Audit Report on the Small Refiners Program, Minerals Management Service

[Audit Report on the Small Refiners Program, Minerals Management Service]
[From the U.S. Government Printing Office, www.gpo.gov]

Report No. 00-I-279

Title: Audit Report on the Small Refiners Program, Minerals Management
Service

Date: March 27, 2000

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U.S. Department of the Interior
Office of Inspector General

EXECUTIVE SUMMARY

Small Refiners Program,
Minerals Management Service,
Report No. 00-I-279
March 2000

BACKGROUND

An estimated 50 small refining companies operate in the United States and account for about
11 percent of the Nation's crude oil refining capacity. Small refiners produce a variety of
products, such as motor gasolines, diesel and jet fuels, and asphalt for road construction.
However, because small refiners generally are independent companies that do not have their
own oil production capabilities, the potential exists for these refiners to face economic
adversity, including possible shutdowns of operations, when oil supplies are low or oil prices
are high. To assist small refiners, the Department of the Interior takes a portion of the
Federal Government's royalties "in-kind" from oil companies and sells the oil to eligible
refiners to ensure that they have a constant supply. The Minerals Leasing Act of 1920 and
the Outer Continental Shelf Lands Act of 1953 govern the sale of royalty-in-kind oil
originating from onshore leases and offshore leases, respectively.

The Small Refiners Program is administered by the Royalty-in-Kind Section, within the
Accounting and Reports Division of the Minerals Management Service's Royalty
Management Program. The Small Refiners Program costs about $1.2 million to operate each
year, and the Section has seven full-time positions. In administrating the Program, the
Service conducts periodic sales of Government royalty oil and negotiates contracts with the
participating small refiners for the purchase of the oil, which generally run for a period of
3 years. Prior to a royalty oil sale, Program regulations require the Service to conduct a study
(known as a Determination of Need) to determine whether small refiners would benefit from
the sale. The Service's regulations also require that the costs of operating the Program be
recovered through administrative fees assessed on the participating refiners.

OBJECTIVE

The objective of our audit was to determine whether the Service had an effective strategy to
correct deficiencies in the Small Refiners Program that were identified by Service, state
government, and industry officials in a formal study completed in 1997.

RESULTS IN BRIEF

We concluded that the Minerals Management Service had made satisfactory progress in
correcting the deficiencies in the Small Refiners Program that were identified in a formal
study conducted by Service, state government, and industry officials. For example, the
Service improved the process for determining the value of royalty oil and was redesigning
the Program to ensure that refiners paid royalties for oil volumes received. We found,
however, that the Program had weaknesses that had not been addressed. Specifically, the
Service did not address the anticipated increase in demand for oil from the refiners, did not
conduct royalty oil sales on a frequent or regular basis, and did not recover the full costs of
administrating the Program. Program regulations (30 CFR 208.4) require that the Service
conduct an analysis of the crude oil market prior to a royalty oil sale to determine whether
small refiners have adequate access to supplies of oil at equitable prices. In addition, 30 CFR
208.4(b)(4) and Office of Management and Budget Circular No. A-25, "User Charges,"
require that the Service recover the full administrative costs of the Program. The identified
weaknesses occurred because the Service's crude oil market analysis did not include
potential oil available to small refiners under the 20 percent set-aside provision in offshore
leases and because Program officials, in attempting to reduce the financial impact on the
refiners, recovered only a portion of the administrative costs incurred to operate the Program.
We found that the Service had not recovered administrative costs of about $1.9 million since
fiscal year 1997.

RECOMMENDATIONS

We recommended that the Minerals Management Service require Small Refiners Program
officials to ensure that the Determination of Need considers all sources of oil available to the
small refiners and to conduct the Determination of Need on a regular and more frequent
basis. We further recommended that the Service ensure that it recovers the full costs of
administrating the Program from the small refiners.

AUDITEE COMMENTS AND OIG EVALUATION

The Service concurred with the recommendation to conduct the Determination of Need on
a regular and more frequent basis but did not concur with the recommendations to consider
all sources of available oil when conducting the Determination and to recover all costs of
administrating the Program. As to the Determination, the Service indicated that its failure
to consider the 20 percent set-aside provision was not relevant to the process. We believe,
however, that the Determination cannot be valid if this potentially significant source of oil
is disregarded. Although the Service held a sale in October 1999, which resulted in smaller
than expected volumes of oil sold, we do not believe that the small refiners necessarily
exhibited a reduced interest in Government royalty oil. Rather, the manner in which the sale
was conducted may have resulted in fewer small refiners participating, in that the
"established reasonable price thresholds" were greater than expected for prospective small
refiners. Regarding cost recovery, the Service stated that it was recovering costs in
accordance with Program regulations and that it should recover only the costs of
administrating leases active in the Program. We believe that the Service should recover the
full administrative costs associated with both active and terminated leases. Accordingly, the
Service was requested to reconsider its responses to the report's remaining two
recommendations, which are unresolved. C-IN-MMS-001-99-R

March 27, 2000
AUDIT REPORT

Memorandum

To: Director, Minerals Management Service

From: Robert J. Williams
Assistant Inspector General for Audits

Subject: Audit Report on the Small Refiners Program, Minerals Management Service
(No. 00-I-279)

INTRODUCTION

This report presents the results of our audit of the Small Refiners Program of the Minerals
Management Service. We initiated this audit as part of our audit workplan for fiscal year
1998. However, at the request of the Service, we agreed to reschedule the audit for fiscal
year 1999 to allow the Service sufficient time to complete certain Program improvements.
The objective of our audit was to determine whether the Service had an effective strategy to
correct deficiencies in the Small Refiners Program that were identified by Service, state
government, and industry officials in a formal study completed in 1997.

BACKGROUND

An estimated 50 small refining companies operate in the United States and account for about
11 percent of the Nation's crude oil refining capacity. Small refiners produce a variety of
refined products, such as motor gasolines, diesel and jet fuels, and asphalt for road
construction. However, because small refiners generally are independent companies that
do not have their own oil production capabilities, the potential exists for these refiners to face
economic adversity, including a possible shutdown of operations, when oil supplies are low
or oil prices are high. In that regard, the Energy Information Administration of the
Department of Energy reported on its Web site (http://www.eia.doe.gov/emeu/cabs/usa.html)
in May 1999 that "[t]he United States has experienced a steep decline in refining capacity
since 1981." The report further stated that in the 1980s, the number of operating refineries
decreased from 324 to 204 and that "[s]ince 1992, about 34 additional, mainly small U.S.
refineries have shut down."

To assist small refiners, the Department of the Interior takes a portion of the Federal
Government's oil royalties "in-kind" and sells the portion to eligible refiners to ensure that
they have a constant oil supply. The Minerals Leasing Act of 1920, as amended, and the
Outer Continental Shelf Lands Act of 1953, as amended, govern the sale of royalty-in-kind
oil originating from onshore leases and offshore leases, respectively. The implementing
regulations for the Small Refiners Program are contained in the Code of Federal Regulations
(30 CFR 208).

In administrating the Small Refiners Program, the Service conducts periodic sales of
Government royalty oil and negotiates contracts with the participating small refiners for the
purchase of the oil. The contracts are generally for a period of 3 years. The number of
refiners participating in the Program, along with the associated values and quantities of oil
since fiscal year 1997, is shown in Table 1.

Table 1. Program Summary Data

FISCAL YEARS

1997

1998

1999

Participating small refiners at start of year

Number of purchase contracts at start of year

Contracts covering offshore leases

Contracts covering onshore leases

Number of leases at start of year

549

212

148

Volumes of oil sold under the Program
(Millions of barrels)

26.8

17.4

12.7 *

Value of oil sold under the Program
(Millions of dollars)

$483.4

$237.6

$151.4*

Estimated percentage of Federal
royalty oil production

32%

22%

16% *

*Amounts projected based on actual data from October 1998 through August 1999.

The reduction in the size of the Program was caused in part by refiners leaving the Program
for market-related reasons, such as the availability of oil from non-Federal sources. In
addition, the size of the Program was also reduced because, according to some refiners, the
Service did not manage the sale and valuation of the royalty oil in a manner consistent with
normal industry trade practices.

In September 1996, the Service initiated a formal study to address the deficiencies in the
Program that were identified by the Royalty Policy Committee, which is composed of
Service, state government, and industry officials. These deficiencies consisted of
discrepancies between the oil volumes reported by the lease operator and the volumes
delivered to the refiner, inconsistent oil measurement points for offshore leases, uncertainty
in the valuation of the royalty-in-kind oil, and a 1-month delay in the Service's receiving
payment from the refiner compared with receiving payments on royalty-in-value leases. In
the report issued by the Service in September 1997 on the results of the formal study, the
Service made three recommendations to correct the problems identified and established a
strategy to test the planned corrective actions in a demonstration pilot. The pilot was
conducted in 1998, and the Service concluded in its preliminary draft report on the results
of the pilot, issued in May 1999, that the recommendations in the September 1997 report
should be implemented. Service officials said that they expected to implement the
improvements to the Program in time for the next sale of royalty oil to the refiners, which
was scheduled for October 1999.

The Small Refiners Program is administered by the Royalty-in-Kind Section, within the
Accounting and Reports Division of the Service's Royalty Management Program. The Small
Refiners Program costs about $1.2 million to operate each year, and the Section has seven
full-time positions. The Service requires, under its regulations (30 CFR 208), that the costs
of operating the Program be recovered by administrative fees assessed on the participating
refiners.

SCOPE OF AUDIT

Our audit scope consisted of a review of the Service's Program activities conducted from
October 1996 through August 1999. The audit fieldwork was conducted primarily at the
Service's Royalty Management Program offices in Lakewood, Colorado, where we
interviewed cognizant Program officials and examined relevant records. We also
interviewed cognizant officials at the Service's Policy and Management Improvement offices
in Lakewood. We visited or contacted 13 small refiner companies: the 5 refiners currently
in the Small Refiners Program, 5 former Program participants, and 3 small refiners that had
not previously participated in the Program. Additionally, we visited or contacted the Service
offices, state government offices, oil companies, and oil industry trade organizations listed
in Appendix 2.

Our audit was conducted in accordance with the "Government Auditing Standards," issued
by the Comptroller General of the United States. Accordingly, we included such tests of
records and other auditing procedures that were considered necessary under the
circumstances. As part of the audit, we reviewed the internal controls to the extent
considered necessary to accomplish our audit objective. We also reviewed the Secretary's
Annual Statements and Reports to the President and the Congress for fiscal years 1993
through 1995, which were required by the Federal Managers' Financial Integrity Act; the
Departmental Reports on Accountability for fiscal years 1996, 1997, and 1998, which
include information required by the Act; and the Service's annual assurance statements on
management controls for fiscal years 1996, 1997, and 1998. We determined that none of the
reported weaknesses were directly related to the objective and scope of this audit.

PRIOR AUDIT COVERAGE

Neither the Office of Inspector General nor the General Accounting Office has issued any
audit reports during the past 5 years concerning the Small Refiners Program. However,
during this period, the Office of Inspector General has issued two reports and the General
Accounting Office has issued one report that related to the royalty-in-kind concept of
collecting Federal oil and gas royalties as follows:

- In May 1996, the Office of Inspector General issued the report "Royalty Gas Marketing
Pilot, Minerals Management Service" (No. 96-I-786), which stated that the Service had
effectively administered the 1995 Royalty Gas Marketing Pilot and had demonstrated the
feasibility of taking gas royalties in-kind as an alternative to the royalty-in-value system. The
report noted, however, that there were weaknesses in the areas of pilot design, revenue
collections, marketing strategies, and administrative controls. We also concluded that the
1995 pilot was too limited in scope to accurately represent gas operations in the Gulf of
Mexico. Although the report contained no recommendations, it did contain suggestions for
the Service to consider in the design of future royalty-in-kind pilots, such as conducting
larger scale pilots with mandatory lease holder participation.

- In March 1999, the Office of Inspector General issued the report "Royalty-in-Kind
Demonstration Pilots, Minerals Management Service" (No. 99-I-371), which stated that the
Service was successfully managing the three royalty-in-kind pilots. However, we determined
that the limited geographic coverage and products examined by the pilots would not result
in a conclusive in-kind feasibility assessment for all Federal oil and gas production. The
report contained no recommendations but made suggestions that we believe will enhance the
effectiveness of the pilot program, such as that the Service should expand the scope of the
pilots to cover additional oil- and gas-producing regions and take both oil and gas from the
same leases.

- In August 1998, the General Accounting Office issued the report "Federal Oil Valuation,
Efforts to Revise Regulations and an Analysis of Royalties in Kind" (No. GAO/RCED-98-
242) in response to a Congressional request to address the following: "(1) the information
used by MMS [the Minerals Management Service] 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." The
report stated that the Service (1) "relied heavily" on an interagency task force report to justify
revising its oil valuation regulations and (2) solicited public comments o
n its proposed regulations in five "Federal Register" notices and revised its proposed
regulations three times in response to the comments received. The report further stated that
available information

. . . 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.

The report did not contain any recommendations.

RESULTS OF AUDIT

We concluded that the Minerals Management Service had made satisfactory progress in
correcting the deficiencies in the Small Refiners Program that were identified in a formal
study conducted by Service, state government, and industry officials. For example, the
Service improved the process for determining the value of royalty oil and was redesigning
the Program to ensure that refiners pay royalties for oil volumes received. We found,
however, that the Program had weaknesses that not been addressed. Specifically, the Service
did not address the anticipated increase in demand for oil from the refiners, did not conduct
royalty oil sales on a frequent or regular basis, and did not recover the full costs of
administrating the Program. Program regulations (30 CFR 208.4) require that the Service
conduct an analysis of the crude oil market prior to a royalty oil sale to determine whether
small refiners have adequate access to supplies of oil at equitable prices. In addition, 30 CFR
208.4(b)(4) and Office of Management and Budget Circular No. A-25, "User Charges,"
require that the Service recover the full administrative costs of the Program. The weaknesses
identified occurred because the Service's crude oil market analysis did not include potential
oil available to small refiners under the 20 percent set-aside lease provision and because
Program officials, in attempting to reduce the financial impact on the refiners, recovered only
a portion of the administrative costs. Because the Service did not conduct a complete
analysis of the oil market, the oil volumes in the next royalty sale will not likely be sufficient
to satisfy the expected increase in demand from the small refiners. Further, the Service has
not recovered administrative costs of about $1.9 million since fiscal year 1997 (see
Appendix 1).

Program Improvements Completed or In Progress

We concluded that the Service was making progress in correcting the deficiencies in the
Small Refiners Program identified by the formal study. As part of this effort, the Service has
held discussions with Program participants since 1996 to create what they consider to be a
commercially oriented Program that operates more efficiently and is more responsive to the
oil industry. The small refiners that we contacted generally agreed that this objective was
being achieved and indicated that they were interested in purchasing the royalty oil.
Although they attributed this interest in part to the fact that the Program represented a rare
source of supply that can be secured for long-term periods at reasonable prices, the refiners
also credited the Service with improving the Program significantly over the past 2 years.

The specific deficiencies and the actions that were implemented or were being considered
to correct the deficiencies were as follows:

- Before fiscal year 1998, the small refiners' oil purchase contracts authorized the Service
to review the validity of the valuation methodologies used for royalty payments and, if
warranted, assess additional royalties up to 7 years after the initial payment. As a result,
time-consuming and expensive disputes with the refiners occurred concerning the proper
valuation of the oil. The Service, however, corrected this Program deficiency in fiscal year
1998 by negotiating price formulas into the oil purchase contracts, an action that prohibits
any redetermination of the values. We believe that the price formulas provide the refiners
with a simple methodology to value the royalty oil, and compliance is readily verifiable by
the Service. Service officials said that they were satisfied that this approach did not result
in reduced royalty collections and that they intended to negotiate price formulas into future
contracts with the small refiners.

- The Service has not adopted the standard industry practice of basing payments on the
volume of oil delivered by the lease operator. Instead, the Program requires that royalty
payments be based on the volume of oil that the refiner is contractually entitled to receive
from the operator. As a result, small refiners paid royalties for undelivered oil. To illustrate,
the volume of oil delivered to the refiner for a given month is based on an estimated
production amount. However, the lease operator regularly produces a volume different from
the estimate, creating an "imbalance." Because royalties are due on the volume of oil
produced (the entitlement volume), the refiner may pay royalties on an oil volume that it did
not receive. Service officials said that they bill the refiners based on entitlement volumes
because these volumes "in theory" should equal delivered volumes. Although the lease
operator corrects imbalances by overdelivering or underdelivering oil in future months or by
making cash payments as necessary, this creates a burden for the small refiners that do not
have sufficient financial resources. For example, one refiner stated that it had paid more than
$1 million of royalties for oil which had not been delivered and that after more than 1 year,
the volume imbalance had not been fully corrected. At the time of our audit, the Service was
reviewing options that would base royalty payments on delivered volumes. Service officials
stated that this Program deficiency would be corrected before the October 1999 Government
royalty oil sale to small refiners.

- The small refiners have been critical of the Program because it requires surety instruments
to be posted for what they consider to be excessive periods of time. Program regulations (30
CFR 208.11) require a refiner to provide a surety at the beginning of a contract covering an
amount estimated to be equal to a 99-day purchase of royalty oil and require the surety to be
enforceable for 9 months after the contract terminates. We found that these time periods
were longer than the industry standard of 50 to 60 days and resulted in less money available
for refinery operations. The refiners stated that the Government did not benefit from its
surety policy because the extra costs incurred by the refiners were passed on to the
Government through lower prices offered for the oil. However, Service officials said that
the Government should be fully insured against possible loss if a refiner does not pay for
royalty oil and that the 99-day period for the surety represents the minimum time frame for
the Service to terminate deliveries of oil under a purchase contract in the event of
nonpayment by the small refiner. At the time of our audit, however, Service officials said
that they might shorten the surety period to 60 days for future royalty oil sales.

Based on the actions implemented or under consideration, we believe that the Service has
demonstrated that it can successfully manage a royalty-in-kind system with small refiners.

Program Improvements Needed

During our audit, we found that the Service had not adequately addressed the issues of oil
volumes and the recovery of administrative costs, as discussed in the paragraphs that follow.

Oil Volumes. We found that the volume of royalty oil the Service plans to market in the
October 1999 sale is not likely to be sufficient to meet the demands from the small refiners.
The small refiners contacted said that they anticipate a decline in oil supplies in the open
market and that they therefore are increasingly interested in obtaining Government royalty
oil. For example, all 13 small refiners that we contacted supported continuation of the
Program, and 3 of the 5 refiners in the Program said that they would like to purchase larger
volumes of royalty oil. Additionally, Service officials said that they expect at least
20 refiners to participate in the October 1999 royalty oil sale, or at least four times the
number currently in the Program. The Service, however, may be unable to substantially
increase the amount of royalty oil in the sale because most of the remaining royalty oil that
has not been dedicated to the Program has been committed to refilling the Strategic
Petroleum Reserve.

We found that the demand for royalty oil could exceed 136,000 barrels per day (based on
6,826 average barrels per day purchased by the five participants during fiscal year 1999
multiplied by the Service's estimate of at least 20 refiners), a number that is significantly
more than the maximum of 80,000 barrels per day from the Gulf of Mexico that the Service
plans to sell in October 1999. Consequently, the Service may have to reduce the volume of
oil to each refiner and/or exclude some refiners from the sale. However, we found that the
Service had not considered that substantial oil volumes are potentially available for sale to
small refiners under the "20 percent set-aside" provision contained in many offshore leases.
Program regulations (30 CFR 208.4) require the Service, prior to a royalty oil sale, to
conduct a study (known as a Determination of Need) to determine whether small refiners
will benefit from the sale. Accordingly, the Service solicited comments from the oil industry
and relevant Governmental agencies in fiscal year 1999 to determine whether small refiners
had adequate access to crude oil supplies at equitable prices. The Service's Accounting and
Reports Division issued an analysis paper in April 1999 that concluded that small refiners
had difficulty in obtaining crude oil supplies at fair market prices and recommended that the
Service continue the Program and hold another sale of royalty oil "as soon as possible."

The Outer Continental Shelf Lands Act (43 U.S.C. �1337(b)(7)) provides that each offshore
lease will contain a provision requiring the lessee to offer 20 percent of the oil production
for sale to small or independent refiners. Our analysis of crude oil production data provided
by the Service's Offshore Minerals Management regional offices in New Orleans, Louisiana,
and Camarillo, California, disclosed that as of January 1999, approximately 160,000 barrels
of oil subject to the provision were produced each day, consisting of 150,550 barrels per day
from the Gulf of Mexico Region and 8,950 barrels per day from the Pacific Region.

While the Service does not monitor compliance or keep records concerning the amount of
set-aside oil purchased by small refiners, cognizant Service officials stated that "few" small
refiners acquired the oil. Our analysis disclosed that this oil supply was not fully accessed
for various reasons, such as the set-aside provision was not well known in the oil industry,
small refiners and lessees may have had difficulty in agreeing on the logistics for delivering
the oil, and insufficient guidance existed on the implementation of the set-aside lease
provision. Further, because the Service considers the provision to be "self-executing," it has
not developed regulations or procedures for implementation except for a Notice of
Interpretation issued in the "Federal Register" in 1983.

In our opinion and consistent with Program regulations, the Service should consider the
volume of oil that is available to refiners under the 20 percent set-aside provision and
coordinate this information with the requirements of the Small Refiners Program. We
estimate that the combined oil from these two sources should provide about 240,000 barrels
per day (160,000 barrels from the 20 percent set-aside provision plus a minimum of 80,000
barrels from the Program) for the small refiners.

Frequency of Sales. The Service has conducted royalty oil sales on an infrequent and
irregular basis, which impairs the ability of small refiners to rely on this supply source for
planning purposes. Specifically, the most recent sales were held in 1983, 1987, and 1994,
with the next sale scheduled for October 1999. Thus, the time frame between sales averaged
about 5 years, which, in our opinion, is too long considering the dynamic and cyclical nature
of the oil industry. Further, regulations (30 CFR 208) for the Program do not clearly specify
when oil sales should be conducted, stating only that the crude oil market may be evaluated
"from time to time." The Service has routinely extended the periods of the existing purchase
contracts with the refiners because of the absence of regular oil sales. However, refiners said
that they would prefer that sales be held more frequently and regularly. We believe that the
Service should accommodate the refiners by establishing a regular schedule of sales every
2 or 3 years. The Service should also consider conducting an interim sale between the
scheduled sales, as allowed by Program regulations (30 CFR 208.4(d)), if sufficient volumes
of royalty oil become available to attract competitive bids.

Recovery of Administrative Costs. The Service has not recovered the full amount of the
Program's administrative costs, as required by applicable regulations. Regulations (30 CFR
208.4(b)(4)) for the Program require administrative costs to be allocated to the refiners on
the basis of the "total number of leases under contract" (that is, active leases). Therefore, if
total administrative costs remain constant but the number of leases in the Program decreases,
the monthly administrative fee should increase because the same amount of costs will be
distributed over a smaller base. However, since March 1997, the Service has documented
the full cost of administrating the Program but has charged only the fee associated with
leases active in the Program. According to Service officials, the lower fee assessment was
charged because certain refiners had terminated leases from the Program and the remaining
refiners objected that the resultant increase in the monthly fee from $180 to $450 (150
percent) would have forced them to resign from the Program. Consequently, the Service did
not raise the monthly fee, and the refiners were assessed only about one-third of the
administrative costs. However, 30 CFR 208.4(b)(4) provides that the Service "will recover
the administrative costs of the RIK [royalty-in-kind] Program through the collection of
administrative fees." Although Service officials said that they interpreted the regulations to
support the collection of costs associated only with active leases, we believe that the
regulations require the Service to collect the full administrative costs of the Program.
Additionally, Office of Management and Budget Circular No. A-25, which provides
guidance for the implementation of Title V of the Independent Offices Appropriations Act
of 1952 (the User Charge Statute), states that agencies should assess user charges to recover
the full costs of Federal activities provided to recipients of special benefits.

Because of its interpretation, the Service has not recovered administrative costs totaling
about $1.9 million for the period of March 1997 through September 1999 and will not
recover costs of approximately $813,000 for each additional year that this matter remains
uncorrected. Further, state governments will be adversely impacted if the Service conducts
a sale of royalty oil for onshore leases because, under the net receipts sharing process, a
portion of the unrecovered costs will be passed on to the states through reductions in their
monthly royalty distributions.

Recommendations

We recommend that the Director, Minerals Management Service, require Small Refiners
Program officials to:

1. Ensure that the Determination of Need considers all sources of oil available to the small
refiners, including the 20 percent set-aside lease provision.

2. Conduct the Determination of Need on a regular basis and increase the frequency of the
analyses, such as every 2 or 3 years. The Service should also consider conducting interim
Government royalty oil sales if the need for the oil is established and sufficient volumes of
oil become available to attract competitive bids.

3. Ensure that the Service recovers the full costs of administrating the Program from the
small refiners, as required by 30 CFR 208.4(b)(4) and Office of Management and Budget
Circular No. A-25.

Minerals Management Service Response and Office of Inspector General
Reply

In the January 5, 2000, response (see Appendix 3) to the draft report from the Director,
Minerals Management Service, the Service concurred with Recommendation 2 but did not
concur with Recommendations 1 and 3. Based on the response, we consider
Recommendation 2 resolved but not implemented. Accordingly, the unimplemented
recommendation will be referred to the Assistant Secretary for Policy, Management and
Budget for tracking of implementation, and the Service is requested to reconsider its
responses to Recommendations 1 and 3, which are unresolved.

Recommendation 1. Nonconcurrence.

Minerals Management Service Response. The Service stated that it would "consider all
relevant information" when conducting a Determination of Need for future royalty oil sales
and that "the failure to use the 20 percent set aside does not preclude a determination that
there is a need to sell royalty oil to the small refiner." The Service further stated that it does
"not believe it would be appropriate to implement" the recommendation.

The Service also disagreed with the report's statement that the volume of royalty oil the
Service planned to market in the October 1999 sale would likely be insufficient to meet the
demands from the small refiners. The Service further stated that in the October 1999 sale,
which was held after the issuance of our preliminary draft report, the Service accepted bids
for 16,600 of the 22,000 barrels of royalty oil from the Pacific Region but that "no acceptable
bids" were received for the 80,0000 barrels of oil from the Gulf of Mexico Region because
none of the bids met the Service's "established reasonable price thresholds." The Service
stated that small refiners may have adequate access to sufficient amounts of oil from non-
Federal sources.

Office of Inspector General Reply. Although the Service stated that it would "consider all
relevant information" when conducting a Determination of Need for future royalty oil sales,
the Service did not specifically affirm that an analysis of oil available under the 20 percent
set-aside lease provision would be performed. To the contrary, the Service indicated that the
20 percent set-aside was not relevant to the Determination of Need process. We believe,
however, that the results of a Determination of Need cannot be valid if this potentially
significant source of oil available to small refiners is disregarded.

Regarding the Service's comments on the results of the October 1999 sale, we believe that
the Service should not interpret the relatively small volume of royalty oil awarded as a lack
of demand for oil by the small refiners. In our opinion, the fact that the bids did not meet the
Service's "established reasonable price thresholds" could indicate that the small refiners have
a different opinion of what constitutes a reasonable price. Our analysis, based in part on
contacts with the small refiner companies and industry trade associations, disclosed a strong
interest among small refiners to purchase Government royalty oil. The Service's own
Determination of Need also reached this conclusion. Therefore, the results of the
October 1999 sale should not be the basis to conclude that small refiners have sufficient
access to oil from non-Federal sources.

Recommendation 3. Nonconcurrence.

Minerals Management Service Response. The Service stated that it was "properly
recovering the costs of administering the program, as required by 30 CFR 208.4." The
Service stated that it should recover only the costs of administrating leases active in the
Program, stating that it "cannot support" our "contention that the costs attributable to
terminated contracts should be borne by the current RIK [royalty-in-kind] program
participants." The Service further stated that the Program regulations provide flexibility in
determining the costs that may be recovered.

Office of Inspector General Reply. We disagree that the Service should recover only the
administrative costs associated with the leases active in the Program. In our opinion, the
Program regulations (30 CFR 208.4(b)(4)) provide for the recovery of total administrative
costs. Moreover, as stated in the report, Office of Management and Budget Circular No. A-
25 requires that agencies assess user charges to recover the full costs of Federal activities
provided to recipients of special benefits. The Circular (Section 6) further requires that
agencies choosing to make an exception to recovering full costs submit a request to the
Director of the Office of Management and Budget. The Service has not requested such an
exception, and without approval of such an exception, the Service should recover the full
costs of administrative activities.

In addition, the Service should recognize that administrative costs, such as post-contract
costs, are routine activities associated with both refiners that have terminated their contracts
as well as refiners that have completed contractual obligations. As such, these costs are
incurred for all small refiners participating in the Program. Accordingly, to recover the costs
in compliance with the Circular, the Service should base the monthly administrative fee on
the full $1.2 million cost of operating the Program.

Other Matters

The eligibility of a company to qualify as a small refiner depends on whether the royalty oil
originates from offshore leases or onshore leases. This situation exists because the laws that
authorize the Program for onshore lease sales (Mineral Leasing Act, as amended in 1946)
and for offshore lease sales (Outer Continental Shelf Lands Act, as amended in 1978) contain
different eligibility criteria. For example, the eligible small refiner for onshore lease sales
must not have total refinery capacity of more than 175,000 barrels per day, while the offshore
eligible small refiner must not have total refinery capacity of more than 75,000 barrels per
day. As a result, if royalty oil produced from both offshore and onshore leases becomes
available for sale, the Service must conduct separate royalty oil sales. We did not locate, nor
did the Service provide, documentation supporting the different qualification criteria.
Although Service officials stated that amending the applicable laws would be time
consuming, we believe that a single eligibility criterion would result in more efficient royalty
oil sales.

In accordance with the Departmental Manual (360 DM 5.3), we are requesting a written
response to this report by May 8, 2000. The response should include the information
requested in Appendix 4.

Section 5(a) of the Inspector General Act (5 U.S.C. app. 3) requires the Office of Inspector
General to list this report in its semiannual report to the Congress. In addition, the Office of
Inspector General provides audit reports to the Congress.