[Audit Report on Minerals Management Service's Work Regarding Underpricing of California Crude Oil]
[From the U.S. Government Printing Office, www.gpo.gov]

Report No. 98-I-484

Title: Audit Report on Minerals Management Service's Work Regarding Underpricing
       of California Crude Oil

Date:  June 10, 1998




                  **********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



MINERALS MANAGEMENT SERVICE'S
WORK REGARDING UNDERPRICING
OF CALIFORNIA CRUDE OIL

REPORT NO. 98-I-484

JUNE 1998




MEMORANDUM


TO:               The Secretary

FROM:             Robert J. Williams
                  Acting Inspector General

SUBJECT SUMMARY:  Final Audit Report for Your Information - "Minerals
                  Management Service's Work Regarding Underpricing of
                  California Crude Oil" (No. 98-I-484)


Attached for your information is a copy of the subject final audit report. This report
presents the results of our audit of the Minerals Management Service's work on accurately
identifying the additional royalties owed the Federal Government by crude oil and gas
companies for underpricing California crude oil.  This audit was performed as part of our
biennial audit of the Service.  The objective of our audit was to determine whether the
Service accurately identified the additional royalties owed the Federal Government for the
California crude oil underpricing issue.

We determined that the Service did not accurately identify the additional royalties that were
allegedly owed the Federal Government for undervalued California crude oil, which has
adversely affected the Service's ability to collect the royalties.  This occurred primarily
because the Service did not use due professional care while conducting its work and did not
follow its Audit Procedures Manual or establish and follow sufficient alternative procedures
to ensure the accuracy and quality of its work.  Specifically, the Service's work that covered
the integrated companies with transactions that occurred during the period of January 1980
through February 1988 was not adequately planned, supporting evidence was not always
accurately prepared, due professional care was not always exercised in performing analyses,
and quality control procedures were not adequate to ensure the accuracy of its conclusions.
Service officials, through a letter to the Chairman of the Subcommittee on Government
Management, Information, and Technology, House of Representatives, stated that the
Service did not intend to audit the integrated companies for this period.  Service officials
informed us that therefore professional standards did not apply.  However, the Service did
not establish alternative procedures to use in accomplishing its work to ensure the accuracy
and quality of the work. We believe that because of the sensitivity of the issue and the
magnitude of the potential royalties, professional standards should have been followed.  In
our opinion, the Service  did not comply with appropriate professional standards and quality
assurance procedures because the Service underestimated the resources and time needed to
successfully complete this complex assignment within the established schedule.  As a result,
19 bills for collection were misstated by at least $185.6 million.  Although the Service took
prompt action to correct the errors when informed by the companies, we believe that the
revised bills were still overstated because the Service did not make adjustments for
transportation costs and differences in crude oil quality (sulfur content).

Based on the Service's response, we requested that the Service  reconsider its responses to
the report's two recommendations, which are unresolved.

If you have any questions concerning this matter, please contact me at (202) 208-5745.



Attachment




AUDIT REPORT                                                      C-IN-MMS-OO1-97(A)

Memorandum


To:       Director, Minerals Management Service

From:     Robert J. Williams
          Acting Inspector General

Subject:  Audit Report on Minerals Management Service's Work Regarding
          Underpricing of California Crude Oil (No. 98-I-484)


INTRODUCTION

This report presents the results of our audit of the Minerals Management Service's work on
accurately identifying the additional royalties owed the Federal Government by crude oil and
gas companies for underpricing California crude oil.  This audit was performed as part of our
biennial audit of the Service.  Based on our review of the work performed by the Service, we
found that the Service did not accurately identify the additional royalties allegedly owed
the
Federal Government, which has adversely affected the Service's ability to collect the
royalties.  We are issuing this report so that the Service can take action to preclude
recurrences of these deficiencies.

This is the first of two reports we are issuing on the Service's Audit Divisions.  The second
report contains the results of our external quality control review of the Audit Divisions,
which was requested by the Service.  Because the Service's work on the underpricing of
California crude oil was conducted under different controls, including methodology and
performance procedures, the conclusions in this report do not relate to the Service's audit
work covered by our external quality control review.


BACKGROUND

The potential underpayment of royalties on crude oil produced from mineral leases in
California dates back to the 1970s, when the State of California and the City of Long Beach
initiated litigation against seven major oil companies.  The lawsuits alleged that the
companies conspired to keep posted prices for crude oil below true market value, which
diminished revenue collections from State- and City-owned leases because royalties were
based on improperly reduced values.  By 1991, settlements were negotiated in which six of
the companies paid a combined amount of $345 million to the State and City to end the legal
actions.  One company continued its litigation and prevailed in court.  However, none of the
lawsuits resolved the issue of whether the oil was underpriced.

In 1986, the Minerals Management Service studied the California oil market in an effort to
determine whether royalties from Federal leases had been properly valued and paid.  The
Service concluded that posted prices fairly represented crude oil values for royalty payment
purposes, and the issue was not pursued further.  However, because of the settlements
completed by 1991 between the State of California, the City of Long Beach, and the six
companies, the Service determined that the issue warranted further study.  By June 1994, an
interagency team was formed with representatives from the Departments of Commerce,
Energy, Justice, and the Interior and the State of California.  The interagency team's May
1996 report stated:

The team concludes that companies often receive gross proceeds higher than
oil company posted prices for crude oil produced in California.  Since the
team was informed by Minerals Management Service (MMS) and California
auditors that most Federal royalty payments were based on postings, it
follows that royalties have been underpaid.

The team also stated, "The 'open market' standard for California crude oil value was (and
still is) Alaskan North Slope crude oil sold in the Los Angeles and San Francisco markets."
Therefore, according to the team, Alaska North Slope crude oil prices, with appropriate
adjustments for transportation costs and differences in the crude oil quality, could be used
to determine the amount of undervalued California crude oil.

In July 1996, the Service initiated action to determine the amount of underpaid royalties to
be billed and collected.  The Service assigned its Houston Compliance Division the
responsibility for coordinating the work among the three Audit Divisions' offices; the State
of California auditors; and the Compliance Verification Division office in Lakewood,
Colorado.  The Service's Headquarters Office approved an implementation plan to guide the
work, which targeted 20 companies that accounted for 96 percent of the oil royalties paid
from Federal leases in California.  The work covered the period of January 1980 to the most
current date (depending on the start date of the work) for which data were available for each
of the 20 companies.  The implementation plan specified that the valuation methodology
approach should depend on whether a company was considered integrated or nonintegrated
and on whether the oil transactions took place before or after a revision to the valuation
regulations became effective in March 1988.  Specifically, for the pre-March 1988 period,
oil transactions for an integrated company were generally considered to be non-arm's-length
transactions that required a comparison of the reported royalty values with posted prices of
Alaska North Slope crude oil.   The values were to be adjusted to make the California crude
oil comparable to the Alaska crude oil in terms of quality and location differentials.  For
transactions beginning in March 1988, the reported royalty values were compared with the
higher of the full consideration received (known as "gross proceeds") or the value as
determined under the Code of Federal Regulations (30 CFR 206.102, referred to as
"benchmark" criteria).  The values for transactions involving nonintegrated companies were
presumed to be arm's length and were generally accepted for royalty valuation purposes,
provided the company remitted royalties on the gross proceeds received from the purchaser.

As of December 1997, the Service had completed its work on 14 of the 20 companies and
had issued 23 bills for collection, totaling $431.2 million, to 12 of the companies.  The
Service determined that two companies did not owe additional royalties.  The 12 companies
that were billed formally appealed and submitted their arguments and supporting analyses
to the Service.  After reviewing the companies' responses, the Service acknowledged that 19
(83 percent) of the 23 bills did not accurately present the amount of alleged underpaid
royalties.  The Service made adjustments that resulted in the individual bills being
corrected by a gross amount of $185.6 million (43 percent), or a combined net reduction of
$174 million (40 percent) to the original billed amounts.  At the end of our audit fieldwork,
the revised bills of $257.2 million remained under appeal, and no collections had been
received.  The Service stated that it expected to issue additional bills for collection for
the remaining six companies (consisting of four integrated and two nonintegrated companies).


OBJECTIVE AND SCOPE

The objective of our audit was to determine whether the Service accurately identified the
additional royalties owed the Federal Government for the California crude oil underpricing
issue.  Our audit scope was limited to reviewing the underpayment analyses the Service
performed for the period of January 1980 through February 1988 for integrated companies
only.  This period accounted for 19 of the 23 bills.  These bills comprised almost 90 percent
of the amounts originally billed and all of the adjustments to the bills.

Our audit was performed in October and November 1997 at the Service's Royalty
Management Program offices in Lakewood and Golden, Colorado, and at the Houston
Compliance Division office in Houston, Texas.  To accomplish the audit objective, we
interviewed Service officials who were involved in planning and performing the work and
reviewed the working papers prepared by the Service that were used to support the bills for
collection.  We also contacted officials knowledgeable of the underpricing issue at the
Service's Appeals Division and the Department's Office of the Solicitor.

The audit was made, as applicable, in accordance with the "Government Auditing
Standards," issued by the Comptroller General of the United States.  Accordingly, we
included such tests of records and other auditing procedures that were considered necessary
under the circumstances.  As part of the audit, we reviewed the internal controls to the
extent considered necessary to accomplish our objective.  We also reviewed the Department's
Accountability Report for fiscal year 1996, which includes information required by the
Federal Managers' Financial Integrity Act of 1982, and determined that none of the reported
weaknesses were directly related to the objective and scope of this audit.


PRIOR AUDIT COVERAGE

Neither the Office of Inspector General nor the General Accounting Office has issued any
audit reports on the California crude oil underpricing issue during the past 5 years.


RESULTS OF AUDIT

We found that the Minerals Management Service did not accurately identify the additional
royalties that were allegedly owed the Federal Government for undervalued California crude
oil, which has adversely affected the Service's ability to collect the royalties.  This
occurred primarily because the Service did not use due professional care while conducting its
work and did not follow its Audit Procedures Manual or establish and follow sufficient
alternative procedures to ensure the accuracy and quality of its work.  Specifically, the
Service's work that covered the integrated companies with transactions that occurred during the
period of January 1980 through February 1988 was not adequately planned, supporting evidence
was not always accurately prepared, due professional care was not always exercised in
performing analyses, and quality control procedures were not adequate to ensure the
accuracy of its conclusions.  Service officials, through a letter to the Chairman of the
Subcommittee on Government Management, Information, and Technology, House of
Representatives, stated that the Service did not intend to audit the integrated companies for
this period.  Service officials informed us that therefore professional standards did not
apply.  However, the Service did not establish alternative procedures to use in accomplishing
its work to ensure the accuracy and quality of the work. We believe that because of the
sensitivity of the issue and the magnitude of the potential royalties, professional standards
should have been followed.  In our opinion, the Houston Compliance Division did not
comply with appropriate professional standards and quality assurance procedures because
the Service underestimated the resources and time needed to successfully complete this
complex assignment within the established schedule.  As a result, 19 bills for collection
were misstated by at least $185.6 million.  Although the Service took prompt action to correct
the errors when informed by the companies, we believe that the revised bills were still
overstated because the Service did not make adjustments for transportation costs and
differences in crude oil quality (sulfur content).

On January 13, 1998, we held an exit conference with Service officials to discuss the results
of our audit.  Service officials stated that the Service did not intend to perform audit work
for the period of January 1980 through February 1988 and had informed the Congress of
such.  Therefore, according to these officials, the "Auditing Standards" did not apply to the
work we reviewed.

Although the Service took the position that the work did not constitute an audit and that the
"Auditing Standards" did not apply, documentation sent to the companies reviewed did not
support this position.  For example, the Service's engagement letter (Appendix 1) sent to
each company before the work began specifically stated that an "audit" would be performed
and that the work would be "conducted in accordance with the professional standards of the
American Institute of Certified Public Accountants and the Comptroller General of the
United States."  In addition, the bills for collection (Appendix 2) that were submitted to
each company after the work was completed also stated that an "audit was initiated" and that
additional royalties were owed the Government.  However, we believe that even if an "audit"
was not intended, compelling reasons existed for the Service to follow professional auditing
standards or to establish sufficient alternative procedures to ensure the accuracy and
quality of its work.  For example, since the issue of underpriced California crude oil has been
a controversial matter since the 1970s, the Service should have expected that its findings
would be examined and questioned by the oil companies.  Additionally, the Service was
aware that the data for the period of January 1980 through February 1988 would be the most
difficult to obtain and would contain most of the alleged underpaid royalties.  Specifically,
the interagency team stated in its May 1996 report that "potential collections for royalty
underpayments would be highest for the years 1980-85, with the peak years being 1982 and
1983."  Further, the Congress and the states have expressed concerns about royalty
underpayments.  Accordingly, we believe that the sensitivity and the magnitude of the effort
warranted professional auditing standards or sufficient alternative procedures to have been
followed to ensure that the Service's conclusions and analyses were accurate, complete, and
fully supported.  Based on this premise, the Service, in our opinion, did not comply with the
professional standards and procedures, as discussed in the paragraphs that follow.


Planning

The Service did not provide sufficient resources to accomplish the scope of its underpayment
efforts.  The implementation plan prepared by the Service provided for an audit team
comprising a team leader and four auditors from the Houston Compliance Division and
"approximately 10" additional auditors from other compliance division offices.  The time
frames for issuing the bills for collection were established at 90 to 120 days for the
underpayment computations applicable to the period of October 1983 through February 1988
and 120 to 180 days for the underpayment computations applicable to the period of January
1980 through September 1983.  However, we found that Service officials made a critical
decision to enforce the shorter time frames for completing the work without accurately
estimating the resources needed to successfully complete the project.  The work consisted
of obtaining and analyzing large quantities of accounting data that had been generated up to
16 years ago.  Consequently, the data were not always readily available and had to be
retrieved from storage facilities.  Moreover, three different automated royalty accounting
systems (the Royalty Accounting System, the Interim Operating System, and the Auditing
and Financial System) were used prior to March 1988, and different royalty reporting forms
were used during that time.  These factors complicated the work required by the audit team
to acquire, organize, and analyze royalty reporting data to develop support for issuing bills
for collection.


Evidence

The Service's Audit Procedures Manual (Section 7.2) states, "Workpapers must be complete
and accurate in order to provide proper support for findings and conclusions."  During our
review, we noted certain deficiencies in the quality of the evidence supporting the amounts
billed.  Specifically, in October 1996, the Service issued bills for collection pertaining to
the period of September 1983 through February 1988 for 10 integrated companies.  These bills,
totaling $108.2 million, including interest, were misstated by $25.8 million (a 24 percent
error rate).  Additionally, in December 1996, the Service issued bills for collection
pertaining to the period of January 1980 through August 1983 for nine integrated companies.
These bills, totaling $273.6 million, including interest, were misstated by $159.8 million (a
58 percent error rate).  The large discrepancies in the bills occurred, in part, because the
Service made computational errors in the computer-prepared spreadsheets ($153.2 million),
misallocated royalty underpayments to three companies because of incorrect ownership data
($11.4 million), misclassified one company as an integrated instead of a nonintegrated
company ($2.8 million), and erroneously billed one company that did not own an interest in
a lease ($5,000).  These errors caused the Service to rescind the original bills and reissue
corrected bills.

We believe that these deficiencies occurred because the work was not conducted with due
professional care and in accordance with the Service's Audit Procedures Manual as follows:

     - Interrelated worksheets were prepared during the fieldwork, but the purpose of the
worksheets, the analytical procedures that were performed, and the relationship to other
worksheets were not documented.  As such, the Service could not readily identify the
analyses that supported its conclusions, as required by the "Auditing Standards"
(Paragraph 6.64) and the Service's Audit Procedures Manual (Section 7.5).

     - The working papers did not show any evidence of supervisory review, as required
by the "Auditing Standards" (Paragraph 6.64).  Effective supervision, as required by the
"Auditing Standards" (Paragraphs 6.22 and 6.23), helps ensure that the objectives are
satisfactorily accomplished and that the conclusions are factual.

     - An audit program containing the specific steps and procedures to be performed
during the work was not prepared.  Written steps and procedures help ensure that the
objectives, scope, and methodologies are accomplished and executed consistently in
accordance with established standards.  The Service's Audit Procedures Manual
(Sections 5.2.4 and 8) requires that a program be prepared.


Internal Quality Controls

We found that the established referencing process of the Service's internal quality control
system was not followed for this work, which contributed to the errors in the bills for
collection going undetected.  The "Auditing Standards" (Paragraphs 3.31 and 3.32) requires
that an audit organization establish an effective internal quality control system to provide
reasonable assurance that it has adopted and is following applicable auditing standards.  The
establishment of effective quality controls helps ensure the accuracy of audit evidence and
conclusions.

The quality control system for the Service's regular audits (such as audits of companies or
individual leases) includes a referencing process whereby information and numerical data
contained in bills for additional royalties are verified by a senior auditor who is not
involved
with the audit.  Specifically, the Audit Procedures Manual (Section 24) states:

Referencing is a detailed review process that verifies the accuracy of all
stated facts and ensures that all issues are supported with the appropriate
documentation.  All final orders will be referenced . . . .

Since the Service's bills for collection constituted final orders, the bills should have been
subjected to the referencing process.  However, because of the time constraints, the
referencing process was not used for this work.  Although we were informed by the Houston
audit staff that computations were "spot-checked," we could not determine the extent of these
verifications because records were not maintained on the procedures performed, such as audit
programs, summaries, or annotations on the analyses spreadsheets.  In our opinion, the use
of spot checks rather than referencing was not effective, as evidenced by the substantial
error rates in the October and December 1996 bills.


Due Professional Care

The Service did not exercise due professional care during the performance of the work,
which contributed to the deficiencies we noted in the planning, evidence, and internal
quality
controls.  The "Auditing Standards" (Paragraphs 3.26-3.28) states:

Due professional care should be used in conducting the audit and in preparing
related reports. . . .  Due care imposes a responsibility upon each auditor
within the audit organization to observe generally accepted government
auditing standards.

Auditors are required to exercise sound judgment in establishing the scope and methodology,
choosing and conducting the tests and procedures, and evaluating and reporting the results.
Although an implementation plan was prepared and approved, the Houston Compliance
Division did not follow all of the specified procedures in developing the amount of underpaid
royalties.  For example:

     - Instead of following the implementation plan's requirement to compare the royalty
payment amounts with values based on posted prices for Alaska North Slope crude oil, the
Division compared a computed amount based on posted prices of California crude oil with
values based on contract prices of Alaska crude oil.  The Houston Compliance Division audit
staff said that this alternative approach was used to meet the short time frames established
for completing the assignment.  However, the companies objected because they were not
given credit for the full amount of royalties they had paid under the Division's alternate
methodology.  Subsequently, the Service recomputed the royalty underpayments and
reissued the bills, which reduced the underpayment amounts by $18.2 million.  The Service
could have avoided reissuing the bills if the original underpayments had been computed in
accordance with the established implementation plan.

     - The Houston Compliance Division did not consider two significant factors that
would have reduced the amount of the royalty underpayments.  First, the effects of
transportation cost differentials between the California and the Alaska crude oil were not
recognized.  Second, an adjustment for quality differences because of the higher sulfur
content of certain California crude oil was not made.  The implementation plan required that
transportation and quality differentials be properly recognized, but the Houston Compliance
Division declined to make the needed adjustments, deciding instead to wait until the
companies submitted their cost data for consideration of these factors.  As a result, we
believe that the revised bills for collection were still overstated.

The "Auditing Standards" (Paragraph 6.19) requires that the audit plan (in this case, the
implementation plan) be updated if any significant changes are subsequently made to the
objectives, scope, or methodology.  However, the alternate procedures and methodologies
that the Service used were not submitted to senior-level officials for approval.


Conclusion

We believe that the deficiencies cited in this report could have been avoided if the Service
had planned the work more effectively, exercised due professional care in performing the
fieldwork, and provided effective management oversight.  The Service needs to take actions
to ensure that the issued bills for collection of additional royalties have been computed
accurately.  If necessary, the bills should be rescinded and reissued.  Additionally, the
Service should take appropriate measures to ensure that the identified weaknesses do not recur
in subsequent special projects.


Recommendations

We recommend that the Director, Minerals Management Service:

     1.  Direct the Audit Divisions to verify the accuracy of the royalty underpayments,
including adjustments for transportation and quality differentials, which were computed for
integrated companies for the period of January 1980 to February 1988 and to correct and
reissue the bills for collection as necessary.

     2.  Improve the planning and performance processes for special projects to ensure that
adequate resources and time are assigned and that the work is performed in accordance with
the applicable "Government Auditing Standards" and the Service's Audit Procedures Manual.

Minerals Management Service Response and Office of Inspector General
Reply

In the March 19, 1998, response (Appendix 3) to the draft report from the Director, Minerals
Management Service, the Service disagreed with both recommendations.  Based on the
response, the Service is requested to reconsider its responses to both recommendations, which
are  unresolved (see Appendix 4).  Also based on the response, we have changed the report
as appropriate.


Recommendation 1.  Nonconcurrence.

     Minerals Management Service Response.  The Service stated that it had "already
reviewed the data supplied by companies as they appealed the demands issued" and that
"[w]here appropriate, based on the later information provided by companies," the Service had
"adjusted [its] demands."  In addition, the Service stated, "If companies provide additional
information justifying further adjustments to the demands, we [the Service] will then revise
them [the bills] further."  The Service also noted that it had "explained that your [the
Office
of Inspector General's] assumption regarding transportation deductions is incorrect" and that
it "sees absolutely no reason to spend any further time or resources on this issue unless and
until the companies provide information documenting transportation deductions in excess of
those previously allowed and taken."  The Service further stated, "To date, although invited
to submit additional data regarding the transportation deductions, no company has."

     Office of Inspector General Reply.  We believe that the Service is responsible for
evaluating and ensuring that the proper value for the minerals is billed, including
adjustments,
and that the payments made by the companies depict those proper amounts.  However, the
Service is not billing companies for the proper value for the minerals; rather, the Service is
relying on the companies to respond to its demands for payment and requiring the companies
to provide additional data that support any requested adjustments to the billed amount.

We disagree that any adjustments for transportation charges should be omitted until the
companies file their appeals and include these charges in their appeals.  The Service computed
amounts for transportation charges using its historical mineral data records, which, as stated
in the implementation plan, should have been included in the royalty underpayment
calculation to ensure that the Federal Government receives royalties on the fair market value
of minerals taken from Federal lands.  Additionally, although the Service did not address oil
quality differentials in its response, we believe that the Service  needs to make adjustments
for oil quality differentials which should have been used in calculating the bills to ensure
the
accuracy and quality of its work.  The implementation plan required that an adjustment for
quality differences be made, and value for these differentials was provided to the auditors by
the Service's Royalty Valuation Division in Lakewood.  We request that the Service
reconsider its response and fully address these issues.


Recommendation 2.  Nonconcurrence.

     Minerals Management Service Response.  The Service stated that it believed the
implementation plan for this special project was "appropriately planned and implemented."
The Service also stated that the Audit Procedures Manual was amended to provide "a specific
reference that auditors may perform non-audit work to which only some of the standards from
the Government Auditing Standards and the Audit Procedures Manual may apply."

     Office of Inspector General Reply.   We agree that the Service's implementation
plan was an adequate plan; however, it was not fully implemented, nor were changes to the
plan fully documented and approved by senior-level officials.  Even if the staff involved, as
stated by the Service, had the delegated authority to make the changes to the plan, such as
omitting the transportation costs and oil quality differentials, and to use posted prices
rather
than actual royalty amounts paid by the companies, those staff members did not apply
adequate professional care in documenting the rationale for these changes and the results of
the changes.  Because these changes were not documented and the resultant calculations were
not fully reviewed, the Service issued bills that were incorrectly stated by $185.6 million
and
the remaining bills of  $257.2 million have been appealed.  Although the Service disagreed
with Recommendation 2, it stated that it had amended the Audit Procedures Manual to
address "non-audit work" performed by its auditors.  However, it did not specify the standards
and procedures that would apply to ensure the quality and accuracy of "non-audit work."
Therefore, we request that the Service reconsider the recommendation.


Additional Comments on Audit Report

The Service also provided additional comments on our audit report.  The Service's comments
and our replies are as follows:

     Minerals Management Service Response.  The Service said that it "strongly
disagree[d] with the vast majority of the statements and conclusions of the report and
believe[d] it [the report] should be withdrawn."  The Service further stated that at the exit
conference, its officials "explained that our [the Service's] actions were not an audit" and
that
therefore the "Government Auditing Standards" did not apply to the Service's work, as
"claimed" by the Office of Inspector General.  The Service noted that the draft report
"seem[ed] to rely" on the Service's Audit Procedures Manual to support the position that the
Service did not properly plan, gather adequate evidence, follow proper internal quality
control
processes, and exercise due professional care.  The Service further stated that just as the
"Auditing Standards" did not apply to the Service's work, the Audit Procedures Manual did
not apply because the work "was not an audit."

     Office of Inspector General Reply.  The Service did not provide us with any
additional information in its response regarding the facts and conclusions in the report to
support its belief that the report should be withdrawn.  As a result of the exit conference,
we
agreed to refer to the Service's efforts concerning the underpricing of California oil as
something other than an audit.  However, regardless of what the Service's work is referred to
as and whether the "Government Auditing Standards" or the Service's Audit Procedures
Manual applied, the work should have been performed with professional care to ensure its
accuracy and quality.  The Service's decision not to follow the "Auditing Standards" or its
Procedures Manual or to devise a sufficient alternative method to ensure the accuracy and
quality of its work resulted in an effort that has required extensive corrections to billed
amounts which in our opinion still have not been fully rectified.  Additionally, as stated in
our report (page 5), the Service issued notification letters to the companies for its work
regarding the underpricing of California oil which stated that "[t]he Houston Compliance
Division of MMS [Minerals Management Service] will conduct an audit" and that "[t]he audits are
conducted in accordance with the professional standards of . . .  the Comptroller General of
the United States [Government Auditing Standards]" (see pages 1 and 2 of Appendix 1).
Likewise, the "bills for collection" issued to the companies also noted that "[t]he audit was
initiated" (see page 2 of Appendix 2).  Therefore, the Service's communications with the
companies did not indicate that "non-audit work" would be performed.

     Minerals Management Service Response.  The Service said that it believes that the
implementation plan was "well conceived and was efficiently and effectively implemented
by the officials assigned the work."  The Service also said that "[d]eviations from the plan
were well within the delegated authorities of the staff involved and, as calculation errors
were identified and other information became available, adjustments were promptly and correctly
made."  The Service said that its auditors "exercised the utmost due professional care in
billing companies based on the information available and inviting [the companies] to provide
additional information to adjust those bills."  The Service further stated that it is "proud
of our [its] accomplishments on this project" and that its "primary objectives -- to promptly
get the magnitude of the issue framed and protect against further losses because of potential
statute of limitations claims -- were accomplished in far less time than would have been
possible under a standard audit and enforcement approach (which has been evidenced by our [the
Service's] continuing difficulties in obtaining certain records subpoenaed over 18 months
ago)."

     Office of Inspector General Reply. We acknowledge that the Service's
implementation plan was adequate for the work to be performed; however, the plan was not
fully implemented, and deviations, which led to inaccurate work, were not documented or
carefully reviewed.  Specifically, company royalty payments were computed using posted
prices rather than actual company payments made, as specified in the plan, and adjustments
for oil quality and transportation costs that were included in the plan were not applied.
Even if these deviations were within the delegated authorities of the staff involved, due
professional care was not used to document the changes and to ensure that royalty payments were
computed accurately.  These errors were found by the companies billed, not by the Service's
auditors, as implied in the Service's response.

Moreover, the Service's expediting of the work, which the Service said was an
accomplishment it was "proud of," adversely affected the accuracy and quality of the work.
The bills had to be rescinded and reissued for approximately $174 million less than the
amount originally billed because of errors.  We do not believe that this is an efficient or
effective use of the Service's or the companies' resources.  While we recognize that there may
have been a legitimate interest in issuing the bills as quickly as possible, the quality of
the work should not have been compromised because of time considerations.  Rather, to the
extent that time was a factor, the Service should have devoted the resources necessary to
complete the work accurately within the necessary time frame.

Regarding the Service's statement that it continues to reserve the right to ensure that it
receives fair market value for minerals from public lands by issuing bills or auditing
companies as appropriate, our report did not state that the Service should not be performing
these functions.  We agree that the Service is responsible for ensuring that it receives
accurate royalties based on the fair market value of minerals taken from Federal lands.
Conversely, the companies should not be asked to pay more than fair market value, which
includes appropriate adjustments such as transportation charges and oil quality differentials.

Regarding the Service's objections to the tone and general conclusion of our report, we
believe that the seriousness of the deficiencies presented in the report supports the basis of
our conclusions and presentation of the issue.

In accordance with the Departmental Manual (360 DM 5.3), we are requesting a written
response to this report by July 15, 1998.  The response should provide the information
requested in Appendix 4.

The legislation, as amended, creating the Office of Inspector General requires semiannual
reporting to the Congress on all audit reports issued, actions taken to implement audit
recommendations, and identification of each significant recommendation on which corrective
action has not been taken

We appreciate the assistance of Service personnel in the conduct of our audit.



APPENDIX 4


STATUS OF AUDIT REPORT RECOMMENDATIONS

Finding/Recommendation
Reference
              1

             2
                              Status
  Unresolved.

 Unresolved.


Action Required

 Reconsider the recommendation, and
 provide a plan that verifies the
 accuracy of the royalty
 underpayments, including adjustments
 for transportation and quality
 differentials, and that ensures that any
 bills for collection are corrected and
 reissued.

 Reconsider the recommendation, and
 provide a plan for implementing
 procedures that ensure the accuracy of
 "non-audit work."




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
