The Interior Department’s Inspector General’s (IG) Office is moving to establish a royalty oversight unit to ensure the adequate collection of revenues from oil and natural gas production on federal and Indian lands, IG Earl Devaney said last Tuesday.

“[We] recognize…that our office will soon need to develop a royalty unit” for the long term, and “we are in the process of doing…that,” he said during a hearing of a House Natural Resources subcommittee that reviewed recommendations to improve the federal royalty system.

In the near term, “we’re [setting] up a modest…oversight office, which will soon complete an evaluation of [the Minerals Management Service’s] royalty in-kind sales program for oil,” and then will undertake an audit of the agency’s process for verifying volumes, Devaney told the House Energy and Minerals Resources Subcommittee.

But in the longer term, “we intend to develop [the capability] to oversee all minerals-related activities managed by [Interior], from the initial leasing of federal Indian lands to the final determination of those leases, which would include the management of those leases and collection of royalty payments,” he said.

Devaney further revealed that his office is continuing to carry out four investigations that could potentially result in criminal charges. Most of the cases, which are now in the hands of the Department of Justice (DOJ), involve “personal behavior” or ethical lapses, where MMS employees are alleged to have accepted gifts from industry, he said. “I think this [behavior] has stopped at the agency.”

Devaney said he has been working with the DOJ for the past 13 months on the cases, but the DOJ has not yet decided whether it will prosecute. If they are not prosecuted, the cases may be turned over to C. Stephen Allred, assistant secretary for Interior’s land and minerals management, for administrative action, he said.

The House hearing examined three separate reports or ongoing audits carried out by Devaney’s office, the Government Accountability Office (GAO) and a subcommittee of Interior’s Royalty Policy Committee into MMS’ royalty-collection efforts. Devaney’s report, which was issued in December 2006, called for “stepped-up oversight” of MMS’ royalty-collection activities (see NGI, Dec. 11, 2006). It further recommended that MMS strengthen its compliance reviews of royalties and develop a risk-based strategy. “We found that while compliance reviews play a useful role…they do not provide the same level of detail or assurance [that] an audit provides.”

The challenge will be in effectively implementing the proposed changes and “holding those responsible for MMS’ many past failures,” Devaney said. The IG report was requested by the Senate Energy and Natural Resources Committee following allegations that MMS was undercollecting billions in federal royalties due to faulty procedures at the agency.

As a result of an investigation ordered by Interior Secretary Dirk Kempthorne, Devaney said his office also found that there was a “systemic dilemma” at the agency, resulting from MMS’ conflicting relationship with the oil and gas industry, which it regulates. And in the wake of the controversy over the flawed 1998-1999 offshore leases that did not include price thresholds, his office has recommended that each lease be legally reviewed by the Interior’s Office of Solicitor.

The GAO reached similar conclusions in its ongoing audit, saying that the MMS lacked adequate internal information technology and management controls to ensure the appropriate amount of oil and gas royalties were being collected. The GAO found “profound and persistent problems” with MMS’ internal controls, said Frank Rusco, acting director for Natural Resources and Environment at GAO. Until 2004, the agency even lacked the ability to detect missing production reports. As a result, the MMS has a backlog of 3,000 such missing reports, he noted.

“I think that in our work we found that the data coming into MMS are unreliable, that there aren’t enough controls on that data, [and] there [isn’t] enough verification with third-party data,” Rusco said. “As a result of that, when MMS does compliance reviews or audits, they frequently find that additional royalties are due.”

The Interior Royalty Management Subcommittee report, which was issued in December 2007, was the most favorable to MMS, finding that the agency’s royalty management program “is not broken at all, but [it] does need a major tune-up,” said David Deal, vice chair of Interior’s Royalty Policy Committee (see NGI, Dec. 24, 2007). However, it did identify a number of weaknesses related to management information, compliance review measures and performance measures that are preventing the agency’s program from reaching its maximum potential, he noted.

Rep. Stevan Pearce (R-NM) was critical of both the unfavorable GAO and Interior IG’s reports. He questioned how the conclusions reached in the GAO audit could be so “diametrically opposed” to those in the Interior subcommittee report.

Pearce expressed doubt about the accuracy of the GAO report. He noted the GAO initially estimated that about $60 billion or more would be at risk as a result of the missing price thresholds in the 1998-1999 offshore leaves and a pending court challenge of Kerr-McGee Oil and Gas. But the MMS this year puts the figure at a much lower level — $20 billion, he said.

“I wonder if your GAO report is 300% off like you estimate,” he quipped.

Because of the confusion over the amount of revenues that would be lost as a result of the 1998-1999 leases and Kerr-McGee lawsuit, the House subcommittee said it intends to asked Interior to analyze the issue further, as well as report on the status of Interior contract renegotiations with the producers who hold the affected leases.

Pearce further questioned whether GAO’s Rusco, who had worked on seven to eight other reports while auditing the MMS, devoted sufficient time to accurately review the agency’s royalty-collection methods. The accounting firm of KPMG for three years said it detected “no deficiencies” in the design of MMS’ internal controls, he noted.

Pearce also argued that Congress itself was responsible for oil and gas royalties being “left on the table.” As a result of federal policies that make less than 5% of Bureau of Land Management lands available to producers and less than 3% of the Outer Continental Shelf currently leased, he said an endless amount of royalties are being bypassed.

Interior’s Allred said he believed there were no significant problems that “threatened the viability” of the royalty management program, although he agreed there was room for improvement. Moreover, Allred said he concurred with the Interior subcommittee’s conclusion that MMS was “best suited” to carry out the stewardship responsibilities of the federal government.

MMS Director Randall Luthi told House lawmakers that the current MMS royalty management program “is not the same program of 15 years ago or even two years ago.” He noted that 2,100 companies report and pay royalties each month on approximately 68,000 producing and nonproducing federal and Indian leases, which the agency processes.

Luthi reported that in fiscal year 2007 alone MMS processed more than 400,000 reports, conducted 404 audits and completed 4,171 compliance reviews. Since FY 2002, 24 external reviews of MMS have result in 195 improvement recommendations, of which it has closed 124.

It also has established an ongoing relationship with the Internal Revenue Service to “compare and contrast” the risk-based compliance programs of the two agencies, according to Luthi.

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