOLUMES
---------------------------------------------------------- Letter :5.2

To be cost-effective, royalty-in-kind programs must have volumes of
oil and gas that are high enough for the revenues made from selling
these volumes to exceed the programs' administrative costs.  The
volumes of oil or gas that are needed for programs to be
cost-effective vary among programs.  For example, when Wyoming tried
in 1997 to initiate a limited oil royalty-in-kind program on 508
leases that produced, on average, less than 3 barrels of oil in
royalties per day, it did not receive any bids that would have
allowed the state to generate more revenues than it already received
by taking its royalties in cash.  Texas and the University of Texas
generally do not accept royalty volumes of less than 10 barrels daily
in their oil royalty-in-kind programs.  MMS does not accept oil
royalties in kind from leases supplying less than around 50 barrels
per day, because it believes that the benefits to refiners from
smaller volumes would not offset its administrative costs.  And while
Alberta accepts all of its oil royalties in kind, these royalty
volumes are relatively large:  200 to 10,000 barrels per day are
common.  Similar situations exist in gas royalty-in-kind programs;
for example, program representatives from Texas and the University of
Texas told us that they needed to have large volumes of gas--a
minimum of either 300,000 or 2,000,000 cubic feet per day, depending
on the pipeline used, to obtain pipeline transportation. 

The majority of oil and gas leases on federal lands produce
relatively small volumes and are geographically scattered across many
miles--particularly for federal leases located in the western states. 
For example, MMS estimates that about 65 percent of the wells on
federal oil leases in Wyoming produce less than 6 barrels of oil
daily, which would result in less than 1 barrel per day in oil
royalties in kind.  Most federal leases in the San Juan Basin of New
Mexico also produce low volumes. 


      COMPETITIVE GAS PROCESSING
      ARRANGEMENTS
---------------------------------------------------------- Letter :5.3

Because natural gas may need to be processed before it can be sold,
arranging for this processing is a critical consideration in
operating a gas royalty-in-kind program.  The University of Texas
noted that many of the university's leases produce small volumes of
gas requiring processing and that these volumes must be aggregated
into a larger amount to be accepted by gas-processing plants. 

Many federal leases also produce small volumes of gas that need to be
processed.  In certain areas, there is only a single plant to process
the gas from many of these leases.  In these circumstances, the lack
of competition might allow the plants to charge high fees.  For
example, MMS estimates that the federal government could lose up to
$4.3 million annually if the agency accepted royalties in kind from
federal leases in Wyoming for which there is access to only a single
gas-processing plant. 


      MARKETING EXPERTISE
---------------------------------------------------------- Letter :5.4

Lessors who accept royalties in kind must sell the oil or gas to
realize revenues, and they are likely to receive higher prices if
they move it away from the lease and closer to marketing centers or
refineries.  Storing, transporting, marketing, and selling oil or gas
can be complicated processes; profit margins are often thin; and
there may be little room for error.  The nonfederal royalty-in-kind
programs have generally been in existence for years, and the entities
running these programs have gained both experience and expertise. 
For example, Alberta has been actively marketing its oil royalties in
kind since 1974.  Similarly, the University of Texas has been
accepting its gas royalties in kind and arranging for transportation
since 1985. 

In contrast, the federal government has limited experience in
marketing oil or gas royalties in kind.  In addition to the limited
oil royalty-in-kind program that MMS currently operates, in 1995 it
conducted a limited gas royalty-in-kind program in the Gulf of
Mexico.  However, MMS' experience in these programs has been limited
to sales that occur at the lease; the agency has not transported its
oil or gas to market centers or received higher revenues than it
would have realized if it had instead taken cash royalties. 


   AGENCY COMMENTS
------------------------------------------------------------ Letter :6

We provided a copy of a draft of this report to the Department of the
Interior for its review and comment.  The Department commented that
this report provides a fair description of its oil valuation
rulemaking efforts and of the issues it would face if required to
implement a mandatory royalty-in-kind program.  The Department also
provided some minor technical clarifications, which we incorporated. 
Interior's comments are reproduced in appendix III. 


---------------------------------------------------------- Letter :6.1

We performed our review from March 1998 through July 1998 in
accordance with generally accepted government auditing standards. 
Our scope and methodology are discussed in appendix IV. 

We will send copies of this report to appropriate congressional
committees, the Secretary of the Interior, and other interested
parties.  We will also make copies available to others upon request. 

If you or your staff have any questions, please call me at (202)
512-3841.  Major contributors are listed in appendix V. 

Barry T.  Hill
Associate Director, Energy,
 Resources, and Science Issues


DOMESTIC OIL MARKETS
=========================================================== Appendix I

In developing its proposed oil valuation regulations, the Minerals
Management Service (MMS) received comments from the oil industry
making the point that separate oil markets exist in different
geographic areas of the United States.  In response to these
comments, MMS' proposed regulations now identify three domestic oil
markets:  (1) Alaska and California; (2) the six Rocky Mountain
states of Colorado, Montana, North Dakota, South Dakota, Utah, and
Wyoming; and (3) the rest of the country. 


   ALASKA AND CALIFORNIA
--------------------------------------------------------- Appendix I:1

A large portion of the oil produced in Alaska comes from the Prudhoe
Bay region on the state's North Slope.  Alaska North Slope (ANS)
crude oil, an intermediate grade of oil, is transported about 800
miles south through the Trans-Alaskan Pipeline System to Valdez,
Alaska, where it is loaded onto oil tankers.  Most ANS oil is shipped
to oil refineries in the Puget Sound, Los Angeles, and San Francisco,
although some is shipped to the Far East or refined in Alaska.  ANS
oil represents about 40 percent of the oil that is refined in
California. 

In California, oil is produced from onshore leases--in the San
Joaquin, Santa Maria, Ventura, and Los Angeles basins in southern
California--and from leases off the coast--from Point Arguello
southeast to Huntington Beach.  Although a variety of grades of crude
oil are produced in California, most of its oil is heavy.  About
two-thirds of the oil in California is produced by seven major oil
companies, which also own about three-quarters of the refinery
capacity in the state and have major investments in oil pipelines in
the state.  Many of these pipelines are common carrier lines that are
regulated by the state and therefore must be made available to
transport the oil of independent producers.  However, these seven
major oil companies also own three heated pipelines--which make the
heavy oil more liquid and therefore more easily transported through
pipelines--that are not common carrier lines; the seven major oil
companies use their heated lines to transport their oil to their
refineries in Los Angeles and San Francisco.  Nearly all of the oil
produced in California is refined within the state, and most of it is
refined into gasoline. 

About 15 percent of the oil produced nationwide from federal leases
is produced in Alaska and California.  Most of this oil is
transported by the major oil companies from the federal leases
directly to their refineries, or it is exchanged for oil that is
ultimately moved to these refineries, rather than being sold on the
open market. 


   ROCKY MOUNTAIN STATES
--------------------------------------------------------- Appendix I:2

Production from the six Rocky Mountain states of Colorado, Montana,
North Dakota, South Dakota, Utah, and Wyoming includes a wide range
of crude oils from geographic basins in a variety of areas.  These
basins are often physically separated from one another by rugged
terrain and long distances, resulting in local markets within the
larger Rocky Mountain market.  Individual wells often produce very
low volumes--a few barrels a day are not uncommon.  Important
producing areas include the Powder River and Big Horn basins in
Wyoming, the Williston Basin in Montana and North Dakota, the Uinta
Basin in Utah, the Piceance Basin in western Colorado, and the
Paradox Basin of the Four Corners area.  About 8 percent of the oil
produced nationwide from federal leases is produced in this region,
and about 65 percent of this amount comes from the Wyoming basins. 

Oil produced in this region is refined almost exclusively within the
region by small refineries.  The larger of these small refineries are
located in Billings, Montana; Denver, Colorado; Salt Lake City, Utah;
and various locations in Wyoming.  Most of the oil from the region is
produced by independent producers who do not own refineries.  These
producers may market their oil themselves, or they may sell it to oil
traders or marketers, who in turn sell and transport the oil to
refineries. 


   THE REST OF THE COUNTRY
--------------------------------------------------------- Appendix I:3

In the rest of the country, most of the oil is produced from leases
located in the Gulf of Mexico and onshore leases located in western
Texas, the Gulf states, and the mid-continental states.  Leases in
the Gulf of Mexico account for about 75 percent of the total federal
royalties received from oil leases nationwide.  The region has a
large number of oil companies, a well-integrated pipeline system, a
large number of refineries, and a high refining capacity. 

Oil that is produced in western Texas and in New Mexico is refined
locally or is gathered and transported via pipeline to the market
center at Midland, Texas.  From Midland, the oil flows either
southeast to refineries along the Gulf Coast or northeast to the
market center of Cushing, Oklahoma.  From Cushing, oil often flows
northeast to major oil refineries in Illinois.  Oil that is produced
in the Gulf of Mexico is generally transported via pipeline to market
centers or refineries at Empire and Saint James, Louisiana.  This oil
can be refined locally or can be piped north to Cushing and
ultimately to the Illinois refineries.  Because of the extensive
pipeline system, oil produced in this region can be easily
transported; for this reason, the area has many oil traders, and oil
is predominantly sold by these marketers. 


ROYALTY-IN-KIND PROGRAMS
========================================================== Appendix II

We examined seven oil royalty-in-kind programs and two gas
royalty-in-kind programs that are currently operating in the United
States and Canada.  Sales of the oil that is taken as royalties occur
competitively at the lease, noncompetitively at the lease, or after
the oil has been transported to storage tanks.  Sales of most of the
gas that is taken as royalties occur after the gas is transported. 


   OIL ROYALTY-IN-KIND PROGRAMS
-------------------------------------------------------- Appendix II:1

We identified four oil royalty-in-kind programs under which the
recipients of the oil royalties sell the oil in competitive sales
that occur at the lease:  programs operated by the City of Long Beach
in California, the University of Texas, and the states of California
and Texas.  The primary purpose of all of these programs is to
maximize revenues.  In operating these programs, these entities
generally select specific leases to include, solicit bids from
interested parties to purchase the oil that has been taken as
royalties in kind, and issue short-term contracts (normally from 6 to
18 months) to the successful bidders to purchase this oil.  Bidders
generally offer premiums above posted prices and must arrange and pay
to transport the oil to market centers or refineries.  These programs
are limited in scope, involving relatively few of the entities' oil
leases that produce high volumes, and none of the programs currently
has more than 13 active contracts. 

Alaska and MMS both operate oil royalty-in-kind programs under which
they sell the oil in noncompetitive sales to small refiners.  In both
programs, the sale occurs at the lease, and the purchaser arranges
and pays to transport the oil to the refinery.  Under Alaska's
program, the state directly negotiates sales with small refiners.  By
law, Alaska must realize revenues from selling this oil that are at
least equal to what the state would receive under current sales
prices for oil; however, the state tries to obtain bonuses on this
oil of at least a 15 cents per barrel.  Currently, Alaska has three
contracts involving about 170,000 barrels of oil per day.  Under MMS'
program, the agency solicits interest from small refiners and makes
oil from certain leases available if there is interest.  MMS must
receive an amount equal to the cash royalties that would have been
paid plus a fee to cover its administrative costs.  Currently, MMS
administers six contracts covering 170 leases located in the Gulf of
Mexico and off the shore of California. 

In the Province of Alberta, Canada, royalties from all of the
provincial oil leases must be taken as royalties in kind, which
constitutes about 125,000 barrels of oil per day.  These oil
royalties in kind are not taken at the lease.  Instead, the province
directs its lessees to gather the oil from the leases (which are
generally concentrated in one geographic area) and transport it to
about 5,500 storage tanks that are centrally located; the province
then reimburses the transportation fees.  Alberta has 5-year
contracts with three oil marketers, each whom is generally
responsible for one of three grades of oil and receives fees equal to
5 cents per barrel to sell this oil. 


   GAS ROYALTY-IN-KIND PROGRAMS
-------------------------------------------------------- Appendix II:2

In addition to their oil royalty-in-kind programs, Texas and the
University of Texas also operate small gas royalty-in-kind programs. 
Texas accepts gas royalties in kind from about 6 percent of its
leases; the program is intended to increase royalty revenues for the
state's school fund and to provide gas to state facilities--schools,
universities, hospitals, and prisons--at a cheaper price than is
offered by local gas distribution companies.  The University of Texas
accepts gas royalties in kind from seven of its leases and sells this
gas under a single contract. 




(See figure in printed edition.)Appendix III
COMMENTS FROM THE DEPARTMENT OF
THE INTERIOR
========================================================== Appendix II


SCOPE AND METHODOLOGY
========================================================== Appendix IV

To determine what information MMS used to justify the need for
revising its oil valuation regulations, we reviewed MMS' reasons for
proposing new regulations as published in Federal Register notices
and read all of the comments submitted in response to the first
notice that solicited information on oil marketing and the relevance
of posted prices.  We interviewed officials in MMS' Royalty Valuation
Division and reviewed the marketing studies for which MMS had
contracted.  We also reviewed the final report of the interagency
task force that examined federal oil valuation in California and
interviewed individuals who had served on that task force and
individuals who were involved in the City of Long Beach's litigation. 
In addition, we solicited information on lawsuits and settlements
from state representatives present at a meeting of the State and
Tribal Royalty Audit Committee in Denver, Colorado, and we
subsequently contacted representatives of these various states for
additional information. 

To ascertain how MMS addressed concerns expressed by the oil industry
and states in developing its proposed regulations, we identified 39
major issues on which MMS had solicited comments in its Federal
Register notices.  We selected a judgmental sample of about 50
percent of the 183 letters that were submitted to MMS in response to
these notices.  In selecting this sample, we sought to represent a
cross-section of the oil industry and included in our sample major
oil companies that both produced and refined oil, large independent
companies that only produced oil, small independent producers,
independent refiners, oil marketers, and oil industry trade
associations.  Because the number of letters MMS received from states
was significantly less than the number of letters MMS received from
representatives of the oil industry, we read all of the comments
submitted by states.  We summarized concerns expressed by the oil
industry and states on each of the 39 issues and determined how MMS
addressed these concerns--that is, whether and how the proposed
regulations were revised in response to the comments.  In addition,
we interviewed representatives from the following oil industry
associations:  the American Petroleum Institute, the Independent
Petroleum Association of America, the Independent Petroleum
Association of Mountain States, the Independent Oil Producers
Association, and the California Independent Petroleum Association. 
We attended or read transcripts from several public meetings
conducted by MMS on the proposed regulations. 

To determine what existing studies and programs indicate about the
feasibility of the federal government's taking its oil and gas
royalties in kind, we (1) identified and read two studies--a 1997
study by MMS of the feasibility of royalties in kind and a 1997
analysis by the Congressional Research Service on the oil
royalty-in-kind program run by the Canadian Province of Alberta--and
interviewed their authors and (2) identified nine royalty-in-kind
programs that are currently in operation and interviewed
representatives of these programs:  the seven oil royalty-in-kind
programs operated by MMS, the Canadian Province of Alberta, the City
of Long Beach, the University of Texas, and the states of Alaska,
California, and Texas; and the two gas royalty-in-kind programs
operated by Texas and the University of Texas.  We also reviewed an
attempt by Wyoming in 1997 to take oil royalties in kind, reviewed a
pilot program conducted by MMS in 1995 in the Gulf of Mexico to take
gas royalties in kind, and interviewed MMS representatives who are
designing limited royalty-in-kind programs that are planned for
federal leases in Wyoming and the Gulf of Mexico.  In addition, we
interviewed oil and gas marketers who are active in the Rocky
Mountains, mid-continental, and Gulf of Mexico regions; we met with
technical staff in MMS' Pacific Outer Continental Shelf Region in
Camarillo, California; and we reviewed the proposed legislation
mandating that MMS accept federal oil and gas royalties in kind, MMS'
analysis of the financial impact of this proposed legislation, and
the Barents Group's response to MMS' analysis. 

We conducted our review from March 1998 through July 1998 in
accordance with generally accepted government auditing standards. 


MAJOR CONTRIBUTORS TO THIS REPORT
=========================================================== Appendix V

RESOURCES, COMMUNITY, AND ECONOMIC
DEVELOPMENT DIVISION

Ronald M.  Belak
Mehrzad Nadji
Sue Ellen Naiberk
Victor S.  Rezendes

OFFICE OF THE GENERAL COUNSEL

Alan R.  Kasdan


*** End of document. ***