Federal Oil Valuation: Efforts to Revise Regulations and an Analysis of
Royalties in Kind (Testimony, 05/19/99, GAO/T-RCED-99-152).

Pursuant to a congressional request, GAO discussed the valuation of
federal oil, focusing on: (1) the information the Minerals Management
Service (MMS) used to justify the need for revising its regulations; (2)
how MMS addressed concerns expressed by the oil industry and the states
in developing these regulations; and (3) the feasibility of the
government's taking its oil and gas royalties in kind, instead of in
cash.

GAO noted that: (1) MMS relied heavily on the findings of an interagency
task force to revise its oil valuation regulations; (2) this task force
concluded that the major oil companies' use of posted prices in
California to calculate federal royalities was inappropriate and
recommended that the federal oil valuation regulations be revised; (3)
MMS also relied on contracted studies of oil markets and on valuation
disputes between the states and oil companies that the oil companies
agreed to settle for more than $1 billion; (4) to address concerns of
the oil industry and the states, MMS solicited public comments on the
proposed regulations in seven Federal Register notices, held 17 public
meetings, and revised its regulations five times; (5) proposed changes
to the regulations are still pending; (6) concerning the government's
taking of its royalties in kind, GAO concluded that this would not be
feasible except under certain conditions; (7) these conditions include
having easy access to pipelines, leases that produce large volumes of
oil and gas, competitive arrangements for processing gas, and expertise
in marketing oil and gas; and (8) however, these conditions are lacking
for the federal government and for most federal leases.

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

 REPORTNUM:  T-RCED-99-152
     TITLE:  Federal Oil Valuation: Efforts to Revise Regulations and
             an Analysis of Royalties in Kind
      DATE:  05/19/99
   SUBJECT:  Prices and pricing
             Gas leases
             Intergovernmental fiscal relations
             Petroleum industry
             Public lands
             Royalty payments
             Oil leases
IDENTIFIER:  California
             Alaska
             Colorado
             Montana
             North Dakota
             Utah
             Wyoming
             Gulf of Mexico
             South Dakota

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Cover
================================================================ COVER

Before the Subcommittee on Government Management, Information, and
Technology, Committee on Government Reform, House of Representatives

For Release
on Delivery
Expected at
2 p.m.  EDT
Wednesday
May 19, 1999

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

Statement of Susan D.  Kladiva,
Associate Director, Energy,
Resources, and Science Issues,
Resources, Community, and Economic
Development Division

GAO/T-RCED-99-152

GAO/RCED-99-152T

(141323)

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

  MMS -
  NYMEX -

============================================================ Chapter 0

Mr.  Chairman and Members of the Subcommittee:

We are here today to testify on the valuation of federal oil.  In
fiscal year 1998, the Department of Interior's Minerals Management
Service (MMS) collected $3.6 billion in royalties from oil and gas
leases on federal lands.  States in which federal leases are located
received a share of the royalties collected.  The value of these
royalties depended upon the price of oil.  As an alternative to
accepting cash royalty payments, the federal government could have
taken a percentage of the actual oil and gas produced and then
arranged for its sale, taking what are known as royalties in kind.

Historically, the value of much of the oil from federal leases has
been based on posted prices which are 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 oil valuation regulations so that they
rely less on posted prices and more on other, and oftentimes, higher
prices.  These revised regulations are still pending.

Most of my statement will summarize the results of a report that we
issued in August 1998 on the Department of Interior's attempts to
revise the federal oil valuation regulations and the feasibility of
the government's taking its oil and gas royalties in kind.\1
Specifically, I will discuss three issues:  (1) the information MMS
used to justify the need for revising its regulations; (2) how MMS
addressed concerns expressed by the oil industry and the states in
developing these regulations; and (3) the feasibility of the
government's taking its oil and gas royalties in kind, instead of in
cash.

In summary, Mr.  Chairman, MMS relied heavily on the findings of an
interagency task force to revise its oil valuation regulations.  This
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.  MMS also relied on contracted studies of oil markets and on
valuation disputes between the states and oil companies that the oil
companies agreed to settle for more than $1 billion.  To address
concerns of the oil industry and the states, MMS solicited public
comments on the proposed regulations in seven Federal Register
notices, held 17 public meetings, and revised its regulations five
times.  Proposed changes to the regulations are still pending.
Concerning the government's taking of its royalties in kind, we
concluded that this would not be feasible except under certain
conditions.  These conditions include having easy access to
pipelines, leases that produce 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.

--------------------
\1 Federal Oil Valuation:  Efforts to Revise Regulations and an
Analysis of Royalties in Kind (GAO/RCED-98-242, Aug.  19, 1998).

   BACKGROUND
---------------------------------------------------------- Chapter 0:1

In fiscal year 1998, MMS collected about $2.4 billion in royalties
for gas sold from leases on federal lands and about $1.2 billion in
royalties for oil sold from leases on federal lands.  Oil and gas
royalties are calculated as a percentage (usually 12-1/2 percent for
onshore federal leases and 16-2/3 percent for offshore federal
leases) of the value of production less certain allowable adjustments
(such as the cost of transporting oil to markets).  The value of
production is determined by multiplying the volume produced (which is
measured in barrels of oil and in cubic feet of gas) by the sales
price.

MMS promulgated the oil valuation regulations that are currently in
effect in 1988.  These regulations differentiate between oil sold ï¿½at
arm's lengthï¿½ and oil that is not sold at arm's length.  "At arm's
length" refers to oil that is bought and sold by parties with
competing economic interests, and the price paid establishes a market
value for the oil.  However, roughly two-thirds of the oil from
federal leases is not sold at arm's length; it 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.  These oil companies may also
exchange similar quantities of oil with other oil companies to
physically place oil closer to their refineries and thereby reduce
their costs of transporting it.

The 1988 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\2 or other relevant matters, and (5) a
netback\3 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, for federal royalty
purposes, that gross proceeds be used to establish the price of oil
sold in arm's-length transactions, except in certain circumstances
involving multiple exchanges or sales.  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.

In Alaska and California, the price of oil not sold in arm's-length
transactions is defined in the proposed regulations as the Alaska
North Slope spot price, adjusted for the location of the lease and
the quality of the oil.  In the six Rocky Mountain states, this price
is proposed to be the first applicable valuation method from the
following list of four alternatives:  (1) the highest bid in 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, when they exceed 50
percent of the lessee's purchases and sales in that specific oil
field; (3) the spot price for West Texas Intermediate crude oil at
Cushing, Oklahoma, (where several major oil pipelines intersect and
storage facilities exist) 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
by local spot prices, adjusted for the location of the lease and the
quality of the oil.

While oil and gas royalties are most often paid in cash, they may
instead be paid with a portion of the actual oil and gas that is
producedï¿½referred to as paying royalties in kind.  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.

--------------------
\2 Under spot sales, the buyer and seller agree to the delivery of a
specific quantity of oil in the following month.

\3 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
---------------------------------------------------------- Chapter 0:2

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.  By 1991, the City of Long Beach,
California, reached 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 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.  The purpose of the task force was
to examine whether the use of posted prices was appropriate for the
purpose of determining federal royalties in California.  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, 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 Alaska North Slope crude, an oil that is
transported into the state by a company that does not own any
California refineries and that is actively traded at arm's length,
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)
to the federal government 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.

MMS also relied on additional studies, for which it had contracted,
that examined oil pricing in other areas of the country.  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 (New York Mercantile Exchange)\4
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.

In addition, various states supplied MMS with information on legal
settlements they had reached with major oil companies concerning the
undervaluation 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.  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.

  -- A major oil company agreed to pay Texas $17.5 million to settle
     allegations that from 1986 through 1995 it had paid royalties on
     prices for oil from state leases that were less than market
     value.

  -- 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.

--------------------
\4 Each NYMEX futures contract establishes a price for the future
delivery of 1,000 barrels of sweet crude oil (similar in quality to
West Texas Intermediate) at Cushing, Oklahoma.

   HOW MMS HAS ADDRESSED
   INDUSTRY'S AND STATES' CONCERNS
---------------------------------------------------------- Chapter 0:3

From December 1995 through April 1999, MMS solicited public comments
on its proposal to change the way oil from federal leases is valued
for royalty purposes in seven Federal Register notices and in 17
public meetings throughout the country, and it has revised the
proposed regulations five 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.  MMS estimates that its
proposed regulations will increase federal royalties by $66 million
annually.  The oil industry generally opposes the proposed
regulations because they would increase oil companies' royalty
payments and administrative burden.

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.  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 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,
proposed retaining 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.  It also
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 Alaska North Slope
spot prices and that the value of oil from other federal leases would
be based on NYMEX futures prices.  Both the Alaska North Slope and
NYMEX prices would be adjusted for differences in the location of the
leases and the quality of the oil.

In its third through seventh Federal Register notices, published from
July 1997 through March 1999, MMS responded to comments and modified
its regulations in response to these comments.  For example, in
response primarily to the oil industry's comments, MMS eliminated the
use of NYMEX for establishing the value of oil not sold at arm's
length, proposed a separate system for valuing oil not sold at arm's
length in the Rocky Mountain states, and modified the definition of
ï¿½affiliate.ï¿½ In response primarily to the states' comments, MMS
proposed the use of spot prices in valuing oil not sold at arms'
length and proposed certain price adjustments for location and
quality.  As suggested by the oil industry and the states, MMS also
deleted a proposed 2-year limitation on the use of a valuation
methodology relying on gross proceeds.  When MMS disagreed with a
comment received, the agency provided reasons for not revising the
proposed regulations as suggested.  For example, 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.

   FEASIBILITY OF A
   ROYALTY-IN-KIND PROGRAM
---------------------------------------------------------- Chapter 0:4

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.  According to information from studies and the programs
themselves, royalty-in-kind programs are feasible if certain
conditions are present.  In particular, the programs are 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.

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 oil
and gas to where they need it at a relatively low cost.  However, 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.  Oil and
gas marketers we contacted confirmed that the federal government
would need to transport any royalty-in-kind production it received to
market centers or refineries in order to increase its revenues.

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
majority of oil and gas leases on federal lands, however, produce
relatively small volumes and are geographically
scattered--particularly 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.

Because natural gas may need to be processed before it can be sold,
arranging for processing is a critical consideration in operating a
gas royalty-in-kind program.  Many federal leases 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.

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.  In
contrast, the federal government has limited experience in marketing
oil or gas royalties in kind.

--------------------
\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.

-------------------------------------------------------- Chapter 0:4.1

Mr.  Chairman, this concludes our prepared statement.  We will be
pleased to respond to any questions that you or Members of the
Subcommittee may have.

*** End of document. ***