[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

 
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   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