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IG Report: MMS Review Process Increases Risk of Royalty Underpayments

The Minerals Management Service's (MMS) increasing reliance on compliance reviews to assess whether oil and natural gas producers are paying the federal government sufficient royalties is problematic, according to the department's Office of Inspector General (OIG).

In a report issued Wednesday, Inspector General Earl Devaney concluded that the growing reliance of the Interior Department's MMS on compliance reviews rather than more detailed audits to verify payment of royalties has increased the risk of underpayment by producers.

"A compliance review is less intensive than an audit and is designed to determine the reasonableness of reported royalties without obtaining detailed source documentation or conducting site visits," the report said. Under a compliance review, an analyst compares a producer's reported data to MMS' "expected values." If the reported data are not within a reasonable range, only then does MMS pursue the matter, it noted.

The agency's use of compliance reviews since the late 1990s has increased the risk that MMS may not detect underpaid royalties, the OIG report said. It noted that compliance reviews should not be used as a substitute for audits, but rather as one part of a comprehensive compliance strategy.

The OIG report was requested by the Senate Energy and Natural Resources Committee following allegations earlier this year that MMS is undercollecting millions, perhaps billions, in federal royalties as a result of faulty procedures. The MMS collected $9.9 billion in royalties in fiscal 2005, according to the report. About 2,600 companies reported and paid royalties on 27,800 producing leases.

To better improve royalty collection, the OIG report proposed that producers be required to supply actual source documents -- for example, tank gauging reports and oil and gas sales summary statements -- for at least one test month. "This would allow a more precise expected volume amount to be established for the property," it said.

The OIG also recommended that MMS coordinate its efforts with the Bureau of Land Management's Energy and Materials Program, which maintains inspection and enforcement data that can be used to help validate the reasonableness of reported volumes for onshore properties. And it suggested that the agency use the verification systems that are maintained by MMS' Offshore Minerals Management Program to validate the reasonableness of production volumes for offshore leases. These systems provide actual oil and gas volume data that are based on company-provided source documents.

Moreover, the OIG report proposed that the MMS expand the coverage of companies and properties that are subject to review. "The [compliance] measure's focus on dollar coverage results in many of the same companies and properties being reviewed year after year," it said. And in choosing producers to be reviewed, the MMS should focus on companies that have historically underreported royalties to the agency, and/or have falsely reported information to other federal agencies.

MMS Director Johnnie Burton said the agency relies on both compliance reviews and audits in collecting royalties. By using this coordinated strategy, the MMS in fiscal year 2006 completed audits and compliance reviews on 72.5% of revenues, up from 46% in fiscal 2003 and 10.5% in fiscal 2002, she said in a statement.

Burton said the MMS "[is] now developing a comprehensive plan to address the recommendations made by the OIG." She noted that the plan would be provided to OIG within 30 days.

The OIG report is just the latest evidence that the MMS' royalty-collection system is broken, said Rep. Tom Davis (R-VA), chairman of the House Government Reform Committee, and Rep. Darrell Issa (R-CA), chairman of the House Energy and Resources Subcommittee, who have been investigating problems with the agency's royalty-collection practices for months.

"It may be that the only way for the royalty system to be fixed is to analyze all of its shortcomings from cradle to grave and then build a new system with new management," Issa said. "It's time for a bipartisan congressional effort to fix the problem once and for all, hopefully with the cooperation of Interior," Davis noted.

The OIG report follows the disclosure earlier this year of faulty deepwater Gulf of Mexico leases, which the MMS issued in 1998 and 1999. The leases failed to include price triggers for the payment of royalties. The Government Accountability Office has estimated that the leases could cost the federal government up to $10 billion over the life of the leases if they are not renegotiated.

In testimony before a House Government Reform subcommittee in September, Devaney called the omission "an example of bureaucratic bungling" at its worst. He further said the failure of MMS employees to report the oversight to superiors when they first detected it in 2000 stemmed from a "culture of irresponsibility" that pervades the Interior agency.

Devaney painted a picture of a department that is out of control. "Short of a crime, anything goes at the highest levels of the Department of Interior," he said during an oversight hearing of the House Energy and Resources Subcommittee, which has been investigating the missing price thresholds in the 1998-1999 leases since March.

Lease price thresholds are designed to cut off royalty relief to producers when oil and gas prices are too high. Lacking this cut-off point in the 1998 and 1999 leases, producers have escaped paying royalties on production up to a specific volume limit. The price caps were included in leases that were negotiated in 1996, 1997 and 2000, but were not in the 1998 and 1999 leases due a mistake on the part of the MMS. Congress has put pressure on producers to renegotiate these leases with the MMS.

Based on past experiences, Devaney said at the House hearing he doubted Interior would accept any recommendations that his office made in the wake of this massive error. "I have observed one instance after another when the good work of my office has been dynamically disregarded by the department," he said.

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