[Audit Report on Supporting Documentation for Operators Participating in the Stripper Oil Well Property Royalty Rate Reduction Program, Bureau of Land Management and Minerals Management Service] [From the U.S. Government Printing Office, www.gpo.gov] Report No. 00-i-300 Title: Audit Report on Supporting Documentation for Operators Participating in the Stripper Oil Well Property Royalty Rate Reduction Program, Bureau of Land Management and Minerals Management Service Date: March 27, 2000 **********DISCLAIMER********** This file contains an ASCII representation of an OIG report. No attempt has been made to display graphic images or illustrations. Some tables may be included, but may not resemble those in the printed version. A printed copy of this report may be obtained by referring to the PDF file or by calling the Office of Inspector General, Division of Acquisition and Management Operations at (202) 208-4599. ********************************** U.S. Department of the Interior Office of Inspector General AUDIT REPORT SUPPORTING DOCUMENTATION FOR OPERATORS PARTICIPATING IN THE STRIPPER OIL WELL PROPERTY ROYALTY RATE REDUCTION PROGRAM, BUREAU OF LAND MANAGEMENT AND MINERALS MANAGEMENT SERVICE REPORT NO. 00-I-300 MARCH 2000 EXECUTIVE SUMMARY Supporting Documentation for Operators Participating in the Stripper Oil Well Property Royalty Rate Reduction Program, Bureau of Land Management and Minerals Management Service (No. 00-i-300) BACKGROUND The Stripper Oil Well Property Royalty Rate Reduction Program, initiated by the Bureau of Land Management (BLM), became effective on October 1, 1992. The Program was to provide an economic incentive for operators to maintain or restart production of marginal or uneconomic oil wells on Federal onshore leases by drilling new wells, by reworking existing wells, and/or by implementing enhanced oil recovery projects. The regulatory requirements for the Program are in the Code of Federal Regulations (43 CFR 3103.4-2). The Secretary is required by 43 CFR 3103.4-2(5) to evaluate the effectiveness of the Program, and this provision allows the Secretary to terminate any or all royalty rate reductions granted under the Program upon a 6-month notice any time after September 10, 1997. On February 18, 1998, the Department of the Interior extended the Program for an indefinite period. The operator is required to submit a "Stripper Royalty Rate Reduction Notification" form, which includes the operator's lease or agreement number, qualifying period, and reduced royalty rate. The operator is required to calculate the reduced royalty rate using information reported on the "Monthly Report of Operations" form. The operator calculates the average production of oil per well per day by dividing the total oil production during the qualifying period by the total number of producing or injecting well days. The reduced royalty rate becomes effective on the first day of the month after the Minerals Management Service (MMS) receives the notification. The operators of the properties included in the Program are allowed to pay Federal royalty rates ranging from 0.5 to 11.7 percent of the value of a barrel of oil. These rates are below the standard onshore rate of 12.5 percent. As of September 30, 1999, approximately 850 operators and 4,100 properties were participating in the Program. Royalty rate reductions during the period of October 1, 1992, through December 31, 1998, totaled more than $139 million. Both BLM and MMS are responsible for the Program. BLM is responsible for promulgating the Program regulations; establishing policies and procedures; conducting all on-the-ground inspections to verify producing volumes and producing days; and reviewing production anomalies that are identified by MMS, which are unexplained differences between reported production from the operator's monthly reports and the notification. MMS is responsible for confirming the reduced royalty rate information provided by the operator on the notification form. OBJECTIVE The objective of the audit was to determine whether BLM provided effective oversight of well classification and production rates used in determining eligibility for the Program. RESULTS IN BRIEF We found that the "Monthly Report of Operations" form prepared by operators and used to support reduced royalty rate determinations for the Program showed production days that were inaccurate or that often could not be supported with operator documentation. Operators are required by 43 CFR 3162.4-3 to accurately disclose all operations conducted on each well during each month. However, BLM (1) did not provide sufficient oversight of operators to ensure that information on the production days was correct and (2) did not establish Program policies and procedures to enable participating operators to accurately compute their reduced royalty rates and for MMS Program staff to accurately review and confirm the reduced royalty rates provided by the operators. For the 14 Program properties reviewed, we found that 5 properties had inaccurate rates, which may result in underpaid royalties of about $1.27 million, and that 7 properties had unsupported rates, which may result in underpaid royalties of $3.22 million. In addition, we found that reviews were conducted by state auditors from the States of California, New Mexico, and Oklahoma on six additional properties. Of the six properties, four had inaccurate rates, which resulted in underpaid royalties of about $847,000, and one property had an unsupported rate, which may result in underpaid royalties of $25,000. Of the 20 properties, 17 had inaccurate or unsupported rates, which resulted in actual or potential underpaid royalties totaling about $5.36 million (30.8 percent). If the 30.8 percent potential underpaid royalty error rate is representative of the $139.7 million in total reduced royalty Program benefits received, the total potential for underpaid royalties could be as much as $43.02 million, which is attributable to inaccurate rates ($16.90 million) and unsupported rates ($26.12 million). RECOMMENDATIONS We recommended that BLM and MMS develop a plan which ensures that operators of the largest benefiting properties are audited and develop a policy for operators that do not have sufficient records to support their reduced royalty rates. We also recommended that they develop a policy and procedures on how to address certain issues when reviewing or preparing Program notifications and that they develop and implement a procedure for reviewing supporting documentation for future Program notifications submitted by operators. AUDITEE COMMENTS AND OIG EVALUATION Both BLM and MMS concurred with the report's four recommendations. Based on the bureaus' response and subsequent information, we considered two recommendations resolved and implemented and two recommendations resolved but not implemented. C-IN-MOA-001-98(C)-D AUDIT REPORT Memorandum To: Director, Bureau of Land Management Director, Minerals Management Service From: Roger La Rouche Acting Assistant Inspector General for Audits Subject: Audit Report on Supporting Documentation for Operators Participating in the Stripper Oil Well Property Royalty Rate Reduction Program, Bureau of Land Management and Minerals Management Service (No. 00-i-300) INTRODUCTION This report presents the results of our self-initiated audit of the supporting documentation for operators participating in the Stripper Oil Well Property Royalty Rate Reduction Program. The objective of the audit was to determine whether the Bureau of Land Management (BLM) provided effective oversight of well classification and production rates used in determining eligibility for the Program. This is the second report that we are issuing on the Program. The first report, entitled "Processing of Notifications for the Stripper Oil Well Property Royalty Rate Reduction Program, Minerals Management Service" (No. 99-I-782), dated August 1999, determined whether the Minerals Management Service (MMS) effectively processed and verified royalty rate reduction notifications. (This report is synopsized in the Prior Audit Coverage section of this report.) BACKGROUND The Secretary of the Interior is required by the Federal Oil and Gas Royalty Management Act of 1982 (30 U.S.C. *1711(a)) to "establish a comprehensive inspection, collection and fiscal and production accounting and auditing system to provide the capability to accurately determine oil and gas royalties, interest, fines, penalties, fees, deposits, and other payments owed, and to collect and account for such amounts in a timely manner." The Mineral Leasing Act of 1920 (30 U.S.C. * 209) allows the Secretary to adjust royalty rates on Federal onshore leases to encourage the maximum amount of oil or gas to be removed. Further, to promote development on leases that cannot be operated economically under the existing lease terms, the Secretary may waive, suspend, or reduce the royalty on all or any portion of the leasehold. Both BLM and MMS have responsibilities for Federal onshore leases. BLM's responsibilities include issuing onshore leases and monitoring production on the leases. MMS's responsibilities include ensuring the proper determination, collection, and distribution of royalties. The Stripper Oil Well Property Royalty Rate Reduction Program,[1] initiated by BLM, became effective on October 1, 1992. The Program was to provide an economic incentive for operators to maintain or restart production of marginal or uneconomic oil wells on Federal onshore leases by drilling new wells, by reworking existing wells, and/or by implementing enhanced oil recovery projects. The regulatory requirements for the Program are at 43 CFR 3103.4-2. The Secretary is required by 43 CFR 3103.4-2(5) to evaluate the effectiveness of the Program, and this provision allows the Secretary to terminate any or all royalty rate reductions granted under the Program upon a 6-month notice any time after September 10, 1997. On February 18, 1998, the Department of the Interior extended the Program for an indefinite period. The operator is required to submit a notification of Program participation on Form MMS-4377, "Stripper Royalty Rate Reduction Notification," which includes the operator's lease or agreement number, qualifying period, and reduced royalty rate. The operator is required to calculate the reduced royalty rate using production and injection information reported on the "Monthly Report of Operations" (Form MMS-3160).[2] The operator calculates the average production of oil per well per day by dividing the total oil production during the qualifying period by the total number of producing or injecting well[3] days. The resulting average is rounded down to the nearest whole barrel regardless of the amount. The reduced royalty rate becomes effective on the first day of the month after MMS receives the notification. The operators of the properties included in the Program are allowed to pay Federal royalty rates ranging from 0.5 to 11.7 percent of the value of a barrel of oil (see Appendix 2). These rates are below the standard onshore rate of 12.5 percent. To qualify for the Program, eligible wells must either produce oil or serve as an injection well for any period of time during the initial 12-month qualifying period, a preceding period, or a subsequent 12-month period. The qualifying period is used to determine the amount of production and the royalty rate that would be effective on or after October 1, 1992. In calculating the royalty rate, operators are required to use either the initial qualifying period, which was August 1, 1990, through July 31, 1991, or if shut-in[4] during this period, the 12-month production period immediately prior to the shut-in. Further, properties not qualifying during or prior to the initial qualifying period are required to use the first consecutive 12-month qualifying period beginning after August 31, 1990. In addition, participating operators can submit notifications for further reduced royalty rates subsequent to their initial participating rate if production levels continue to decline (these subsequent periods are referred to as outyears). After the first outyear notification is filed, a notification is required thereafter for each subsequent 12-month period or the royalty rate reverts to the initial reduced royalty rate. Each outyear notification is due within 60 calendar days after the applicable 12-month period. Both BLM and MMS are responsible for the Program. BLM is responsible for promulgating the Program regulations; establishing policies and procedures; conducting all on-the-ground inspections to verify producing volumes and producing days; and reviewing production anomalies that are identified by MMS, which are unexplained differences between reported production from the operator's monthly reports and the notification. MMS is responsible for confirming the reduced royalty rate information provided by the operator on the form "Stripper Royalty Rate Reduction Notification." In confirming the reduced royalty rate, MMS compares information submitted in the notification with production and well status data previously submitted in the "Monthly Report of Operations." The information confirmed by MMS includes the following: the Federal mineral interest in the property, the identification and the proper description of the property, and the operator's status as the current operator of the property. MMS also confirms that wells meet the Program definition of a producing oil or injection well, that reported production is complete, and that the corresponding reduced royalty rate is accurate. Upon completion of this review, MMS notifies the operator that the calculated rate has been confirmed, adjusted, or disqualified. As of September 30, 1999, approximately 850 operators and 4,100 properties were participating in the Program. Royalty rate reductions during the period of October 1, 1992, through December 31, 1998, totaled more than $139 million (see Appendix 3). Stripper oil properties included single leases, communitization agreements, and units and ranged in size from a single well to more than 1,300 wells per property. SCOPE OF AUDIT Our audit fieldwork was conducted during March through July 1999 at MMS's Royalty Management Program office in Lakewood, Colorado, and BLM's Fluid Minerals Office in Washington, D.C. In addition, we contacted or visited BLM, state, and industry officials at the offices and locations listed in Appendix 4. To meet our audit objective, we selected 8 New Mexico and 6 Wyoming properties (see Appendix 5) from a list of the 100 largest benefiting properties in 1997. The properties were selected based on the number of producing days per well and the number of wells included on the operators' monthly reports. Our objective was to determine whether the error of overreported production days identified by the Comptroller of the State of California (see Prior Audit Coverage) was a systemic problem. For these properties, we examined BLM and MMS records and contacted operators or performed site visits to the offices of 5 of the 10 operators that were responsible for the 14 properties reviewed. We obtained information from participating operators supporting the monthly reports such as daily production logs, water injection records, and well-production test records. Our audit was made 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 to accomplish our objective. We also reviewed the Department of the Interior's Accountability Report for fiscal year 1998, which includes information required by the Federal Managers' Financial Integrity Act of 1982, and BLM's annual assurance statement on management controls to determine whether any reported weaknesses were within the objective and scope of our audit. Neither the Accountability Report nor BLM's assurance statement addressed BLM's involvement in the Program. In addition, we evaluated BLM's system of internal controls related to the Program. The internal control weaknesses we found are discussed in the Results of Audit section of this report. Our recommendations, if implemented, should improve the internal controls in the areas reviewed. PRIOR AUDIT COVERAGE During the past 5 years, the General Accounting Office has not issued any audit reports on the Program. However, in August 1999, the Office of Inspector General issued the report "Processing Notifications for the Stripper Oil Well Property Royalty Rate Reduction Program, Minerals Management Service" (No. 99-I-782), which addressed the second part of our audit objective. The report stated that MMS did not timely confirm notifications it received and did not timely input the confirmed reduced royalty rates or review differences in the royalty rates confirmed with the royalty rates paid for properties participating in the Stripper Oil Well Property Royalty Rate Reduction Program. The report made two recommendations for MMS to develop and implement a plan to (1) eliminate the Stripper Oil Well Property Royalty Rate Reduction Program notification processing and data entry backlog and to approve future notifications in a timely manner and (2) review Program exceptions generated by the automated matching process and collect underpaid royalties from operators. Based on MMS's response, we considered the first recommendation resolved and implemented and the second recommendation resolved but not implemented. As discussed previously (see Scope of Audit), the Controller of the State of California issued an October 30, 1998, audit report on royalties reported by a production company for its Program leases located in California for the period of January 1, 1993, through December 31, 1995. The report said that the company overstated well-production days on its "Monthly Report of Operations" during the qualifying period for the Stripper Oil Well Property Royalty Rate Reduction Program. According to the State auditors, a primary factor causing the misreporting was that the company's automated system reported all days of a month as producing unless adjustments were made based on manually generated reports showing when a well was inactive (well downtime). Adjustments for well downtime often were not input into the automated system. The report also stated that overstated well-production days were the main factor for the royalty rate to be adjusted from 2.1 percent to 2.9 percent, which resulted in royalty underpayments of more than $500,000. The company agreed with the conclusions and subsequently paid the underpaid royalties. RESULTS OF AUDIT We found that the "Monthly Report of Operations" (Form MMS-3160) prepared by operators and used to support reduced royalty rate determinations for the Stripper Oil Well Royalty Rate Reduction Program showed production days that were inaccurate or that often could not be supported with operator documentation. Operators are required by 43 CFR 3162.4-3 to accurately disclose all operations conducted on each well during each month. However, BLM (1) did not provide sufficient oversight of operators to ensure that information on the production days was correct and (2) did not establish Program policies and procedures to enable participating operators to accurately compute their reduced royalty rates and for MMS Program staff to accurately review and confirm the reduced royalty rates provided by the operators. For the 14 Program properties reviewed, we found that 5 properties had inaccurate rates, which may result in underpaid royalties of about $1.27 million, and that 7 properties had unsupported rates, which may result in increased royalties of $3.22 million (see Appendix 5). In addition, we found that reviews were conducted by state auditors from the States of California, New Mexico, and Oklahoma on six additional properties. Of the six properties, four had inaccurate rates, which resulted in underpaid royalties of about $847,000, and one property had an unsupported rate, which may result in increased royalties of $25,000. Of the 20 properties, 17 had inaccurate or unsupported rates, which resulted in actual or potential underpaid royalties totaling about $5.36 million (30.8 percent). If the 30.8 percent potential underpaid royalty error rate is representative of the $139.7 million in total reduced royalty Program benefits received, the total potential for underpaid royalties could be as much as $43.02 million, which is attributable to inaccurate rates ($16.90 million) and unsupported rates ($26.12 million). Participating Program operators are required by 43 CFR 3103.4-2 to calculate reduced royalty rates using production data, including well-production days as reported on the monthly reports. Monthly reports are required by 43 CFR 3162.4-3 to disclose accurately all operations conducted on each well during each month. Specifically, 43 CFR 3162.4-3 states that "it is particularly necessary that the report show for each calendar month: . . . The number of days each well produced, whether oil or gas, and the number of days each input [injection] well was in operation." According to 43 CFR 3161, BLM is responsible for all operations conducted on Federal onshore leases, including the approval, inspection, and regulation of oil and gas operations. Record maintenance and retention requirements are established in Section 103 of the Federal Oil and Gas Royalty Management Act of 1982. The Act requires records to be maintained for 6 years after the records are generated unless the Secretary notifies the record holder that he has initiated an audit or an investigation involving such records and requires such records to be maintained for a longer period. The Federal Oil and Gas Royalty Simplification and Fairness Act of 1996 amended sections of the Federal Oil and Gas Royalty Management Act of 1982. Section 115 of the 1996 Act established a 7-year period for the retention of records from the date an obligation becomes due. This 7-year period (30 U.S.C. *1724(f)) applies to oil and gas produced after September 30, 1996. Our audit was designed to determine whether the error of overreported production days identified by the Controller of California (see Prior Audit Coverage) was systemic. We determined that California, New Mexico, and Wyoming properties received more than 91 percent of the royalty rate reductions provided through the end of calendar year 1998 (see Appendix 3). Based on our review of the 14 properties (see Appendix 5), we found that only 2 properties had accurate and supported Program rates. Of the remaining 12 properties, 9 properties had deficiencies related to inaccurate or unsupported production days. Three of the nine properties had inaccurate rates with sufficient records for recalculation, one property had an inaccurate rate with insufficient records for recalculation, and five properties had no records to support their Program rates. The remaining three properties had deficiencies related to insufficient Program policies and procedures. Production Days BLM did not provide adequate oversight to ensure that operators participating in the Program accurately reported well-production days on their monthly reports used in their reduced royalty rate determinations. Because reduced royalty rates were based on the average production per day per well during the qualifying period, the number of producing days reported was a critical part of the reduced royalty rate calculations. BLM officials stated that producing days reported on the "Monthly Report of Operations " were normally not verified by BLM oil and gas inspectors because production days were not considered to be an essential factor when production totals were verified. In addition, BLM did not have Program policies and procedures to ensure that operators retained records supporting their claimed reduced royalty rates. These deficiencies are detailed in the paragraphs that follow. Sufficient Records for Recalculation. We identified three properties for which well-production days were misreported during the qualifying period and for which records were sufficient for us to recalculate the proper reduced royalty rates. Based on our recalculations, we found that royalties were underpaid by $1,037,953 for the three properties as follows: - In September 1992, an operator of a New Mexico property submitted an initial notification claiming a reduced royalty rate of 1.3 percent effective in October 1992. The claimed rate was confirmed by MMS in March 1993. The rate calculation was based on the monthly reports, which showed only one producing oil well that produced 61 barrels of oil during 52 well-production days. In March 1999, we obtained daily production logs from the operator for this property in support of the monthly reports. Our review of these records indicated that the well was producing oil for between 4 and 6 days during the qualifying period. The operator agreed with our findings and acknowledged that the production days shown on the monthly reports were incorrect, which resulted in a reduced royalty rate that was also incorrect. Further, a BLM Washington Office Program official reviewed the operator's field records and concluded that the records supported only 4 well-production days. Consequently, using the 4 production days and the 61 barrels of oil, we determined that the property averaged more than 15 barrels of oil per day, which made it ineligible for a reduced royalty rate. Based on our recalculation of the royalties that were paid for the period of October 1, 1992, through December 31, 1998, we determined that the operator underpaid royalties by $888,416. - In September 1992, an operator of a Wyoming property submitted an initial notification claiming a reduced royalty rate of 11.7 percent effective in October 1992. The claimed rate was confirmed by MMS in October 1994. The rate calculation was based on the monthly reports, which showed three producing oil wells and two water injection wells that produced 20,178 barrels of oil over a period of 680 producing and 672 injecting days (1,352 total days). In March 1999, we obtained oil well-production test records from the operator for this property that purportedly supported the production data shown on the monthly reports. Our review of these production rate tests indicated that the reported volumes were produced in 1,194 days, which was 158 fewer days than the 1,352 days reported on the monthly reports. Consequently, using 1,194 producing days and 20,178 barrels of production, we determined that the property produced more than 15 barrels of oil per day and was therefore ineligible for a reduced royalty rate. The operator agreed that a discrepancy existed between the operator's well test records and the reported monthly production and said that he would provide us with additional information to explain the discrepancies. However, we had not received the information as of October 1999. Based on our recalculation of the royalties paid for the period of October 1, 1992, through December 31, 1998, we determined that the operator underpaid royalties by $76,935. - In September 1992, the same Wyoming operator in the previous example submitted a notification for another property. Our review disclosed similar reporting discrepancies. We performed the same recalculation and determined that for the same period, the operator underpaid royalties by $72,602 on this property. Incomplete Records. One property for which well-production days were misreported during the qualifying period had records that were not sufficiently adequate for us to accurately recalculate the proper reduced royalty rate for the property. However, based on available information, we determined that royalties were underpaid by as much as $672,384 for the property. Specifically, in September 1992, an operator of a New Mexico lease submitted an initial notification claiming a reduced royalty rate of 6.1 percent effective in October 1992. The claimed rate was confirmed by MMS in January 1993. The rate calculation was based on the monthly reports, which identified 46 producing oil wells and 8 water injection wells with production of 143,796 barrels of oil over a period of 16,637 producing and 2,920 injecting days (19,557 total days). In March 1999, we obtained daily tank gauging reports from the operator for this lease in support of production data that were reported on the monthly reports. Based on our review, we found that the operator had reported all 19,557 possible elapsed calendar days for the producing and injecting wells during the qualifying period. Based on discussions with BLM personnel, we determined that it was not reasonable for the 54 wells to produce or inject every day of the year. The operator stated that its reporting system is automated and contains a default which reports all days during each month as producing unless the system is changed manually. In addition, the operator stated that field personnel would make written notes of well downtime but that these records were not retained. The president of the operating company stated that "there is not a stripper well in New Mexico that would operate 365 days a year." Regarding water injection records, we noted that 240 days were reported as injecting when meter readings indicated that injection had not occurred. The operator also concurred that these data may have been misreported. The operator was able to provide only one well test record for a single well of the 46 producing oil wells. The record for the one well showed oil production of 76 barrels over 8 days (average production of 9.5 barrels per day) versus production of 92 barrels over the full 31 days reported on the monthly report for this well. Based on the well test average production of 9.5 barrels per day, we concluded that the reported production of 92 barrels would be produced in about 10 days. Based on our conclusion that the wells could not have been operating for every day during the qualifying period, on documentation obtained on water injection well meter readings and one well test record, and on statements made by the president of the property's operating company, we considered this rate to be unsupported. Consequently, we recalculated the royalties paid for the period of October 1, 1992, through December 31, 1998, using the standard onshore 12.5 percent royalty rate and concluded that the operator did not support royalty reductions of $672,384. Lack of Records. The current operators of five properties could not provide documentation supporting the eligibility of their properties for royalty rate reductions. These operators all stated that they had purchased the participating property from a previous qualifying Program operator and that records supporting the reduced royalty rate were not provided at the time of sale. We attempted to contact the previous operators of these properties and were able to contact two of them, who also stated that they were unable to locate the records. However, one previous operator told us that records such as well test records, pumper logs, downtime reports, and tank gauging reports are normally given to the purchaser when a property is sold. Each of the five properties for which we requested records had reported high numbers of producing days during the qualifying period. Specifically, production days reported on the monthly reports during the qualifying periods averaged 96.2 percent of the total number of days in the year (the range was from 84 percent to 100 percent of the available days). As stated in the section "Incomplete Records," BLM officials and an operator told us that stripper and associated injection wells are frequently down for reasons such as workovers (cleaning out a well that has sanded up, pulling tubing, washing out the bottom of the well with mud or acid, or using explosives to dislodge sand or silt); maintenance activities (such as hot oiling to remove paraffin wax buildup); and work on pumps, motors, pipelines, and oil storage tanks. Wells may also be down for regularly scheduled periods of time to allow oil or gas to migrate to areas of low pressure, such as the area surrounding the well bore of a producing well. Consequently, because records were lacking and the number of reported producing days was high, we concluded that the five properties should not qualify for the reduced rates claimed by the four operators. We determined that reduced royalties for these five properties totaled $2,395,865 for the period of October 1, 1992, through December 31, 1998. Program Policies and Procedures BLM did not establish Program policies and procedures for participating operators and for MMS Program staff to ensure the accuracy of reduced royalty rate determinations. Specifically, policies and procedures were not established to address certain situations that would impact the operators' calculation of reduced royalty rates related to (1) the use of load oil in fracturing;[5] (2) multiple completions,[6] commonly known as down hole commingling and multiple completion wells;[7] and (3) water injection in a nonproducing formation on that property. We determined that the failure to consider these situations resulted in inaccurate Program royalty rate determinations. For the 14 sampled properties, we identified 3 properties with these situations that required technical interpretation and guidance by BLM officials. These officials acknowledged that these situations had not been anticipated when the Program was established. Based on our discussions and recalculations, we determined that royalties were underpaid for the three properties by $383,131, as described in the paragraphs that follow. Fracturing. In November 1994, an operator of a Wyoming property submitted an initial notification claiming a reduced royalty rate of 6.1 percent effective in December 1994. The claimed rate was subsequently recalculated and confirmed by MMS at 5.3 percent. The rate calculation was based on the monthly reports that identified two oil wells with production of 4,090 barrels of oil over 648 producing days. In March 1999, we obtained well-production test records from the operator for this property in support of the monthly reports. Our review of these records revealed large production volume reporting discrepancies between the well-production test volumes and the volumes reported on the monthly reports. For example, in October 1993, the operator reported production of 326 barrels of oil over 31 claimed production days, while the well test records showed production of 716 barrels of oil over just 18 test days. Similarly, in December 1993, the operator reported no oil production over 31 claimed production days, while the well test records showed production of 209 barrels of oil over just 10 test days. The operator told us that the reporting discrepancies were due to recovering oil used on the property for fracturing the formation. In this case, the operator was using load oil[8] to fracture the formation. For the subsequent recovery of this oil, the operator appropriately did not report the load oil as production but did report the number of days it took to recover the load oil as producing days. While BLM had no formal policy and procedure on fracturing with load oil as it relates to calculating reduced royalty rates for the Program, BLM Program officials have taken the position that neither recovered load oil nor days spent recovering load oil for fracturing should be considered for reduced royalty rate calculations. As with the preceding examples, we used the well test records to calculate the expected number of well-production days. This calculation resulted in a decrease of qualifying days from 648 to 358. At 358 production days and 4,090 barrels of production, the property qualifies for a reduced royalty rate of 9.3 percent rather than the 5.3 percent claimed. Based on our recalculation of the royalties paid for the period of November 1, 1993, through December 31, 1998, we determined that the operator underpaid royalties by $39,671. Multiple Completions and Multiple Completion Wells. In September 1992, an operator of a New Mexico property submitted an initial notification claiming a reduced royalty rate of 5.3 percent effective in October 1992, and the rate claimed was confirmed by MMS in March 1993. The rate calculation was based on the monthly reports that identified 13 producing oil wells with production of 31,432 barrels of oil over 4,501 well-producing days. In March 1999, we obtained daily production logs from the operator in support of the monthly report. Based on our review of the monthly report, we found that 8 of the 13 oil wells reported were multiple completions with down hole commingled production[9] which was produced from only 3 oil wells. According to BLM Program officials, BLM has no written policy for the Program on multiple completions that are commingled down hole. However, these officials told us that multiple completions with commingled production should be counted as only one well. Accordingly, the eight wells reported on the operations report should have been reported as only three wells. We recalculated the well-production days based on 8 wells instead of 13 wells, which reduced the well-producing days to 2,684. At 2,684 producing days and 31,432 barrels of production, the property qualifies for a reduced royalty rate of 9.3 percent instead of the 5.3 percent rate claimed. Based on our recalculation of the royalties paid for the period of October 1, 1992, through December 31, 1998, we determined that the operator underpaid royalties by $190,927. BLM also did not have a written policy and procedure for calculating reduced royalty rates for properties containing multiple completion wells. BLM Program officials stated that in the case of a multiple completion wells, each producing tubing string[10] should be counted as an individual well. MMS Program officials who reviewed and confirmed the operator's reduced royalty rate said that they had not received guidance on how to count multiple completions or multiple completion wells and had assumed that multiple completions should be counted as multiple wells regardless of commingling. Water Injection in a Nonproducing Formation. In September 1992, an operator of a Wyoming lease submitted an initial notification claiming a reduced royalty rate of 2.9 percent effective in October 1992. Subsequent to MMS's review of that rate, the operator submitted amended monthly reports, and MMS confirmed a 2.1 percent rate. The rate calculation was based on the amended monthly reports, which showed two producing oil wells and three water injection wells with production of 3,902 barrels of oil over a period of 535 producing and 994 injecting days (1,529 total days). In March 1999, we obtained well-production test records from the operator for this lease in support of the monthly reports. Based on our review of these records, we found large reporting discrepancies between the well-production test volumes and the volumes reported by the operator on the monthly reports. For example, during May, June, and July 1991, the operator reported no oil production over 74 claimed production days; however, the well test records identified production of 806 barrels of oil over just 28 tested days. In addition, based on our review of the amended monthly reports, we determined that the operator claimed 446 injecting days during the period of December 1990 through July 1991 for injection to a formation which produced no oil from the formation on that property. BLM's petroleum engineer for that area said that this injection was either for the benefit of another lease or was a water disposal well with no benefit to production and should not be counted as an eligible Program well. In April 1999, the operator agreed that a discrepancy existed between the operator's well test records and the reported monthly production. Although the operator agreed to provide us with additional information to explain the discrepancies, we had not received this information as of August 1999. Based on the reporting discrepancies noted and the absence of records to support the operator's amended monthly reports and the operator's claimed rate, we considered this rate to be unsupported. Based on our recalculation of the royalties paid for the period of October 1, 1992, through December 31, 1998, we determined that the operator had underpaid royalties by $152,533. During this audit, we discussed our findings with BLM and MMS officials and with state audit agency officials, including discussions with these officials during our participation in the April and June 1999 State and Tribal Royalty Audit Committee[11] meetings, since some state audit agencies are responsible for auditing Federal onshore leases within their boundaries. BLM and MMS officials agreed that there was a lack of policies and procedures. Further, some state officials agreed to amend their annual audit plans to include audits of significant Program properties. To assist in this effort, MMS officials agreed at the April Committee meeting to identify the top 100 properties that benefited from the Program since the Program's inception. BLM officials subsequently agreed to request records supporting the reduced royalty rates for these properties. Officials of California, New Mexico, and Wyoming told us that they will begin auditing these properties. As previously stated, the Program's properties in these states received more than 91 percent of the royalty rate reductions provided through the end of calendar year 1998. We have provided copies of our applicable working papers to audit officials in New Mexico and Wyoming. The 14 audited properties that we reviewed (see Appendix 5) received reduced royalty Program benefits totaling about $6.94 million, and we identified 12 properties that had inaccurate or unsupported rates, which resulted in actual or potential underpaid royalties totaling about $4.49 million (64.7 percent). Specifically, five properties had inaccurate rates with approximately $1.27 million in underpaid royalties, and seven properties had unsupported rates with $3.22 million in reduced royalties in which some or all of the royalties may be underpaid. In addition, the States of California, New Mexico, and Oklahoma reviewed six additional properties that had received reduced royalty Program benefits totaling about $10.48 million. Of the six properties, five had inaccurate or unsupported rates, which resulted in potential underpaid royalties totaling about $872,000 (8.3 percent). Specifically, four properties had inaccurate rates with $847,000 in potential underpaid royalties, and one property had an unsupported rate with $25,000 in reduced royalties. The combined 20 properties reviewed had reduced royalty Program benefits totaling about $17.42 million. Of the 20 properties, 17 had inaccurate or unsupported rates, which resulted in actual or potential underpaid royalties totaling about $5.36 million (30.8 percent). If the 30.8 percent potential underpaid royalty error rate is representative of the $139.7 million in total reduced royalty Program benefits received, the total potential for underpaid royalties could be as much as $43.02 million, which is attributable to inaccurate rates ($16.90 million) and unsupported rates ($26.12 million). We believe that BLM and MMS, in consultation with the states which have Federal properties participating in the Program, should develop an overall audit strategy for participating properties other than the largest benefiting properties. Smaller properties could be audited along with the largest benefiting properties having the same operator, especially when systemic errors are found. For example, erroneous information for all of an operator's leases may occur because the automated production reporting systems automatically report production days equal to the number of days in the month unless the number of production days is manually changed to reflect actual producing days. In addition, BLM and MMS need to develop policy and procedures for instances where the operators say that records prior to 1993 are no longer available. Such policies and procedures are essential because while the program is entering its eighth year, a 6-year records retention requirement applies to production occurring prior to September 1, 1996. For example, State of New Mexico royalty auditors told us that they had initiated a review on one stripper property but were unable to obtain the supporting records. The auditors subsequently notified the operator by issue letter that the reduced rate would not be allowed unless supporting documentation was provided. The operator responded that it could not locate the records and that it was required to maintain those records for only 6 years after the records are generated. Based on our review of the top 100 benefiting properties, we found that 57 properties had rates based on the original qualification period of August 1990 through July 1991. However, operators had filed for subsequent outyear rate reductions on the remaining 40 properties; thus, the supporting records for these reductions should be less than 6 years old. At a minimum, we believe that operators who cannot provide documentation to support their reduced royalty rates should be required to requalify for the Program. Further, we believe that BLM and MMS need to develop and implement policies and procedures for reviewing supporting documentation on future and existing notifications that MMS has not confirmed. Our prior audit report (see Prior Audit Coverage) noted that MMS had a backlog of 589 notifications that it had not confirmed. Because of the 85 percent error or unsupported rate (17 of the 20 properties reviewed) identified by this review and in state auditors' reviews, we believe that supporting documentation should be reviewed before MMS confirms that a reduced royalty rate is warranted. Recommendations We recommend that the Directors of BLM and MMS: 1.Develop and implement a plan, in coordination with the states, which ensures that the largest benefiting stripper oil well properties are audited. The plan should also identify smaller properties (other than the largest benefiting properties) for audit and/or properties that can be audited in conjunction with the largest properties. 2.Develop a policy for participating Program operators which do not have records prior to 1993 supporting their qualifying information on the "Monthly Reports of Operations." In addition, consideration should be given to requiring requalification of operators that cannot provide documentation to support their reduced royalty rates. 3.Develop Program policy and procedures which address the issues of using load oil in fracturing, multiple completions and multiple well completions, injecting water in a nonproducing formation, and other issues for reviewing and confirming the reduced royalty rate notifications provided by the operators. 4.Develop and implement a procedure to review supporting records for future Program notifications submitted by operators and existing notifications that MMS has not confirmed. BLM and MMS Response and Office of Inspector General Reply In the January 27, 2000, response (Appendix 6) to the draft report, the Acting Director, BLM, and the Director, MMS, agreed with the report's four recommendations. Subsequent to the response, officials from BLM and from the Assistant Secretary for Land and Minerals Management's office provided additional information regarding Recommendations 2 and 4. Based on the response and the additional information, we consider Recommendations 2 and 3 resolved and implemented and Recommendations 1 and 4 resolved but not implemented. Accordingly, the unimplemented recommendations will be referred to the Assistant Secretary for Policy, Management and Budget for tracking of implementation (see Appendix 7). Regarding Recommendation 2, officials stated, in March 3, 2000, electronic correspondence, that MMS will make referrals to the states "for pursuit at their discretion" those cases in which "operators claim that they have no documentation beyond the statutory records retention period " and in which MMS "has reasonable basis to doubt either the claims or the veracity of their stripper royalty rate notifications." The electronic correspondence further stated that MMS "will incorporate alternative compliance techniques to be used for such cases into its routine compliance training programs" as appropriate. Regarding Recommendation 4, the officials stated that BLM would propose a rule or revised regulations by December 29, 2000, for retaining supporting records for future notifications and subsequent periods. **FOOTNOTES** [1]:According to 43 CFR 3103.4-2, a stripper well property is "any Federal lease or portion thereof segregated for royalty purposes, a communitization agreement, or a participating area of a unit agreement, operated by the same operator, that produces an average of less than 15 barrels of oil per eligible well per well-day for the qualifying period." Also, 43 CFR 3105.2-2 states, "When a lease or portion thereof cannot be independently developed and operated in conformity with an established well-spacing or well-development program, the authorized office may approve communitization or drilling agreements for such lands with other lands whether or not owned by the United States, upon a determination that it is in the public interest." [2]: The "Monthly Report of Operations" contains monthly production data reported by operators for individual leases and wells, including data on lease identification; well location; well production of oil, gas, and water; number of days during the month that each well produced or injected; and other data about well site conditions and operations. [3]:According to 43 CFR 3103.4-1(c)(4), an eligible injection well is a "well that injects a fluid for secondary or enhanced oil recovery, including reservoir pressure maintenance operations." [4]: Shut-in wells are wells from which the lease operator has temporarily stopped producing oil and gas because of economic or other considerations but for which production may be restarted by opening a valve or turning on a switch. [5]:According to "Oil and Gas Terms" (by Howard R. Williams and Charles J. Meyers, Matthew Bender, New York, 1997), fracturing refers to "a process of opening up underground channels in hydrocarbon-bearing formations by force, rather than by chemical action such as acidizing." Load oil may be utilized in hydraulic fracturing, which is defined as "a mechanical method of increasing the permeability of rock, and thus increasing the amount of oil and or gas produced from it. The method employs hydraulic pressure to fracture the rock." [6]:According to "Oil and Gas Terms" (by Howard R. Williams and Charles J. Meyers, Matthew Bender, New York, 1997), multiple completion refers to "the completion of a single well into more than one producing horizon. Such a well may produce simultaneously from the different horizons, or alternately from each." [7]:According to "Oil and Gas Terms" (by Howard R. Williams and Charles J. Meyers, Matthew Bender, New York, 1997), multiple completion well refers to "a well producing from two or more formations by means of separate tubing strings run inside the casing, each of which carries crude oil from a separate and distinct producing formation. The separate tubing strings distinguish this form of well from a commingled well, which produces from two or more oil bearing formations through a single tubing string in the common well casing." [8]:According to "Oil and Gas Terms" (by Howard R. Williams and Charles J. Meyers, Matthew Bender, New York, 1997), load oil refers, in part, to "oil injected into a well as part of a fracturing operation." [9]:According to "Oil and Gas Terms" (by Howard R. Williams and Charles J. Meyers, Matthew Bender, New York, 1997), commingled production refers to "production from two or more wells or leases or oil-bearing formations commingled by an operator." [10]:Tubing strings are explained in footnote 7. [11]:The State and Tribal Royalty Audit Committee is an organization composed of states and Indian tribes that have audit agreements with MMS. Since the report's recommendations are considered resolved, no further response to the Office of Inspector General is required (Appendix 7). 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. APPENDIX 1 CLASSIFICATION OF MONETARY AMOUNTS[1] ----------------------------------------------------------- Finding Potential Additional Area Revenues* (In millions) ----------------------------------------------------------- Royalties underpaid because of: ----------------------------------------------------------- - incorrect royalty rates $1.56[2] to $16.90 - unsupported royalty $3.25 to $26.12 rates ----------------------------------------------------------- Total $4.81** to $43.02 ----------------------------------------------------------- **FOOTNOTES** [1]:These amounts are exclusive of the $3.5 million audit exception reported in the August 1999 audit report "Processing Notifications for the Stripper Oil Well Property Royalty Rate Reduction Program, Minerals Management Service" (No. 99-I-782) (see Prior Audit Coverage). [2]:This amount is exclusive of an underpayment of more than $500,000 identified by the State of California that the operator subsequently paid (see Prior Audit Coverage). APPENDIX 2 ROYALTY RATES FOR THE STRIPPER OIL WELL PROPERTY ROYALTY RATE REDUCTION PROGRAM Average Barrels Reduced of Oil Produced Royalty Rate Per Well Per Day Percent[1] 0 0.5 1 1.3 2 2.1 3 2.9 4 3.7 5 4.5 6 5.3 7 6.1 8 6.9 9 7.7 10 8.5 11 9.3 12 10.1 13 10.9 14 11.7 **FOOTNOTES** [1]:The standard onshore Federal royalty rate as of December 1999 was 12.5 percent for 15 or more average barrels of oil produced per well per day. APPENDIX 3 SCHEDULE OF ESTIMATED ANNUAL STRIPPER OIL WELL PROPERTY ROYALTY RATE REDUCTIONS PROVIDED BY STATE STATE 1992 1993 1994 1995 1996 1997 1998 Total Alabama $672 $2,359 $2,146 $1,974 $1,574 $1,876 $1,072 $11,673 California[1] 569,181 1,685,248 1,693,639 1,740,660 2,148,081 6,195,428 3,351,905 17,384,142 Colorado* 83,493 207,191 249,630 362,120 325,791 314,448 185,249 1,727,922 Illinois 1,309 10,478 8,500 7,116 6,707 12,696 8,178 54,985 Kansas 1,012 87,256 104,839 92,756 87,769 98,380 53,028 525,040 Kentucky 2,825 31,971 35,770 31,872 28,739 26,247 13,829 171,253 Louisiana* 1,052 7,250 8,981 8,021 9,657 19,906 10,763 65,631 Michigan 0 0 2,977 12,343 5,782 8,000 1,382 30,485 Mississippi 10,740 42,659 38,806 27,262 25,701 31,894 15,923 192,985 Montana* 43,245 226,169 198,564 231,954 189,920 219,736 118,629 1,228,216 Nebraska 0 459 836 782 1,071 6,763 29,824 39,735 New Mexico* 2,167,788 8,030,576 9,282,29510,512,81911,516,695 15,122,579 9,643,011 66,275,763 Nevada 0 0 0 0 0 1,895 5,374 7,269 North Dakota* 16,217 39,288 42,350 44,890 40,888 49,819 1,046 234,499 Ohio 1,105 6,910 8,781 8,763 10,817 44,594 26,248 107,217 Oklahoma* 59,158 65,429 55,984 56,253 70,471 83,806 43,592 434,692 Pennsylvania 0 0 0 0 0 2,366 1,027 3,393 South Dakota 474 2,262 407 5,791 4,556 3,959 302 17,752 Texas* 15,446 72,814 66,918 60,612 62,661 83,100 63,947 425,498 Utah* 138,446 693,100 999,760 1,097,454 1,092,823 1,298,732 970,115 6,290,430 Wyoming* 1,912,577 7,417,172 7,792,807 8,000,065 7,549,482 7,503,793 4,318,587 44,494,483 TOTALS $5,024,740 $18,628,591 $20,593,990 $22,303,507 $23,179,185 $31,130,017 $18,863,031 $139,723,063 **FOOTNOTES** *States with Section 205 agreements authorized by the Federal Oil and Gas Royalty Management Act. Although the State of Alaska also has a Section 205 agreement, no Federal oil properties in the State participate in the Program. APPENDIX 4 OFFICES AND SITES VISITED AND/OR CONTACTED OFFICES AND SITES LOCATION Department of the Interior Bureau of Land Management Division of Fluid Minerals Washington, D.C. Carlsbad Resource Area Carlsbad, New Mexico Hobbs Resource Area Hobbs, New Mexico Roswell District Office[2] Roswell, New Mexico Wyoming State Office* Cheyenne, Wyoming Casper District Office Casper, Wyoming Pinedale Field Office Pinedale, Wyoming Rawlins District Office Rawlins, Wyoming Minerals Management Service Royalty Management Program Office Lakewood, Colorado State of California Oil and Gas Unit, Division of Audits Sacramento, California State of New Mexico Bureau of Oil and Gas Santa Fe, New Mexico State of Wyoming Mineral Audit Division Cheyenne, Wyoming Program Operators Amoco Production Company Bair Oil, Wyoming Conoco* Ponca City, Oklahoma Devon Energy Corporation Artesia, New Mexico Enron Oil and Gas Big Piney, Wyoming Marathon Oil Company* Cody, Wyoming Mack Energy Corporation* Artesia, New Mexico Marbob Energy Corporation Artesia, New Mexico North Finn, LLC* Casper, Wyoming Plains Petroleum Operating Co.* Midland, Texas Texaco Exploration and ProductionHobbs, New Mexico **FOOTNOTES** [2]:Contacted only. APPENDIX 5 ----------------------------------------------------------- RESULTS OF PROPERTIES REVIEWED ----------------------------------------------------------- Additional/ Audited Unsupported Property Rate Audited Royalty Royalties Royalties Paid Number Paid Rate Amount Due ----------------------------------------------------------- PRODUCTION DAYS ----------------------------------------------------------- Sufficient Records for Recalculation ----------------------------------------------------------- 1 1.3% 12.5% $991,536 $103,120 $888,416 ----------------------------------------------------------- 2 11.7% 12.5% 626,553 549,618 76,935 ----------------------------------------------------------- 3 5.3% 6.1% 303,592 230,990 72,602 ----------------------------------------------------------- Subtotal $1,037,953 ----------------------------------------------------------- Incomplete Records ----------------------------------------------------------- 4 6.1% 12.5% $1,018,708 $346,324 $672,384* ----------------------------------------------------------- Subtotal $672,384 ----------------------------------------------------------- Lack of Records ----------------------------------------------------------- 5 6.1% 12.5% $2,320,429 $1,132,369 $1,188,060* ----------------------------------------------------------- 6 6.1% 12.5% 1,175,620 476,012 699,608* ----------------------------------------------------------- 7 1.3% 12.5% 361,414 37,587 323,827* ----------------------------------------------------------- 8 10.9% 12.5% 297,493 211,589 85,904* ----------------------------------------------------------- 9 8.5% 12.5% 331,869 233,403 98,466* ----------------------------------------------------------- Subtotal 2,395,865 ----------------------------------------------------------- Subtotal $7,427,214 $3,321,012 $4,106,202 (Production Days) ----------------------------------------------------------- PROGRAM REGULATIONS ----------------------------------------------------------- Fracturing ----------------------------------------------------------- 10 5.3% 9.3% $92,235 $52,564 $39,671 ----------------------------------------------------------- Multiple Completion and Multiple Completion Wells ----------------------------------------------------------- 11 5.3% 9.3% $443,907 $252,979 $190,928 ----------------------------------------------------------- Water Injection Into a Non-Producing Formation ----------------------------------------------------------- 12 2.1% 12.5% $183,342 $30,810 $152,532* ----------------------------------------------------------- Subtotal (Program $719,484 $336,353 $383,131 Regulations) ----------------------------------------------------------- Total $8,146,698 $3,657,365 $4,489,333 ----------------------------------------------------------- NO PROGRAM EXCEPTIONS ----------------------------------------------------------- 13 6.9% 6.9% $625,653 $625,653 0 ----------------------------------------------------------- 14 2.9% 2.9% $436,007 $436,007 0 ----------------------------------------------------------- $1,061,660 $1,061,660 Total0 ----------------------------------------------------------- Grand $9,208,358 $4,719,025 $4,489,333 Total ----------------------------------------------------------- *Unsupported royalties due. ----------------------------------------------------------- APPENDIX 6 Page 1 of 5 APPENDIX 6 Page 2 of 5 APPENDIX 6 Page 3 of 5 APPENDIX 6 Page 4 of 5 APPENDIX 6 Page 5 of 5 APPENDIX 7 STATUS OF AUDIT REPORT RECOMMENDATIONS Finding/Recommendation Reference Status Action Required 1 and 4 Resolved; not No further response to the Office implemented of Inspector General is required. The recommendations will be referred to the Assistant Secretary for Policy, Management and Budget for tracking of implementation. 2 and 3 Implemented. No further action is required. ILLEGAL OR WASTEFUL ACTIVITIES SHOULD BE REPORTED TO THE OFFICE OF INSPECTOR GENERAL BY: Sending written documents to: Within the Continental United States U.S. Department of the Interior Office of Inspector General 1849 C Street,N.W. Mail Stop 5341 Washington, D.C. 20240 Calling: Our 24 hour Telephone HOTLINE 1-800-424-5081 or (202) 208-5300 TDD for hearing impaired (202) 208-2420 or 1-800-354-0996 Outside the Continental United States Caribbean Region U.S. Department of the Interior Office of Inspector General Eastern Division- Investigations 1550 Wilson Boulevard Suite 410 Arlington, Virginia 22209 Calling: (703) 235-9221 North Pacific Region U.S. Department of the Interior Office of Inspector General North Pacific Region 238 Archbishop F.C. F'lores Street Suite 807, PDN Building Agana, Guam 96910 Calling: (700) 550-7428 or COMM 9-011-671-472-7279