Oil and Gas Royalties
Royalty Relief Will Cost the Government Billions of Dollars but Uncertainty Over Future Energy Prices and Production Levels Make Precise Estimates Impossible at this Time Gao ID: GAO-07-590R April 12, 2007Oil and gas from federal lands and waters is critical to meeting the nation's energy needs, providing about 35 percent of all oil and 25 percent of all the natural gas produced in the United States in fiscal year 2005. Oil and gas companies that lease federal lands and waters agree to pay the federal government royalties on the resources extracted and produced from these leases. In 1995--a time when oil and natural gas prices were significantly lower than they are today--Congress passed the Outer Continental Shelf Deep Water Royalty Relief Act of 1995 (DWRRA), which authorized the Department of the Interior's (Interior) Minerals Management Service (MMS) to provide "royalty relief" on oil and gas produced in the deep waters of the Gulf of Mexico from leases issued from 1996 through 2000. This "royalty relief" waived or reduced the amount of royalties that companies would otherwise be obligated to pay. In implementing the DWRRA for leases sold in 1996, 1997, and 2000, MMS specified that royalty relief would only be applicable if oil and gas prices were below certain levels, known as "price thresholds," thereby protecting the government's royalty interests should oil and gas prices increase significantly. MMS did not include price thresholds for leases it issued in 1998 and 1999. Because oil and natural gas prices have risen significantly in recent years, the omission of price thresholds on the leases issued in 1998 and 1999 has resulted in significant foregone royalties to the federal government. In an effort to recoup some of these royalties, Interior is currently negotiating with some of the oil and gas companies that own these leases. Congress has also been considering legislative actions to recoup foregone royalty revenues on these leases or to encourage companies to negotiate with MMS. In addition to the foregone royalties on the 1998 and 1999 leases, one company, Kerr-McGee, is currently pursuing a legal challenge to the Interior's authority to place price thresholds on any deep water leases issued between 1996 and 2000 under the DWRRA. If successful, this legal challenge would lead to additional foregone royalties on leases issued in 1996, 1997, and 2000. We reported to the Senate Committee on Energy and Natural Resources in January 2007 that the royalty relief for leases issued under the DWRRA will likely cost the federal government billions of dollars, but that the final costs have yet to be determined. At that time, MMS' most recent estimates of forgone royalties were made in October 2004. In light of these findings, Congress asked us to evaluate the potential for foregone royalties resulting from the omission of price thresholds on the leases issued in 1998 and 1999. We are also reporting on the status of Kerr-McGee's legal challenge to the Interior's authority to set price thresholds for the leases issued in 1996, 1997, and 2000 under the DWRRA, and the potential implications this challenge could have on federal royalty revenues.
The absence of price thresholds in leases issued in 1998 and 1999 has already cost the government about $1 billion and MMS' most recent estimate in February 2007 indicates a range of future foregone royalties of between $6.4 billion and $9.8 billion over the lives of the leases. We believe the methodology and assumptions used by MMS to make these estimates are reasonable. However, because there is considerable uncertainty about future oil and natural gas prices and production levels, actual foregone royalties could end up being higher or lower than MMS's estimates. Our analysis shows that future foregone royalties are quite sensitive to changes in prices or in the amount of oil and natural gas produced. For example, one scenario that assumed high production levels and a price of $70 per barrel for oil and $6.50 per thousand cubic feet for natural gas--prices that are higher than those used by MMS but within the range of recent market prices--indicated that the future foregone royalties could be as high as $10.5 billion. Alternatively, a scenario that assumed low production levels and $50 per barrel for oil and $6.50 per thousand cubic feet for natural gas indicated that future forgone royalties could be as low as $4.3 billion. MMS is currently negotiating with oil and gas companies to apply price thresholds to future production from the 1998 and 1999 leases. To date, the results of these negotiations have been mixed -- 6 of the 45 companies involved have agreed to terms; others have agreed to negotiate but have not yet come to terms; and some companies have yet to agree to negotiate. With regard to the legal challenge to the Interior's authority to include price thresholds on leases issued under the DWRRA, Kerr-McGee filed suit in early 2006, but agreed to enter mediation with Interior in an attempt to resolve the issue. The mediation was unsuccessful and litigation has resumed. If the government loses this litigation it will lead to additional foregone royalty revenues from the 1996, 1997, and 2000 leases that included price thresholds. The additional foregone royalty revenues could include royalties on these leases totaling approximately $1 billion that have already been collected and which may have to be refunded as well as royalties on future production. MMS estimated in October 2004 that potential foregone royalties on future production could be up to $60 billion over the life of the leases, should the federal government lose the legal challenge. In our review of the methodology and assumptions used in MMS' estimate, we found that MMS may have over-estimated the amount of oil and natural gas that would be produced from these leases over the course of their lifetime. MMS officials agreed with this assessment and said that an updated estimate of foregone revenue from these leases might be considerably lower than the $60 billion figure but that they are not currently working to develop a revised estimate.
RecommendationsOur recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
Director: Team: Phone:GAO-07-590R, Oil and Gas Royalties: Royalty Relief Will Cost the Government Billions of Dollars but Uncertainty Over Future Energy Prices and Production Levels Make Precise Estimates Impossible at this Time
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April 12, 2007:
Congressional Requesters:
Subject: Oil and Gas Royalties: Royalty Relief Will Cost the Government
Billions of Dollars but Uncertainty Over Future Energy Prices and
Production Levels Make Precise Estimates Impossible at this Time:
Oil and gas from federal lands and waters is critical to meeting the
nation's energy needs, providing about 35 percent of all oil and 25
percent of all the natural gas produced in the United States in fiscal
year 2005. Oil and gas companies that lease federal lands and waters
agree to pay the federal government royalties on the resources
extracted and produced from these leases. In 1995--a time when oil and
natural gas prices were significantly lower than they are today--
Congress passed the Outer Continental Shelf Deep Water Royalty Relief
Act of 1995 (DWRRA), which authorized the Department of the Interior's
(Interior) Minerals Management Service (MMS) to provide "royalty
relief" on oil and gas produced in the deep waters of the Gulf of
Mexico from leases issued from 1996 through 2000. This "royalty relief"
waived or reduced the amount of royalties that companies would
otherwise be obligated to pay. In implementing the DWRRA for leases
sold in 1996, 1997, and 2000, MMS specified that royalty relief would
only be applicable if oil and gas prices were below certain levels,
known as "price thresholds," thereby protecting the government's
royalty interests should oil and gas prices increase significantly. MMS
did not include price thresholds for leases it issued in 1998 and 1999.
Because oil and natural gas prices have risen significantly in recent
years, the omission of price thresholds on the leases issued in 1998
and 1999 has resulted in significant foregone royalties to the federal
government. In an effort to recoup some of these royalties, Interior is
currently negotiating with some of the oil and gas companies that own
these leases. Congress has also been considering legislative actions to
recoup foregone royalty revenues on these leases or to encourage
companies to negotiate with MMS. In addition to the foregone royalties
on the 1998 and 1999 leases, one company, Kerr-McGee, is currently
pursuing a legal challenge to the Interior's authority to place price
thresholds on any deep water leases issued between 1996 and 2000 under
the DWRRA.[Footnote 1] If successful, this legal challenge would lead
to additional foregone royalties on leases issued in 1996, 1997, and
2000.
We reported to the Senate Committee on Energy and Natural Resources in
January 2007 that the royalty relief for leases issued under the DWRRA
will likely cost the federal government billions of dollars, but that
the final costs have yet to be determined.[Footnote 2] At that time,
MMS' most recent estimates of forgone royalties were made in October
2004. In light of these findings, you asked us to evaluate the
potential for foregone royalties resulting from the omission of price
thresholds on the leases issued in 1998 and 1999. We are also reporting
on the status of Kerr-McGee's legal challenge to the Interior's
authority to set price thresholds for the leases issued in 1996, 1997,
and 2000 under the DWRRA, and the potential implications this challenge
could have on federal royalty revenues.
To evaluate the potential for foregone royalties on the 1998 and 1999
leases, we reviewed estimates made by MMS in October 2004 as well as
its updated estimates from February 2007. Specifically, we reviewed
MMS' methodology and assumptions that were used to estimate the amount
of future oil and natural gas production from DWRRA leases, and we
examined the timing of this future production using decline curve
analysis--an engineering tool that projects future production based on
the decline in past production. We also reviewed statistical data on
field sizes, discovery success rates, and drilling rig availability in
the deep waters of the Gulf of Mexico to assess the likelihood of
future oil and gas discoveries on DWRRA leases. In addition to
reviewing MMS' estimates, we developed and analyzed a series of
scenarios to study the uncertainty surrounding estimates of future
foregone royalties. These scenarios used a range of assumptions about
oil and natural gas prices and future production levels. Since MMS has
not yet updated its estimate of the forgone royalties from leases
issued in 1996, 1997, and 2000 should thresholds no longer apply, we
did not have all of the available data to fully report on expected
future foregone royalties on these leases. However, we did evaluate
MMS' methodology and assumptions used to make its 2004 estimate of
foregone revenue during the three year period and provide our comments
on this. We also collected information from MMS on the amount of
royalties that have already been collected on the 1996, 1997, and 2000
leases, which may need to be refunded if the federal government loses
the ongoing legal challenge related to these leases. Finally, we worked
with MMS and reviewed legal documents to provide an update on the
status of the legal challenge. A more detailed description of our scope
and methodology is provided in enclosure 1. We conducted our review
from September 2006 through March 2007 in accordance with generally
accepted government auditing standards.
In summary:
The absence of price thresholds in leases issued in 1998 and 1999 has
already cost the government about $1 billion and MMS' most recent
estimate in February 2007 indicates a range of future foregone
royalties of between $6.4 billion and $9.8 billion over the lives of
the leases. We believe the methodology and assumptions used by MMS to
make these estimates are reasonable. However, because there is
considerable uncertainty about future oil and natural gas prices and
production levels, actual foregone royalties could end up being higher
or lower than MMS's estimates. Our analysis shows that future foregone
royalties are quite sensitive to changes in prices or in the amount of
oil and natural gas produced. For example, one scenario that assumed
high production levels and a price of $70 per barrel for oil and $6.50
per thousand cubic feet for natural gas--prices that are higher than
those used by MMS but within the range of recent market prices--
indicated that the future foregone royalties could be as high as $10.5
billion. Alternatively, a scenario that assumed low production levels
and $50 per barrel for oil and $6.50 per thousand cubic feet for
natural gas indicated that future forgone royalties could be as low as
$4.3 billion. MMS is currently negotiating with oil and gas companies
to apply price thresholds to future production from the 1998 and 1999
leases. To date, the results of these negotiations have been mixed --6
of the 45 companies involved have agreed to terms; others have agreed
to negotiate but have not yet come to terms; and some companies have
yet to agree to negotiate.
With regard to the legal challenge to the Interior's authority to
include price thresholds on leases issued under the DWRRA, Kerr-McGee
filed suit in early 2006, but agreed to enter mediation with Interior
in an attempt to resolve the issue. The mediation was unsuccessful and
litigation has resumed. If the government loses this litigation it will
lead to additional foregone royalty revenues from the 1996, 1997, and
2000 leases that included price thresholds. The additional foregone
royalty revenues could include royalties on these leases totaling
approximately $1 billion that have already been collected and which may
have to be refunded as well as royalties on future production. MMS
estimated in October 2004 that potential foregone royalties on future
production could be up to $60 billion over the life of the leases,
should the federal government lose the legal challenge. In our review
of the methodology and assumptions used in MMS' estimate, we found that
MMS may have over-estimated the amount of oil and natural gas that
would be produced from these leases over the course of their lifetime.
MMS officials agreed with this assessment and said that an updated
estimate of foregone revenue from these leases might be considerably
lower than the $60 billion figure but that they are not currently
working to develop a revised estimate.
The Congress needs accurate and timely information to consider
legislative action to recoup forgone royalties. Because the amount of
royalties potentially recouped from such action may be dependent upon
fluctuating oil and gas prices and changing production volumes, we are
recommending that MMS provide to the Congress (1) the status of the
leases and the annual amount of royalties that have been foregone on
the 1998 and 1999 DWRRA leases until the issue is resolved, (2) the
status of the leases and the annual amount of royalties collected to
date from the 1996, 1997, and 2000 DWRRA leases until the Kerr-McGee
suit is resolved, and (3) periodic estimates of future foregone
royalties from 1998 and 1999 DWRRA leases and future royalties that may
be at risk from 1996, 1997, and 2000 DWRRA leases until these issues
are resolved.
Failure to Include Price Thresholds in 1998 and 1999 Leases Will Cost
the Government Billions in Foregone Royalty Payments:
As Assistant Secretary Allred of the Department of the Interior
recently testified before the Congress, the absence of price thresholds
in leases issued in 1998 and 1999 has already cost the government
almost $1 billion. In February 2007, MMS estimated a range of potential
future foregone revenue for these leases of between $6.4 billion and
$9.8 billion. MMS calculated these estimates under a range of
assumptions about oil and natural gas prices and future production
levels. MMS used two price assumptions--one employing a constant price
of $45 per barrel of oil equivalent and the other using the Office of
Management and Budget's projected oil and gas prices, which escalate
through time.[Footnote 3] For future production volumes from the 1998
and 1999 leases, MMS made low and high estimates--the low estimate did
not allow for expected growth in oil and natural gas reserves, while
the high estimate included expected growth in reserves based on past
experience with oil and natural gas leases in the Gulf of
Mexico.[Footnote 4] Reserves are the amount of oil (or natural gas)
that is believed to be economically recoverable at current technology
and prices. Reserve growth is the tendency of the initial reserve
estimates to increase or "grow" in the future as more becomes known
about the oil and gas field. We reviewed MMS' assumptions and
methodology for estimating the potential foregone revenue from 1998 and
1999 leases and found them to be reasonable.
In order to provide further perspective on just how much these future
costs may vary, we developed and analyzed different scenarios that
illustrate how the cost to the federal government is sensitive to
changes in both oil and natural gas prices and future production
volumes.[Footnote 5] In developing these scenarios, it is important to
understand that the three key variables that determine total federal
royalty revenues are production volume, sales price, and royalty rate.
Royalties paid to the federal government are then calculated using the
following equation: Royalty Revenue = volume sold x sales price less
deductions x royalty rate.
Accordingly, our scenarios employ a range of values for oil and natural
gas prices and future production volumes to illustrate the uncertainty
surrounding potential foregone federal royalty revenues.[Footnote 6]
Since oil and natural gas prices have historically been volatile, we
selected a variety of prices, ranging from a low of $36 per barrel of
oil to a high of $70 per barrel and a low of $4.50 per thousand cubic
feet of natural gas to a high of $6.50 per thousand cubic feet. In our
analyses, we assumed that price thresholds would rise 2.1 percent per
year, based on their average annual increase over the past 10 years.
Similarly, our scenarios included low and high volume estimates for
future oil and natural gas production from these leases. In these
scenarios, the estimated foregone royalty revenues vary significantly.
For example, an oil price of $50 per barrel and a natural gas price of
$6.50 per thousand cubic feet and low production volumes results in
$4.3 billion in foregone royalties.[Footnote 7] With the same prices
but higher production volumes, this estimate increases to $7.4 billion.
Alternatively, with $70 per barrel of oil and $6.50 per thousand cubic
feet of natural gas, the low production volume assumption yields
foregone royalties of $6.2 billion and the high production volume
assumption yields $10.5 billion. For more detailed information on each
of the scenarios and the estimated potential foregone royalty revenue,
see enclosure 2.
To recoup some of the potential foregone revenue on the 1998 and 1999
leases, MMS is currently negotiating with oil and gas companies in an
attempt to apply price thresholds to future production from these
leases. If successful, this approach would partially undo the omission
of price thresholds for future production, thereby implementing the
royalty relief as though price thresholds had been included in the
leases. However, the results of these negotiations have been mixed--as
of late February, 2007, only 6 of 45 companies had agreed to terms,
while others were either negotiating or had not yet agreed to
negotiate. Moreover, uncertainty about the current legal challenge to
Interior's authority to set price thresholds on any DWRRA leases may
further deter or complicate negotiated settlements.
A Successful Challenge to Interior's Authority to Include Price
Thresholds On Leases Issued Under the DWRRA Could Cost the Government
Billions In Additional Revenues:
Kerr-McGee filed suit against the Department of the Interior in early
2006, challenging its authority to place price thresholds on any of the
leases issued under the DWRRA. In particular, this suit seeks to in
effect, remove price thresholds from leases issued in 1996, 1997, and
2000. In June 2006, Kerr-McGee agreed to enter into mediation with
Interior in an attempt to resolve the issue; however, the mediation was
unsuccessful and litigation has resumed. As of July 2006, the 1996,
1997, and 2000 leases have generated approximately $1 billion in
royalties. If the government loses this legal challenge, it may be
required to refund these royalties and to forego future royalties on
these leases.[Footnote 8] As a result, the government could stand to
lose billions of additional dollars. In addition to the impact on
royalties on the 1996, 1997, and 2000 leases, losing the suit brought
by Kerr-McGee would also impact the government's negotiation of price
thresholds for the 1998 and 1999 leases.
MMS estimated in October 2004 that foregone royalties on the 1996,
1997, and 2000 leases could be as high as $60 billion. Because much has
been learned about the productivity of the leases since that initial
estimate and because price expectations have changed, an updated
estimate may differ significantly from the 2004 estimate.
For example, of the 2,369 leases issued in 1996, 1997, and 2000, 1,294
have expired without ever producing oil or gas. Of the remaining
leases, 12 have produced and have either reached the end of their
productive lives or appear incapable of further production; 38 were
still producing as of July 2006; 26 appear capable of producing in the
future after being connected to infrastructure; and 999 are still
active but untested for oil and gas. On the other hand, oil and natural
gas prices have increased since the estimate of foregone royalties in
2004. In our review of the methodology and assumptions used in MMS'
2004 estimate, we found that MMS may have made overly optimistic
assumptions about the amount of oil and natural gas production that
would occur over the lifetime of these leases. MMS officials agreed
with this assessment and also agreed that a new estimate of potential
foregone royalties might be considerably lower than their earlier $60
billion figure. However, MMS officials told us that they are not
currently working to update these figures.
Conclusions:
It is impossible to precisely estimate how much royalty revenue the
federal government could lose as the result of the 1998 and 1999 leases
that did not include price thresholds or if Interior loses the legal
challenge to its authority to include price thresholds for the leases
issued in 1996, 1997, and 2000, because of the inherent uncertainty of
future oil and natural gas prices and production volumes. Nonetheless,
MMS estimates of foregone royalty revenues from 1998 and 1999 leases
seem reasonable, in light of our analysis. There is considerably more
uncertainty, however, regarding potential foregone royalty revenue for
leases issued in 1996, 1997, and 2000. Although MMS has not yet updated
its 2004 estimate of the future potential royalty losses on the leases
at issue in the Kerr-McGee suit, it is clear that such an update could
differ significantly from its earlier estimate because of likely
changes to production and price assumptions. As Congress considers ways
to address foregone royalties, it will need the best available
information on a year-to-year basis about royalties that have been
foregone to-date, those that have been paid but that are at risk in the
suit, and estimates of how much is at stake going forward. Because new
information will become available every year that these leases are in
effect, we expect these figures and estimates to change significantly
over time.
Recommendations for Executive Action:
To assist the Congress in its efforts to find appropriate remedies for
foregone royalty revenues or those that may be at risk, we recommend
that MMS report to the Congress (1) the status of the leases and the
annual amount of royalties that have been foregone on the 1998 and 1999
DWRRA leases until the issue is resolved, (2) the status of the leases
and the annual amount of royalties collected to date from the 1996,
1997, and 2000 DWRRA leases until the Kerr-McGee suit is resolved, and
(3) periodic estimates, as MMS resources allow, of future foregone
royalties from 1998 and 1999 DWRRA leases and future royalties that may
be at risk from 1996, 1997, and 2000 DWRRA leases until both of these
situations are resolved.
Agency Comments:
We provided a draft of this report to the Department of the Interior
and the Minerals Management Service (MMS) for review and comment. They
provided oral comments, which we have incorporated as appropriate. In
general, MMS officials said they agreed with our findings and
recommendations. Specifically, MMS officials said that providing the
Congress with both the retrospective annual amounts of foregone
royalties from 1998 and 1999 DWRRA leases and royalties collected from
1996, 1997, and 2000 leases would be manageable. However, agency
officials stated that providing the Congress annual prospective
estimates of both of these values would require significant work and
cost. Accordingly, we revised our recommendations to provide MMS with
the flexibility to develop these estimates as MMS resources allow or as
needed by the Congress.
We are sending copies of this report to appropriate Congressional
committees, the Secretary of the Interior, the Director of MMS, the
Director of the Office of Management and Budget, and other interested
parties. We will also make copies available to others upon request. In
addition, the report will be available at no charge on GAO's Web site
at http://www.gao.gov.
If you or your staff have any questions or comments about this report,
please contact me at (202) 512-3841 or gaffiganm@gao.gov. Contact
points for our Offices of Congressional Relations and Public Affairs
may be found on the last page of this report. GAO staff who made
contributions to this report include Ron Belak, Glenn C. Fischer, Dan
Haas, Frank Rusco, and Barbara Timmerman.
Signed by:
Mark Gaffigan:
Acting Director, Natural Resources and Environment:
Enclosures:
[End of section]
Enclosure I: Scope and Methodology:
To determine the fiscal impacts of not including price thresholds on
deep water oil and gas leases issued under the Outer Continental Shelf
Deep Water Royalty Relief Act of 1995 (DWRRA), we met with MMS
personnel in the Economics Division in Herndon, Virginia. We reviewed
their October 2004 estimate of forgone royalties due to not including
price thresholds in 1998 and 1999 deep water leases and their estimate
of royalties that could be forgone if price thresholds did not apply to
1996, 1997 and 2000 DWRRA leases. We concluded that they followed
standard engineering and financial practices and had generated the
estimates in good faith. However, more than two years had passed since
their estimates, and we believed that the estimates needed to be
updated. MMS concurred and gave us their preliminary results in March
2007. We recently reviewed these preliminary results and generally
concurred with their methodology and assumptions as well as with the
magnitude of their estimates. During the course of our work in 2006, we
visited MMS's Gulf of Mexico Regional Office in New Orleans and
interviewed engineers and geologists on technical aspects of oil and
gas production in the deep waters of the Gulf of Mexico. In addition,
we contacted industry representatives for opinions on oil and gas
exploration and development in the deep waters of the Gulf of Mexico.
To perform our scenario analysis, we identified within MMS's Technical
Information Management System (TIMS) all 3,401 leases issued under the
DWRRA, 1,032 of which were issued in 1998 and 1999. From this database,
we were able to identify the status of these leases and the extent to
which they had been explored and developed and the production that had
occurred on some of them. As of July 2006, a total of 33 of the leases
issued in 1998 and 1999 have produced, are currently producing, or are
expected to produce oil and gas in the future. Four of the 33 leases
have either stopped producing or appear to be no longer capable of
producing significant amounts; 14 are still producing; and 15 are
expected to commence production at some future time. As of January 1,
2007, 563 additional 1998 and 1999 leases were still active but had not
yet been tested for oil and gas. As of March 28, 2007, 486 of the
leases issued in 1998 and 1999 have expired, been relinquished, or been
terminated.[Footnote 9] We also collected from TIMS pertinent
information current through July 2006 on the status of each lease and
the estimated reserves of producing leases and leases capable of
producing but not yet connected to infrastructure (producible leases).
We interviewed MMS personnel in New Orleans to better understand how
these reserve estimates were made. For producing and producible leases,
we corroborated lease information in TIMS with MMS's final bid results.
We also obtained recent information on reserve growth for each
producing or producible lease and obtained monthly oil and gas
production volumes through July 2006 from MMS's Oil and Gas Operations
Reports (OGOR). We reviewed production data for characteristic decline
patterns, questioned MMS personnel on how they verified these data and
on reasons for periods of time with zero production (predominantly the
result of hurricane activity), and compared each lease's cumulative
production with reserve estimates in TIMS. We found the data in TIMS
and in OGOR to be sufficiently reliable for the purposes of our
analysis.
In consultation with MMS experts, we estimated the timing of future
production to identify and exclude from our analysis the possible
production volumes that will be royalty free when sales prices drop
below anticipated price thresholds in the future. To determine the
timing of future production from currently producing leases, we used
standard decline curve analysis, which projects future production based
on the declining pattern of past production. For 1998 and 1999
producing leases, we segregated leases into three zones based on water
depth, which determines how much production is royalty free. Zone A
contains leases in waters from 200 to 400 meters deep (17.5 million BOE
exempt from royalties); zone B contains leases in waters from 400 to
800 meters deep (52.5 million BOE exempt from royalties); and zone C
contains leases in waters deeper than 800 meters (87.5 million BOE
exempt from royalties). We constructed separate decline curves for the
oil and gas fraction for leases in zone C, but did not do so for leases
in the A and the B zones because these leases were either not producing
or were producing insignificant volumes. When constructing decline
curves, we adjusted for time periods of zero production due to major
hurricanes. We also ensured that the total production predicted by the
decline curves was equal to the total reserves estimated by MMS. For
larger leases, we tracked projected cumulative production to predict
whether a lease would exceed its royalty suspension volume so as not to
include the amounts over the suspension volumes in our estimate of
forgone royalties.
We also used decline curve analysis to predict the timing of future
production from producible leases, all of which are in the C zone. In
consultation with MMS experts, we constructed a composite gas decline
curve and a composite oil decline curve using production data from all
producing DWRRA leases in the C zone, adjusted for missing data. Based
on advice from MMS and industry representatives, we assumed that
producible leases would produce for 15 years. Based on the 7 year
average time from discovery to first production of 144 producing fields
in Gulf of Mexico waters deeper than 800 meters, we assumed that each
of the producible C zone leases would first start producing seven years
after its discovery.
To project production from future discoveries on 1998 and 1999 leases,
we examined MMS projections for future drilling activity, historic
discovery rates, average field sizes, and anticipated lease expiration
dates for DWRRA leases in waters deeper than 800 meters, where MMS
anticipates all the future DWRRA discoveries to occur. First, we
assumed that the range for the number of possible untested leases
drilled in all of the deep waters of the Gulf of Mexico would be
between 30 and 60. This assumption was based on the availability of
rigs to drill exploratory wells in waters deeper than 800 meters and
MMS projections in the 2006 deep water report. Second, we assumed the
success rate of future deep water lease discoveries would be the same
as for such deep water leases issued from 1974 through 1995--this
success rate was 28 percent. Third, we scheduled the expiration dates
of the 1998 and 1999 leases for each year through 2009 and calculated
for each of these years the percentage of all untested deep water
leases below 800 meters that would be 1998 and 1999 leases, assuming
that there would be 3,700 total active deep water leases each year.
Fourth, we assumed that each new field discovery would consist of two
leases because 97 percent of the existing 198 fields in Gulf of Mexico
waters deeper than 800 meters are composed of from one to four leases,
with two leases being the average field size. Finally, for 2007 through
2009, we assumed the number of field discoveries on 1998 and 1999
leases would be between 5 and 10. This assumption was derived by
multiplying the estimated range of untested leases that could be
drilled in all Gulf of Mexico deep waters (30 to 60 per year) by the
percentage of all deep water leases that are active untested 1998 and
1999 leases and by the assumed success rate of 28 percent. We doubled
this number in order to account for the average field consisting of two
leases. For these new discoveries, we converted these numbers into oil
and gas production volumes by multiplying them by the average of the
reserves for all producing and producible DWRRA leases, adjusting for
the possibility that some leases would have reserves greater than the
royalty suspension volume of 87.5 million BOE.
With these assumptions, we developed several scenarios that illustrate
that the potential for forgone royalties is highly dependent upon
prices and production volumes. We selected the price scenario of $36
for oil and $4.50 for gas to illustrate that there would be no forgone
royalties at these prices because they should remain below predicted
price thresholds for the lives of the DWRRA leases. We chose prices of
$50 and $70 for oil and $6.50 for gas because these were in the range
of common prices during 2006. We did not escalate oil and gas prices
over the time period of our scenario. However, we increased 2006 price
thresholds by 2.1 percent per year, based on the average increase over
the past 10 years. To illustrate the impact of changing production
volumes on forgone royalties from producing and producible leases, we
assumed low and high production levels. Our low production assumption
is equal to MMS's estimated reserves. Our high production assumption is
equal to MMS's estimated reserves multiplied by the average weighted
growth factor. To illustrate the impact of changing production volumes
on forgone royalties from future discoveries, we also selected low and
high assumptions. Our low production assumption is 5 discoveries, and
our high assumption is 10 discoveries. We did not multiply production
assumptions from future discoveries by growth factors but such growth
is possible.
[End of section]
Enclosure II: Scenarios Illustrating the Sensitivity of the Cost to the
Federal Government to Changes in Oil and Natural Gas Prices and Future
Production Volumes:
We present two scenarios below to illustrate the range of potential
future costs to the federal government that could result from the
omission of price thresholds in leases issued in 1998 and 1999.
Scenario 1 illustrates possible foregone federal royalty payments
resulting from MMS's omission of price thresholds in leases issued in
1998 and 1999 when oil and natural gas prices exceed price thresholds
(see table 1).[Footnote 10] Specifically, we selected an oil price of
$50 per barrel and a natural gas price of $6.50 per thousand cubic feet
to illustrate the forgone royalties with both low and high volume
estimates of future oil and gas production. In this scenario, the
productive timeframe is from August 2006 through the lives of the
leases--about 25 years. In the low production volume estimate, we use
MMS's "ungrown reserve" estimates and assume 5 additional leases are
discovered in the future. Our scenario results in $4.3 billion in
foregone royalties. This estimate increases to $7.4 billion in the high
production volume case, which uses MMS' "grown reserves" and 10 future
discoveries.
Table 1: Scenario 1 assumes that from 1998 and 1999 leases, oil would
be sold for $50 per barrel and natural gas would be sold for $6.50 per
thousand cubic feet.
Ungrown Reserves and 5 Future Discoveries:
Grown Reserves and 10 Future Discoveries:
Foregone royalties on Future Production from Producing and Producible
Leases;
Ungrown Reserves and 5 Future Discoveries: $3.8 billion;
Grown Reserves and 10 Future Discoveries: $6.0 billion.
Additional Foregone Royalties on Future Production from Leases with New
Discoveries;
Ungrown Reserves and 5 Future Discoveries: $0.5 billion;
Grown Reserves and 10 Future Discoveries: $1.4 billion.
Total Foregone Royalties;
Ungrown Reserves and 5 Future Discoveries: $4.3 billion;
Grown Reserves and 10 Future Discoveries: $7.4 billion.
Source: GAO:
[End of table]
Scenario 2 illustrates possible forgone royalties with a higher oil
price, but the price is within the range of prices we have seen in
recent years (see table 2). Using similar assumptions on production
volumes as in Scenario 1, $70 per barrel of oil and $6.50 per thousand
cubic feet of natural gas yields $6.2 billion in forgone future
royalties for the low estimate and $10.5 billion in forgone future
royalties for the high estimate.
Table 2: Scenario 2 assumes that from 1998 and 1999 leases, oil would
be sold for $70 per barrel and natural gas would be sold for $6.50 per
thousand cubic feet.
Foregone royalties on Future Production from Producing and Producible
Leases;
Ungrown Reserves and 5 Future Discoveries: $5.2 billion;
Grown Reserves and 10 Future Discoveries: $8.1 billion.
Additional Foregone Royalties on Future Production from Leases with New
Discoveries;
Ungrown Reserves and 5 Future Discoveries: $1.0 billion;
Grown Reserves and 10 Future Discoveries: $2.4 billion.
Total Foregone Royalties;
Ungrown Reserves and 5 Future Discoveries: $6.2 billion;
Grown Reserves and 10 Future Discoveries: $10.5 billion.
Source: GAO:
[End of table]
List of Addressees:
The Honorable Jeff Bingaman:
Chairman, Committee on Energy and Natural Resources:
United States Senate:
The Honorable Carl Levin:
Chairman, Permanent Subcommittee on Investigations:
Committee on Homeland Security and Governmental Affairs:
United States Senate:
The Honorable Norm Coleman:
Ranking Member, Permanent Subcommittee on Investigations:
Committee on Homeland Security and Governmental Affairs:
United States Senate:
The Honorable Nick J. Rahall:
Chairman, Committee on Natural Resources:
House of Representatives:
The Honorable Darrel E. Issa:
Ranking Member, Subcommittee on Domestic Policy:
Committee on Oversight and Government Reform:
House of Representatives:
The Honorable Daniel K. Akaka:
United States Senate:
The Honorable Maria Cantwell:
United States Senate:
The Honorable Thomas R. Carper:
United States Senate:
The Honorable Byron L. Dorgan:
United States Senate:
The Honorable Richard J. Durbin:
United States Senate:
The Honorable Russell D. Feingold:
United States Senate:
The Honorable Dianne Feinstein:
United States Senate:
The Honorable Tim Johnson:
United States Senate:
The Honorable John F. Kerry:
United States Senate:
The Honorable Frank R. Lautenberg:
United States Senate:
The Honorable Robert Menendez:
United States Senate:
The Honorable Barbara A. Mikulski:
United States Senate:
The Honorable Patty Murray:
United States Senate:
The Honorable Barack Obama:
United States Senate:
The Honorable Jack Reed:
United States Senate:
The Honorable Ken Salazar:
United States Senate:
The Honorable Charles E. Schumer:
United States Senate:
The Honorable Ron Wyden:
United States Senate:
The Honorable Carolyn B. Maloney:
House of Representatives:
(360752):
FOOTNOTES
[1] Kerr-McGee Oil and Gas Corp. v. Burton, No. CV06-0439LC (W.D. La.
March 17, 2006).
[2] Oil and Gas Royalties: Royalty Relief Will Likely Cost the
Government Billions, but the Final Costs Have Yet to Be Determined, GAO-
07-369T (Washington, D.C.: January 18, 2007).
[3] One barrel of oil equivalent (BOE) equals one barrel of oil or 5.62
thousand cubic feet of natural gas.
[4] As oil and gas reserves are developed and more knowledge of the
field is obtained, proven reserves generally experience some growth.
[5] These scenarios are not probabilistic estimates of what may
actually happen with royalty revenue. Rather, they are illustrative
examples using estimates of future oil and natural gas production that
we believe are reasonable based on the history of leases in the Gulf of
Mexico and using oil and gas prices that are within the range of prices
that have existed in the past three years. As such, we believe the
scenarios are reflective of plausible possibilities, but we do not
assign any probabilities to any of the scenarios.
[6] The royalty rate for DWRRA leases in less than 400 meters of water
is 16.67 percent, and the royalty rate for leases in waters greater
than 400 meters is 12.5 percent.
[7] It should be noted that if oil prices were to fall and remain at
$36 per barrel or below and natural gas prices at $4.50 per thousand
cubic feet or below, no royalties would be due even if the price
thresholds that were imposed on the 1996, 1997, and 2000 leases were
applied to the 1998 and 1999 leases.
[8] Future foregone royalties are dependent on the "royalty suspension
volume." Royalty suspension volumes are cumulative production amounts
above which royalty relief no longer applies.
[9] Total lease numbers for 1998 and 1999 leases do not add to 1,032
due to overlapping time periods.
[10] In some of our scenarios, oil and gas prices drop below price
thresholds in the latter years of the producing lives of the leases. In
these cases, this royalty revenue is not considered forgone royalties.
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