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Allegations in Published Report Spark Calls for Probe of Gas Royalty Collections

January 30, 2006
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Senate and House lawmakers last week called for an investigation into the federal government's collection of royalties for natural gas produced on public lands amid claims in a published report that the government's arcane method for calculating gas royalties has prevented it from taking advantage of the bonanza in gas prices over the past couple of years. The Interior Department's Mineral Management Service (MMS), the royalty collection agency for the government, and industry and royalty experts defended the government's valuation method for computing gas royalties.

Sen. Jeff Bingaman of New Mexico, the ranking Democrat on the Senate Energy and Natural Resources Committee, asked the Government Accountability Office (GAO) to probe the allegations in a New York Times' article that the federal government -- because it calculates royalties based on the lower wellhead price for gas rather than the higher market price -- is significantly undercollecting royalties from natural gas production on federal onshore and offshore lands.

"This is an important, complicated issue, and we need to get the facts," Bingaman said. He asked he GAO to review the royalty accounting and collection process for oil and gas produced from federal and tribal lands, report on why royalty collections are not increasing at a rate comparable to the rise in natural gas prices, and to review the adequacy of the Department of Interior's audit capabilities.

Sen. Charles E. Schumer (D-NY) ordered Interior to report to Congress within 30 days on the scope of the alleged royalty underpayment and the steps it plans to take to better enforce royalty regulations, as well as the impact of the newly enacted energy law on gas royalty collections.

"I am extremely disturbed by the possibility that as American families are paying significantly higher prices to heat their homes, they may also be getting short-changed through underpaid royalties by the same companies that have reaped extraordinary profits from increased energy prices," he said in a letter to Interior's Inspector General Earl E. Devaney.

House Resources Committee Chairman Richard Pombo (R-CA) asked Interior to turn over all "relevant data" so the panel can determine if the federal government is receiving "full compensation" for the production of oil and natural gas from federal lands. Pombo's letter to Interior Secretary Gale Norton, however, did not immediately call for a congressional hearing or investigation into claims the agency is significantly undercollecting gas royalties because there are a "number of unanswered questions" about the Times article, Pombo spokeswoman Jennifer Zuccarelli told NGI.

"The article itself was rather confusing, in that it did not detail volumes of oil or natural gas produced from federal lands. It also did not reference the royalty-in-kind program, in which the federal government takes oil and natural gas in product, rather than revenue. I would like your department to provide the committee with the impact of these programs," Pombo wrote in the letter to Norton last Monday.

Interior's MMS wasted no time in responding to Pombo's request. In a letter, MMS Director R.M. "Johnnie" Burton last Tuesday countered that the MMS has been recovering the required amount of gas royalties from producers that it is allowed under long-standing regulation, and has tightened its valuation audits of energy producers.

The Times article, published last Monday, alleged that out-dated royalty regulations -- which require the agency to value royalties based on the lower wellhead price rather than the higher market price -- prevented the federal government from taking advantage of the bonanza in natural gas prices in fiscal year 2005. It estimated that the MMS could have collected an additional $700 million in gas royalties last year for the federal coffers had royalties been calculated using the higher market price for gas instead of the wellhead price.

The published report said a "byzantine set of federal regulations, largely shaped and fiercely defended by the energy industry itself," was the reason producers were able to report lower wellhead prices for their natural gas to Interior, while they reported significantly higher market prices for natural gas to the Securities and Exchange Commission (SEC) and their shareholders.

The average sales price of natural gas at the lease reported by producers to MMS in fiscal year 2005 was $5.62/Mcf, despite the fact that ExxonMobil, Chevron and Kerr-McGee posted significantly higher market prices of $6.88, $6.49 and $6.59 respectively during the same time frame, the newspaper said. "The disparities in gas prices parallel those uncovered just five years ago in a wave of scandals involving royalty payments for oil," it noted.

"We, at the Minerals Management Service, base royalties on the value of the product at the lease [wellhead price] where the gas is produced, or, if you will, at the wholesale level," Burton told Pombo. This is the value of gas minus the costs for transportation and processing of gas. "The price that companies are reporting to the Securities and Exchange Commission is akin to a retail price," which includes transportation and processing costs, MMS' Burton explained.

For the first 10 months of 2005, the Energy Information Administration showed an average differential of $1.15/Mcf between the lease price and delivery price for natural gas at destination, "reflecting the type of difference one might expect to see between the prices reported to the SEC and the royalty values reported to MMS," she said.

"The article alleges that we should have collected an additional $700 million in royalties. We assume this is calculated using the price reported to the SEC. The objection [in the article], therefore, is to the calculation of the value of the gas at the lease [to determine royalties], which is an approach that has been used for over 70 years and has been codified in many rules."

The Times claimed that the amount of royalties collected for natural gas produced on federal lands has not kept pace with rate of increase in gas prices. In fact, it noted that while gas prices nearly doubled from 2001 to 2005, the amount of gas royalties recovered in 2005 ($5.15 billion) was less than the amount of royalties collected in 2001 ($5.35 billion).

In 2005, there were a "number of factors" that affected reported royalties, according to Burton. "One issue is related to Hurricanes Katrina and Rita. Companies with New Orleans-based operations were unable to submit the required royalty reports at the end of August and September due to hurricane damage...They will appear in the FY 2006 data when the reports were received, rather than with the FY 2005 data, thereby making 2005 royalty collections appear to be less than what we will actually receive for 2005 production," she said.

"Another reason royalties have not increased as quickly as gas prices is that a large share of production from federal leases has shifted to properties with lower royalty rates," Burton noted. "Over the past few years, a greater proportion of federal production has come from deep-water Gulf of Mexico leases and onshore leases, where royalty rates are typically [the lower] 12.5%, while gas production from the shallow-water offshore leases, where the royalty rate is 16.67%, has fallen." She said that since 1990 gas production in the shallow waters of the Gulf has fallen by more than half.

Burton also cited the increased royalty relief from Congress as a factor contributing to the recovery of fewer royalties. "In order to encourage companies to invest in high-risk areas, Congress enacted the Deep Water Royalty Relief Act of 1995, which allows for certain volumes of deep-water oil and gas to be produced royalty-free. Although today most of that production is not enjoying any royalty-free volumes due to the high market prices, leases issued in 1998 and 1999 are not subject to a price threshold cap and are still enjoying royalty relief," she said.

Burton further refuted claims that the agency's royalty auditing practices were lax. "In FY 2005, 129 new audits were completed in addition to 376 old audits that were caught up and completed, for a total of 505 audits." She estimated that a total of 3,395 properties were reviewed for compliance last year. In addition, the Bush administration "asked us to tighten our audit and compliance cycle from a five-year cycle to a three-year cycle."

Due to the expansion of the agency's royalty-in-kind program, which allows producers to pay their royalties with product rather than cash, MMS has been able to carry out more audits with less auditors, Burton said. "We are now taking 80% of the royalty oil and 20% of the royalty gas in the Gulf of Mexico in kind. Since this oil and gas is sold by MMS, there are no cash royalty payments from producing companies, and therefore no need for valuation audits and accompanying litigation for this production. This program, along with the efficiency gains..., has allowed us to reduce the number of auditors on staff."

Legal and industry experts disputed the conclusions reached in the Times article as well. L. Poe Leggette, an attorney with the Washington, DC law firm of Fulbright & Jaworski and an expert on royalty cases, said the disparities in the gas prices reported to the MMS and SEC do not point to any wrongdoing on the part of producers.

While producers report gross downstream gas prices (market prices) to the SEC and their shareholders, they are permitted to report to the MMS wellhead prices, or the value of gas minus the costs of transportation and processing, Leggette said. He noted the Times did not take into account the allowed deductions for the transportation and processing costs when calculating producers' royalties. Instead, the newspaper contends that the deductions -- which are permissible under what it calls a "byzantine set of federal regulations" -- are preventing the federal government from reaping the full royalty benefits from the run-up in gas prices.

"I could look at the [Times reporter's] tax return and show you a big difference between his gross income and his taxable income because of a byzantine set of tax regulations that allow him to take deductions," Leggett countered.

As for why fewer royalties were collected in 2005 than in 2001, he said he suspected that the newspaper failed to take into account the royalties that were lost in 2005 due to the gas production that was shut in following Hurricanes Katrina and Rita. The latest Interior statistics show that 585 Bcf has been cumulatively offline since September. At an average gas sales price of $5.62/Mcf on federal leases in 2005 and a typical royalty rate of 16% in the Gulf of Mexico, this would mean that more than $500 million in royalties were lost in 2005, he said.

In addition, Leggette questioned whether the Times reporter allowed for royalty in-kind (RIK) payments, whereby producers pay the royalties owed to the federal government with gas product, not cash. The federal government then turns around and sells the gas. In fiscal year 2005, Interior estimated that it sold 183.9 MMBtu of RIK gas received from producers at an average price of $6.88/Mcf, taking in a total of $1.27 billion, the agency said.

"We feel very strongly that the New York Times was off base on a number of points. It was mainly looking at apples and oranges," comparing retail gas prices to wholesale prices, said Dan Naatz, vice president for federal resources at the Independent Petroleum Association of America (IPAA), which represents independent oil and gas producers.

The biggest drawback of the Times report was that there "was no mention of the hurricanes and the [subsequent] reduction of volumes" of gas produced in fiscal year 2005, he told NGI. "Nowhere in the article is that addressed." Nor, Naatz said, could he tell if the newspaper factored in royalty-in-kind payments. "I do not believe so, but I'm not sure."

If anything positive comes from the Times report, "I hope the agency moves forward with a broader royalty-in-kind" program, which would eliminate any discrepancies with gas royalties, Naatz said.

"I hope there is no immediate rush to judgement [by Capitol Hill lawmakers]" based on the Times report. Naatz said the IPAA is working with several energy industry groups -- the Domestic Petroleum Council, American Petroleum Institute, National Ocean Industries Association, U.S. Oil and Gas Association and the Natural Gas Supply Association -- to craft a formal reply to the allegations in the Times article, he said.

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