[Final Special Report on the Royalty Gas Marketing Pilot, Minerals Management Service] [From the U.S. Government Printing Office, www.gpo.gov] Report No. 96-I-786 Title: Final Special Report on the Royalty Gas Marketing Pilot, Minerals Management Service Date: May 20, 1996 **********DISCLAIMER********** This file contains an ASCII representation of an OIG report. No attempt has been made to displaygraphic 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, Logistical Services Branch at (202) 219-3840. ****************************** United States Department of the Interior OFFICE OF THE INSPECTOR GENERAL Washington, D.C. 20240 MEMORANDUM To: The Secretary From: Wilma A. Lewis Inspector General SUBJECT SUMMARY: Final Special Report for Your Information - " Royalty Gas Marketing Pilot, Mineral Management Service" (No. 96-I-786) Attached for your information is a copy of the subject final special report. At the request of the Minerals Management Service, we reviewed the Service's natural gas royalty-in-kind pilot project. We concluded that the Service had established effective administrative procedures over the pilot project and demonstrated that the royalty-in-kind concept holds promise. However, we also concluded that the current project was too limited in scope for the Service to be able to draw any definitive conclusions on how successful such a program could be. Accordingly, we made several suggestions which, if implemented in future pilot projects, would provide more meaningful results upon which a management decision can be made. If you have questions concerning this matter, please contact me or Ms. Judy Harrison, Assistant Inspector General for Audits, at (202) 208-5745. Attachment C-IN-MMS-O01-96 United States Department of the Interior OFFICE OF THE INSPECTOR GENERAL Washington, D.C. 20240 SPECIAL REPORT MAY 20 1996 Memorandum To: Director, Minerals Management Service Assistant Inspector General for Audits Subject: Final Special Report on the Royalty Gas Marketing Pilot, Minerals Management Service (No. 96-I-786) INTRODUCTION This special report is to advise you of the results of our review of the Minerals Management Service's Royalty Gas Marketing Pilot. The review was initiated in response to a request from the Service to provide assistance in its evaluation of the gas royalty-in-kind concept. BACKGROUND The Minerals Management Service has royalty management responsibilities for minerals produced from Federal and Indian lands. These responsibilities include collecting certain rents, royalties, and other payments; maintaining accounting records; determining royalty liability; and auditing royalty payments to determine whether royalties received represent fair and equitable value to the lessor. To fulfill these obligations, the Service issues regulations concerning mineral production and develops procedures for the collection of royalties. The Service collects about $4.1 billion annually from mineral leasing activities and has collected about $76 billion since 1982, the year it was created, through 1995. Traditionally, the Service has received royalties for natural gas produced on Federal leases in value (that is, cash payments). However, the Federal royalty gas valuation and collection procedures as stated in the Code of Federal Regulations (30 CFR 206) associated with the royalty-in-value system have long been subject to controversy and litigation. For example, approximately 50 percent of royalty appeals and litigation actions originate from valuation disputes. In an effort to find ways to resolve these disputes, the Service in 1994 initiated the Royalty Gas Marketing Pilot, which involved taking royalty gas in kind (that is, accepting gas production instead of receiving cash payments) and immediately selling the gas to marketers at or near the lease sites through competitively awarded contracts. Under the Pilot program arrangement, the producer delivered the royalty gas directly to the contract marketer without the Service actually taking physical possession of the gas. The Service's objective in conducting this pilot was to streamline the royalty collection process and to improve the efficiency of determining gas valuations without decreasing revenue collections. Other expected benefits included administrative cost savings, reduced audit effort, and fewer royalty appeals and litigation. In view of this innovative approach to royalty management, the Department of the Interior designated the Pilot as a National Performance Review Laboratory. The Royalty Gas Marketing Pilot was formally announced in a June 28, 1994, letter from the Service's Director requesting gas producers in the Gulf of Mexico to volunteer leases for the project. In response to the request, many major and independent companies expressed interest in the Pilot, and the Service negotiated agreements with 19 producers who volunteered 84 leases. The Service aggregated the volunteered leases into 36 bid groups; issued a formal Invitation for Bids for the royalty gas on October 21, 1994; and opened the bids on November 21, 1994. (The flow of gas from the lease groups is illustrated in Appendix 1.) The Service received 23 bids from 22 marketers and awarded 14 contracts. The winning bids submitted by the contract marketers represented the highest offered prices for the royalty gas using standard published index prices as a base. The Service subsequently eliminated several bid groups when certain marketers requested to be released from the Pilot because their bids had not considered the full transportation costs for the royalty gas. Accordingly, the Pilot began with 32 groups consisting of 79 leases volunteered by 14 producers. The Pilot represented 6.5 percent of the approximately 1.9 billion cubic feet of Federal royalty gas produced daily from the Gulf of Mexico in 1995. The Pilot was conducted from January through December 1995, after which time the leases reverted to royalty in value. At the time of our review, the Service was evaluating the Pilot results and said that it expected to issue a final report by June 30, 1996. The report will provide the Service's Quality Council with recommendations regarding the future of the gas royalty-in-kind program. OBJECTIVE AND SCOPE The objective of our review was to evaluate the Semite's administration of the Royalty Gas Marketing Pilot and present information that the Service may use to establish a permanent gas royalty-in-kind program. The scope of our review covered the lease selection process; the contract bidding and award procedures; the monetary collection process; and the system of internal controls over the planning, implementation, and evaluation of the Pilot. We also determined whether impediments exist in changing the program from a voluntary to a mandatory taking of gas. 2 To accomplish our objective, we reviewed the Pilot's planning, implementation, and evaluation phases and analyzed data pertaining to the Pilot that were developed and compiled by the Service. We interviewed key personnel from numerous Service offices and surveyed representatives from 25 gas production, marketing, and distribution companies who either participated in or were knowledgeable of the Pilot. We also interviewed officials in states that had or attempted to have a royalty-in-kind program (see Appendix 2). PRIOR AUDIT COVERAGE Neither the Office of Inspector General nor the General Accounting Office has issued any audit reports in the past 5 years that specifically addressed our objective or the royalty-in-kind concept. DISCUSSION We found that the Minerals Management Service was effective in administering the Royalty Gas Marketing Pilot and had demonstrated the feasibility of taking gas royalties in kind as an alternative to the royalty-in-value system. However, we noted weaknesses in the Pilot design, revenue collections, marketing strategies, and administrative controls that the Service should consider in studying the royalty-in- kind concept. Design The Pilot did not represent overall gas operations in the Gulf of Mexico. This occurred because the Service conducted the Pilot as a voluntary project. That is, producers were under no obligation to participate and were allowed to select which leases to contribute. Although this procedure helped ensure cooperation from the participants while testing this approach, it limited the number of companies that participated and thus diminished the usefulness of the Pilot results. For example, some of the largest of the 143 operators in the Gulf, such as Shell Oil Company and Exxon Corporation, chose not to participate, and one company represented 49 percent of the lease production in the Pilot, although no single operator produced more than 9.4 percent of the gas in the Gulf. Further, the Service excluded from the Pilot certain leases with complex ownership arrangements, including Section 8(g) leases, which involve state ownership. We believe that in order to simulate a permanent and comprehensive royalty-in-kind program, future pilots should encompass a realistic balance of producing companies, lease types, and lease ownership situations. Otherwise, the concept will not be thoroughly tested, and pilot evaluations will not provide a useful basis for formulating policy decisions. 3 We did not identify any impediments to the Government's taking royalty gas on an involuntary basis other than the potential objections by industry to being selectively forced to participate in an experimental program. Objections were raised by slightly over one-half of the companies in our survey of industry, but no strong opposition was expressed, as industry recognized that the lease agreements authorized the Government to take royalty gas in kind. We believe that future pilots should require mandatory participation from the oil and gas industry to ensure the complete evaluation of the in-kind concept. Industry officials expressed concern that certain provisions in the Invitation for Bids and the marketing contract were unfairly biased in favor of the Government. The provisions that industry generally objected to included the penalties for the marketer's failure to take the gas, the payment disputes clause, and the termination for convenience clause. Additionally, at least one company did not participate in the Pilot because of the contract provisions, which resulted in decreased competition. We believe that the Service should consider the companies' concerns when designing a future pilot. In that regard, industry has developed its own contract language to deal with the complicated business of buying and selling gas. Since the Government assumes the position of a gas marketer under a royalty-in-kind program, we suggest that future pilots consider incorporating standard industry contract clauses but ensure that the Government's interests are protected. Despite the concerns raised by industry regarding the Pilot's design, we found that 80 percent of the companies in our survey endorsed the gas royalty-in-kind concept. The benefits cited by industry pertained mainly to their own potential cost savings associated with simplified royalty reporting, less Government audit activity, fewer royalty appeals, and less royalty litigation. Revenue Collections The Pilot did not achieve revenue neutrality in that revenues collected did not equal what would have been received had royalties been taken in value. Lease agreements and the Outer Continental Shelf Lands Act, as amended, stipulate that royalties be paid on the fair market value of production saved, removed, or sold from a lease. Uncertainty exists in the Service, however, regarding whether revenue neutrality under the royalty-in-kind system must be maintained for each individual lease or for all leases taken as a whole. Additionally, no guidance exists regarding whether revenue neutrality analyses may consider factors such as administrative cost savings, increased management efficiencies, and litigation avoidance realized under a royalty- in-kind system. Further, the effect of proposed amendments to the Federal gas valuation regulations (published in the "Federal Register" on November 6, 1995) on a royalty-in-kind system have not yet been determined. These issues have important ramifications regarding revenue neutrality and need to be addressed in the Service's evaluation of the Pilot. At the time of our review, initial partial year estimates prepared by the Service indicated that royalty collections were approximately 5 percent less than if royalties had been received in value. Based on our audit results, we found that several reasons accounted for the low bid prices that produced the revenue shortfall. We believe that the primary cause was that some marketers reduced bid prices to offset their increased costs to transport gas on privately owned lateral pipelines that connected the Pilot leases to trunklines. 1 To illustrate, under the royalty-in-value system, only the actual transportation costs incurred by the lessee, who also generally owns the lateral pipeline, are deducted from the royalty payment. This differs from the royalty-in-kind system because the contract marketer may not own the lateral pipeline, and consequently, the contract marketer must negotiate a transportation fee with the pipeline owner, who may charge a fee in excess of actual costs. These additional costs increase the risks to the contract marketer's profits and in the Pilot translated to, in some cases, lower bids. However, we believe that the full extent of the effect of lateral pipelines on gas prices cannot be determined at this time because changes in future pilots regarding the size, location, and term length of gas sales contracts may affect market conditions and bids. Other reasons cited by the Service for - The uncertainty of industry unproven program. - The difficulties encountered in the decreased revenues included the following: becoming involved in an experimental and designing and planning the Pilot, which caused a 3-month delay in the start date. The Pilot eventually began in January, after the contract marketers had generally secured their gas sources for the busy and profitable winter season. - The 30-day deadline to respond to the Invitation for Bids, which many contract marketers stated was insufficient time to complete their bid preparations. - The possible deductions in bids for the costs to deliver the royalty gas in pipeline-quality condition. Under the royalty-in-value system, no deductions would be allowed for these costs. - The recovery of marketing costs in the bid prices, whereas no deduction for these costs would be allowed under the royalty-in-value system. Despite these concerns, we believe the Service should continue to explore the royalty-in-kind process and that future pilots can be designed to address the identified problems. 1 Trunklines are main pipelines that transport gas from production areas to gas processing plants or other terminals. 5 Marketing Strategies We identified marketing-related strategies that the Service should consider in a future pilot to enhance revenue collections as follows: - The Service could warrant, or guarantee, the volumes of royalty gas that are delivered to the contract marketer. Our survey of industry indicated that the lack of guaranteed gas volumes in the Pilot was reflected in lower bid prices. Although warranted volumes create a risk for the Government in that it must guarantee delivery of specified volumes, this risk can be minimized by following the customary industry practice of withholding a portion of the gas supply to cover unexpected drops in production. This reserve gas supply, known as "swing gas," can be stored or sold on the spot market when not needed to support the warranted gas. - The Service could package gas volumes in the sizes most desired by industry. Our survey of industry disclosed that most gas marketing companies preferred lease production to be packaged in sizes ranging between 5,000 to 20,000 MMBtu per day.2 However, our analysis of the Invitation for Bids disclosed that the 32 groups averaged only about 4,800 MMBtu per day and 21 (66 percent) of these groups produced less than 5,000 MMBtu per day. We found a direct correlation between bid prices and gas volumes. Specifically, the bid prices for the 11 groups producing over 5,000 MMBtu per day were almost 2 cents higher than those with smaller gas volumes, while the 4 groups producing over 10,000 MMBtu per day were almost 6 cents higher. The larger volume groups also generally attracted more bids, and thus more competition, than the smaller ones. - The Service could package lease groups along the most logical transportation routes. For example, the Service could group gas volumes that are produced along a single pipeline system. This would simplify the bid preparation for industry and also provide companies with the opportunity to bid on multiple groups to satisfy their individual volume purchase requirements. Packaging gas from a single pipeline system would also help ensure that the gas is of a similar quality and would avoid the problem encountered in the Pilot in which remote stand-alone leases were combined with other leases. Our survey of industry disclosed that at least one company refused to submit bids on the Pilot groups which contained remote leases, since these properties produced relatively small quantities of gas and required that separate transportation agreements be negotiated with the pipeline owners. - To address the lateral pipeline cost issue, the Service could attempt to negotiate reasonable transportation fees with the pipeline owners and publish these 2 One million British thermal units. A British thermal unit is the amount of heat needed to raise the temperature of 1 pound of water 1 degree Fahrenheit. 6 rates in the Invitation for Bids. Recognizing that the Service holds a strong and unique bargaining position as the lessor, pipeline owners may be more inclined to accept lower fees than would be negotiated with the contract marketers. This procedure may also attract more bidders by simplifying the bid preparation process and increase competition by eliminating the bargaining advantage that larger contract marketers have over smaller ones in dealing with pipeline owners. - The Service could publish information in the Invitation for Bids concerning the quality of the gas, such as the Btu content. Full disclosure of the actual value and processing potential of the product may attract more bidders and possibly increase bid prices. - A two-round bidding process could be utilized whereby the top three or so bidders are asked to submit their best and final offered prices. This process would extend the bargaining period and might motivate bidders to offer a higher price. - The Invitation for Bids could include variable contract lengths. The Pilot contract length was 1 year; however, our industry survey indicated that some companies would bid higher for different term lengths. Contracts of two or more years in duration appeal to many gas marketing companies, as they place a premium on securing guaranteed and uninterruptible sources of gas to meet customer commitments. Conversely, some marketing companies prefer the price adjustment flexibility provided by short-term contracts of less than 1 year. As an alternative to taking gas in kind and subsequently marketing it, the Service should explore the concept of taking and using the gas. We identified one successful state-operated royalty-in-kind program in which the state took and used the gas at its facilities. This concept, although more administratively challenging, could offer financial benefits to the U.S. Treasury. Internal Controls As part of our review, we examined the system of internal controls pertaining to the planning, implementation, and evaluation phases of the Pilot. In general, we found that the internal controls provided for a well-managed project and for a comprehensive evaluation of project results. However, we did identify a significant weakness in the initial design of the Pilot. Specifically, 17 (47 percent) of the original 36 lease groups in the Invitation for Bids contained incorrect price index points, which necessitated an amendment to the solicitation. This matter could have been avoided with a better review process to verify information presented in the Invitation for Bids. 7 Management Actions At the time of our review, the Service was conducting its own evaluation of the Pilot, including determining whether savings could be realized in reduced administrative costs, reduced audit effort, and avoidance of royalty appeals and litigation. Although the final results of these analyses were not available at the time of our review, Service officials said that significant benefits were not expected to be realized unless the gas royalty-in-kind program was implemented on a large scale, such as for all leases in the Gulf of Mexico. In our opinion, the Service needs to consider the problems encountered and the ideas developed under the Pilot and establish overall goals and objectives for the program if it decides to study this concept further. A response to this report is not required. However, if you have any questions regarding this report, please call Mr. Alan Klein, Regional Audit Manager, Central Region, or Mr. Lee Scherfel, Senior Auditor, at (303) 236-9243. cc: Assistant Secretary for Land and Minerals Management Chief, Division of Management Control and Audit Follow-up, Office of Financial Management Audit Liaison Officer, Land and Minerals Management Audit Liaison Officer, Minerals Management Service APPENDIX 1 DIAGRAM OF A PILOT LEASE GROUP I BID GROUP This diagram shows the flow of royalty gas from a simple bid group containing one lease. From individual wells, the royalty gas flows along gathering pipelines to the platform, where it is combined into a single stream. At the facility measurement point on the platform, the producer delivers the gas to the contract marketer. This is also where the Minerals Management Service sells the gas and transfers title to the contract marketer. The gas then flows through a lateral pipeline to a main trunkline and on to its eventual destination onshore. Transportation fees for trunklines are regulated by the Federal Energy Regulatory Commission, whereas fees for lateral pipelines are not subject to Government oversight. Finally, the index pricing point on the use to trunkline denotes the location of a published gas price that contract marketers base their bids. 9 APPENDIX 2 Page 1 of 2 OFFICES AND SITES VISITED OR CONTACTED DURING AUDIT Offices and Sites Department of the Interior Minerals Management Service Administration and Budget Procurement & Property Management Division Policy and Management Improvement Office of the Associate Director Appeals Division* Policy Coordination Staff Royalty Management Analysis Division Royalty Management Program Office of Enforcement Royalty Liaison Office Office of the Deputy Associate Director for Compliance Dallas Compliance Division* Office of the Deputy Associate Director for Valuations and Operations Valuation and Standards Division* Reports and Financial Division* Offshore Minerals Management OCS Regional Office Office of the Solicitor* State of Alaska Alaska Department of Royalty Accounting* Location Herndon, Virginia Washington, D.C. Golden, Colorado Washington, D.C. Golden, Colorado Lakewood, Colorado Lakewood, Colorado Lakewood, Colorado Dallas, Texas Lakewood, Colorado Golden, Colorado Lakewood, Colorado New Orleans, Louisiana Washington, D.C. Anchorage, Alaska *Contacted only. 10 APPENDIX 2 Page 2 of 2 Offices and Sites State of Texas Texas General Land Office* State of Wyoming Wyoming State Land and Farm Loan Office, Mineral Leasing and Royalty Compliance* Oil and Gas Companies Amerada Hess Corporation Amoco Production Company Apache Corporation Chevron U. S. A.* CNG Energy Services Corporation Coastal Oil & Gas Corporation Delhi Gas Pipeline* Enron Oil & Gas Company Enserch Corporation Exxon U.S.A. Forest Oil Corporation ICC Energy Corporation The Louisiana Land & Exploration Company MidCon Gas Services Corporation Mobil Oil Corporation* * Murphy Exploration Company NGC Energy, Incorporated Oryx Energy Company Shell Oil Company* Superior Natural Gas Corporation Taylor Energy Company Texaco, Incorporated Transcontinental Gas Pipe Line Corporation Whiting Petroleum Corporation Zilkha Energy Company Location Austin, Texas Cheyenne, Wyoming Houston, Texas New Orleans, Louisiana Houston, Texas Houston, Texas Houston, Texas Houston, Texas Dallas, Texas Houston, Texas Dallas, Texas Houston, Texas Denver, Colorado Dallas, Texas. New Orleans, Louisiana Houston, Texas Dallas and Houston, Texas New Orleans, Louisiana Houston, Texas Dallas, Texas New Orleans, Louisiana Houston, Texas New Orleans, Louisiana New Orleans, Louisiana Houston, Texas Denver, Colorado Houston, Texas **Contacted the Dallas office and visited the Houston office. 11 ILLEGAL OR WASTEFUL ACTIVITIES SHOULD BE REPORTED TO THE OFFICE OF INSPECTOR GENERAL BY: Sending written documents to: calling: Within the Continental United States U.S. Department of the interior Our 24-hour Office of Inspector General Telephone HOTLINE 1550 WiIson Boulevard 1-800-424-5081 or Suite 402 (703) 235-9399 Arlington, Virginia 22210 TDD for hearing impaired (703) 235-9403 or 1-800-354-0996 Outside the Continental United States Caribbean Region U.S. Department of the interior (703) 235-9221 Office of Inspector General Eastern Division - Investigations 1550 Wilson Boulevard Suite 410 Arlington, Virginia 22209 North Pacific Region U.S. Department of the Interior (700) 550-7279 or Office of Inspector General COMM 9-011-671-472-7279 North Pacific Region 238 Archbishop F.C. FIores Street Suite 807, PDN Building Agana, Guam 96910