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Senate Democrats Call for Probe of Alleged Gas Royalty Undercollections

Two Senate Democrats on Monday called for an investigation of allegations in a New York Times published report alleging natural gas royalty undercollections by the federal government.

Sen. Jeff Bingaman of New Mexico, the ranking Democrat on the Senate Energy and Natural Resources Committee, said he will ask the Government Accountability Office (GAO) to probe allegations in the Times' article that the federal government is significantly undercollecting royalties from natural gas production on federal onshore and offshore lands.

"In this time of high oil and gas prices, I'm especially concerned by the alleged undercollection of royalties from public lands. This is an important, complicated issue, and we need to get the facts," Bingaman said. He noted he will ask the GAO to specifically 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 (DOI) audit capabilities.

Sen. Charles E. Schumer (D-NY) on Monday ordered Interior to report to Congress within 30 days on the scope of the 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. The newspaper article indicates a "number of areas in which misreporting by energy companies, arcane DOI rules, and lax DOI enforcement efforts may have cost American taxpayers millions of dollars in uncollected royalties," Schumer wrote.

In the meantime, legal and industry experts are disputing the conclusions reached in the Times article, which was published Monday following a three-month probe by the newspaper of gas royalty payments to the agency.

Royalty collections did not keep pace with the significant uptick in natural gas market prices in 2005, and as a result the Interior's Mineral Management Service (MMS) took in about $700 million less than it should have, the newspaper alleged. Due to an often "byzantine set of federal regulations," gas producers have been able to provide the Interior Department with much lower sales prices for their natural gas -- the basis on which royalties are calculated -- than the prices for gas that they report to the Securities and Exchange Commission (SEC) and their shareholders, it noted. As a result, royalties were sorely underreported last year, the newspaper said.

Using data from energy companies, Interior said the average sales price of natural gas 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 prices of $6.88, $6.49 and $6.59 respectively during the same time frame, Schumer pointed out.

"The disparities in gas prices parallel those uncovered just five years ago in a wave of scandals involving royalty payments for oil," the Times' article reported. But L. Poe Leggette, an attorney with the Washington, DC law firm of Fulbright & Jaworski and an expert on royalty cases, said the differences in reported sales prices for natural gas do not point to any wrongdoing.

While producers report gross downstream gas prices (pre-deductions) to the SEC and their shareholders, they are permitted to report to the MMS downstream prices minus the costs of transportation, processing and other allowances under the agency's regulations. He questioned whether the Times took these deductions into consideration when it calculated the amount of royalties the MMS was entitled to collect in 2005.

"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 said. The MMS allows for similar deductions for producers when it comes to paying royalties, he noted.

Reliance on gross sales prices appears to be the "biggest factor" in explaining away the disparities in the gas prices that were reported to shareholders, the SEC and the MMS, Leggette said.

"I have no idea how he derived" the $700 million shortfall in royalty collections in 2005, Leggette noted. 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. "That could be a big part of the $700 million there."

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 natural gas, not money. 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.

"It's not clear what he [the reporter] did with royalties taken in kind. It [the article] is very poorly explained. It looks as if there are a lot of things that could easily explain [away]" the alleged $700 million royalty shortfall, Leggette said.

He noted that the royalty relief approved by Congress also could be contributing to the reduced royalty collections. He said a number of projects in the Gulf are not paying any royalties in the deepwater. "Some of that is pretty substantial." Moreover, a lot of gas production is coming out of Wyoming at the Opal Hub -- where gas prices are $1 or more below those at the Henry Hub or the Katy Hub -- that results in fewer royalties.

An Interior source believes that the lag (typically two months) in reporting production volumes to the MMS may partly explain why producers did not report higher sales prices to MMS in 2005. He noted that much of the run-up in gas prices occurred in October and November 2005, following the twin hurricanes in the Gulf of Mexico. As a result of the reporting lag, he expects higher gas prices to be reflected in reports filed in 2006.

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