Oil and Gas Royalties
Litigation over Royalty Relief Could Cost the Federal Government Billions of Dollars Gao ID: GAO-08-792R June 5, 2008Oil and gas production from federal lands and waters is critical to meeting the nation's energy needs. This production provided about 31 percent of all oil and 29 percent of all natural gas produced in the United States in fiscal year 2007. Every five years, the federal government decides the areas in the offshore waters of the United States it will offer for leasing and establishes a schedule for individual lease sales. The Department of the Interior's Minerals Management Service (MMS) has conducted these sales at least once per year for at least the past 30 years. During the sales, oil and gas companies bid for the rights to explore and develop the oil and gas resources on these leases and also agree to pay the federal government royalties on the resources produced. 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 (DWRRA), which authorized MMS to provide "royalty relief" on oil and gas produced in the deep waters of the Gulf of Mexico from certain leases issued from 1996 through 2000. This "royalty relief" waived or reduced the amount of royalties that companies would otherwise be obligated to pay on the initial volumes of production from leases, which are referred to as "royalty suspension volumes." The DWRRA also authorized the Secretary of the Interior to provide royalty relief to promote oil and gas development or to increase production from leases in the Gulf of Mexico. In implementing the DWRRA for leases sold in 1996, 1997, and 2000, MMS specified that royalty relief would be applicable only if oil and gas prices were below certain levels, known as "price thresholds," with the intention of protecting the government's royalty interests if oil and gas prices increased significantly. MMS did not include these same price thresholds for leases it issued in 1998 and 1999, and this action raised Congressional concerns that the federal government would lose billions of dollars in forgone revenues. We reported in April 2007 that MMS's failure to include price thresholds on leases issued in 1998 and 1999 under the DWRRA would likely cost the federal government billions of dollars in forgone royalties, but precise costs were impossible to determine because of uncertain future prices and production levels. In light of the recent rise of oil prices to more than $100 per barrel and natural gas to $8 per thousand cubic feet and the recent judgment against MMS-imposed price thresholds, you asked us to: (1) update our scenario that illustrates the potential loss of royalties because of the absence of price thresholds in leases issued in 1998 and 1999 and (2) provide an update of the possible consequences of Kerr-McGee's legal challenge on royalties already collected and evaluate the potential for additional forgone royalties if price thresholds no longer apply to future production from the 1996, 1997, and 2000 DWRRA leases.
Regarding the 1998 and 1999 leases, which included no price thresholds, the cost to the federal government could be significantly more than the upper bound we reported in April 2007 if higher oil and natural gas prices are sustained over the lives of these leases. In April 2007, we developed scenarios that illustrated the federal government could sustain losses of between $4.3 billion and $10.5 billion, depending on production levels and oil and gas prices over about the next 25 years. Assuming similar oil production levels but higher oil and natural gas prices of $100 per barrel and $8 per thousand cubic feet, respectively--prices that are closer to current prices than the maximum prices used in our 2007 scenarios--the upper bound of these scenarios could climb to as high as $14.7 billion, a 40 percent increase. There are no guarantees, however, about what future prices will be. For example, oil prices have topped $130 per barrel since we did the analysis for this report, but it is also possible that prices could fall below our lower price assumptions. Thus, these scenarios should not be viewed as probabilistic estimates of what actual forgone royalties will be, or even firm boundaries within which forgone royalties will fall. Rather, the scenarios reflect reasonable possibilities based on recent experience and possible future prices. With regard to the 1996, 1997, and 2000 leases, because the U.S. District Court for the Western District of Louisiana ruled in October 2007 that price thresholds do not apply to DWRRA leases, the federal government may have to refund over $1.13 billion in royalties that have already been collected from DWRRA leases issued in 1996, 1997, and 2000, if the government loses on appeal. The government also faces forgoing additional royalty revenues, which will likely be in the billions of dollars, on future production from these leases. We developed a number of scenarios that illustrate the magnitude of possible forgone royalties at different price levels. For example, our scenarios ranged from $15.1 billion of lost revenue for a low production scenario with $70 per barrel of oil and $6.50 per thousand cubic feet of gas to as high as $38.3 billion for high production levels and prices of $100 per barrel of oil and $8 per thousand cubic feet of natural gas over about the next 25 years. The same caveats apply to interpreting these scenarios as those for the 1998 and 1999 leases. Overall, our work illustrates that the value of future forgone royalties is highly dependent upon oil and gas prices, production levels, and the ultimate outcome of litigation over price thresholds. Assuming that the District Court's ruling in the Kerr-McGee case is upheld, future forgone royalties from all the DWRRA leases issued from 1996 through 2000 could range widely--from a low of about $21 billion to a high of $53 billion. The $21 billion figure assumes low production levels and oil and gas prices that average $70 per barrel and $6.50 per thousand cubic feet over the lives of the leases. The $53 billion figure assumes high production levels and oil and gas prices that average $100 per barrel and $8 per thousand cubic feet over the lives of the leases.
GAO-08-792R, Oil and Gas Royalties: Litigation over Royalty Relief Could Cost the Federal Government Billions of Dollars
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GAO-08-792R:
United States Government Accountability Office:
Washington, DC 20548:
June 5, 2008:
Congressional Requesters:
Subject: Oil and Gas Royalties: Litigation over Royalty Relief Could
Cost the Federal Government Billions of Dollars:
Oil and gas production from federal lands and waters is critical to
meeting the nation's energy needs. This production provided about 31
percent of all oil and 29 percent of all natural gas produced in the
United States in fiscal year 2007. Every five years, the federal
government decides the areas in the offshore waters of the United
States it will offer for leasing and establishes a schedule for
individual lease sales. The Department of the Interior's Minerals
Management Service (MMS) has conducted these sales at least once per
year for at least the past 30 years. During the sales, oil and gas
companies bid for the rights to explore and develop the oil and gas
resources on these leases and also agree to pay the federal government
royalties on the resources produced.
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 (DWRRA), which authorized MMS to provide
"royalty relief" on oil and gas produced in the deep waters of the Gulf
of Mexico from certain leases issued from 1996 through 2000. [Footnote
1] This "royalty relief" waived or reduced the amount of royalties that
companies would otherwise be obligated to pay on the initial volumes of
production from leases, which are referred to as "royalty suspension
volumes."[Footnote 2] The DWRRA also authorized the Secretary of the
Interior to provide royalty relief to promote oil and gas development
or to increase production from leases in the Gulf of Mexico.
In implementing the DWRRA for leases sold in 1996, 1997, and 2000, MMS
specified that royalty relief would be applicable only if oil and gas
prices were below certain levels, known as "price thresholds," with the
intention of protecting the government's royalty interests if oil and
gas prices increased significantly. MMS did not include these same
price thresholds for leases it issued in 1998 and 1999, and this action
raised Congressional concerns that the federal government would lose
billions of dollars in forgone revenues.[Footnote 3] In addition, the
Kerr-McGee Corporation--which was active in the Gulf of Mexico and is
now owned by Anadarko Petroleum Corporation--filed suit challenging the
Department of the Interior's authority to include price thresholds in
DWRRA leases issued from 1996 through 2000. Recently, the U.S. District
Court for the Western District of Louisiana granted summary judgment in
favor of Kerr-McGee concerning the application of price thresholds to
those leases.[Footnote 4] The court held that the DWRRA did not provide
MMS with the authority to impose price thresholds on production below
the royalty suspension volumes for leases issued under the DWRRA from
1996 through 2000. Interior officials disagree with the court's
decision, and in December 2007 the Department of Justice filed notice
to appeal this decision. In response to the possible loss of future
royalty revenues on these leases, Congress has been considering
legislative action.
We reported in April 2007 that MMS's failure to include price
thresholds on leases issued in 1998 and 1999 under the DWRRA would
likely cost the federal government billions of dollars in forgone
royalties, but precise costs were impossible to determine because of
uncertain future prices and production levels.[Footnote 5] However, we
developed a number of scenarios to illustrate how different prices and
production levels will influence these costs. We determined that, in
addition to the $1 billion that had already been forgone, future costs
could range between $4.3 billion and $10.5 billion over about 25 years,
depending on the future prices of gas and oil and the volumes produced
on these leases. MMS also estimated that the Department of the Interior
faced losing an additional $60 billion in forgone royalties if it lost
legal challenges to its application of price thresholds in all the
DWRRA leases issued in 1996, 1997, and 2000. We noted, however, that
MMS made this estimate in October 2004 and that this estimate may have
included overly optimistic assumptions about the amount of oil and gas
production that could occur over the lifetime of the leases. In light
of the recent rise of oil prices to more than $100 per barrel and
natural gas to $8 per thousand cubic feet and the recent judgment
against MMS-imposed price thresholds, you asked us to: (1) update our
scenario that illustrates the potential loss of royalties because of
the absence of price thresholds in leases issued in 1998 and 1999 and
(2) provide an update of the possible consequences of Kerr-McGee's
legal challenge on royalties already collected and evaluate the
potential for additional forgone royalties if price thresholds no
longer apply to future production from the 1996, 1997, and 2000 DWRRA
leases.
To update our scenario illustrating the potential loss of royalties
from leases issued in 1998 and 1999, we increased the upper bounds of
oil and gas prices to $100 per barrel and $8 per thousand cubic feet,
respectively, well above the levels of our high-price scenario in the
April 2007 report. We did not, however, revise our lower bounds for
prices. To update the consequence of the Kerr-McGee challenge to
royalties already collected, we interviewed MMS officials, reviewed
legal documents, and reviewed MMS's estimate on royalties paid to date.
To evaluate the potential for forgone royalties on future production
from the 1996, 1997, and 2000 leases, we reviewed estimates made by MMS
in October 2004 and its more recent estimates released in February
2008. Specifically, we reviewed the methodology and assumptions MMS
used to estimate the amount of future oil and natural gas production
from DWRRA leases. To assess the likelihood of future oil and gas
discoveries on DWRRA leases, we reviewed statistical data on field
sizes, discovery success rates, and the availability of drilling rigs
in the deep waters of the Gulf of Mexico. We determined that the data
were sufficiently reliable for the purposes of this report. We also
developed a series of scenarios to illustrate the uncertainty of prices
and future production and their effect on the amount of future forgone
royalties. A more detailed description of our scope and methodology is
provided in enclosure 1. We conducted our review primarily from
November 2007 through April 2008 in accordance with generally accepted
government auditing standards. These standards require that we plan and
perform the audit to obtain sufficient, appropriate evidence to provide
a reasonable basis for our findings and conclusions based on our audit
objectives. We believe the evidence we obtained provides a reasonable
basis for our findings and conclusions based on our audit objectives.
Summary:
Regarding the 1998 and 1999 leases, which included no price thresholds,
the cost to the federal government could be significantly more than the
upper bound we reported in April 2007 if higher oil and natural gas
prices are sustained over the lives of these leases. In April 2007, we
developed scenarios that illustrated the federal government could
sustain losses of between $4.3 billion and $10.5 billion, depending on
production levels and oil and gas prices over about the next 25 years.
Assuming similar oil production levels but higher oil and natural gas
prices of $100 per barrel and $8 per thousand cubic feet, respectively-
-prices that are closer to current prices than the maximum prices used
in our 2007 scenarios--the upper bound of these scenarios could climb
to as high as $14.7 billion, a 40 percent increase. There are no
guarantees, however, about what future prices will be. For example, oil
prices have topped $130 per barrel since we did the analysis for this
report, but it is also possible that prices could fall below our lower
price assumptions. Thus, these scenarios should not be viewed as
probabilistic estimates of what actual forgone royalties will be, or
even firm boundaries within which forgone royalties will fall. Rather,
the scenarios reflect reasonable possibilities based on recent
experience and possible future prices.
With regard to the 1996, 1997, and 2000 leases, because the U.S.
District Court for the Western District of Louisiana ruled in October
2007 that price thresholds do not apply to DWRRA leases, the federal
government may have to refund over $1.13 billion in royalties that have
already been collected from DWRRA leases issued in 1996, 1997, and
2000, if the government loses on appeal. The government also faces
forgoing additional royalty revenues, which will likely be in the
billions of dollars, on future production from these leases. We
developed a number of scenarios that illustrate the magnitude of
possible forgone royalties at different price levels. For example, our
scenarios ranged from $15.1 billion of lost revenue for a low
production scenario with $70 per barrel of oil and $6.50 per thousand
cubic feet of gas to as high as $38.3 billion for high production
levels and prices of $100 per barrel of oil and $8 per thousand cubic
feet of natural gas over about the next 25 years. The same caveats
apply to interpreting these scenarios as those for the 1998 and 1999
leases.
Overall, our work illustrates that the value of future forgone
royalties is highly dependent upon oil and gas prices, production
levels, and the ultimate outcome of litigation over price thresholds.
Assuming that the District Court's ruling in the Kerr-McGee case is
upheld, future forgone royalties from all the DWRRA leases issued from
1996 through 2000 could range widely--from a low of about $21 billion
to a high of $53 billion. The $21 billion figure assumes low production
levels and oil and gas prices that average $70 per barrel and $6.50 per
thousand cubic feet over the lives of the leases. The $53 billion
figure assumes high production levels and oil and gas prices that
average $100 per barrel and $8 per thousand cubic feet over the lives
of the leases.
Not Including Price Thresholds in 1998 and 1999 Leases Could Cost the
Government More in Forgone Royalty Payments Should Recent Increases in
Oil and Natural Gas Prices Be Sustained:
In February 2007, MMS estimated that in addition to the $1 billion in
revenues already forgone the range of future forgone revenues is
between $6.4 billion and $9.8 billion from not including price
thresholds in leases issued in 1998 and 1999. 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 (OMB) projected oil
and gas prices, which escalate through time.[Footnote 6] 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 7] Reserves are the amount of
oil and natural gas that is believed to be economically recoverable
with current technology and prices. Reserve growth is the tendency of
the initial reserve estimates to increase in the future as more becomes
known about the oil and gas field. We reviewed MMS's assumptions and
methodology for estimating the potential forgone 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 in April
2007 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 8] Accordingly, our scenarios used a range
of values for oil and natural gas prices and future production volumes
to illustrate the uncertainty surrounding future forgone federal
royalty revenues.[Footnote 9] Because oil and natural gas prices have
historically been volatile, at the time we made our initial estimates
we selected a variety of prices, including $50 and $70 per barrel of
oil and $6.50 per thousand cubic feet of natural gas. In our analyses,
we assumed that price thresholds would rise 2.1 percent per year, based
on their average annual increase over the past 12 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 forgone 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 resulted in $4.3 billion
in forgone royalties.[Footnote 10] Alternatively, with $70 per barrel
of oil and $6.50 per thousand cubic feet of natural gas, the high
production volume assumption yielded $10.5 billion.
In June 2007, MMS also provided an update on the loss of potential
royalties from not including price thresholds on the leases issued in
1998 and 1999. MMS used oil and natural gas prices cited within OMB's
Economic Assumptions for the 2008 Budget. Based on an average oil price
of $60.78 per barrel and an average natural gas price of $7.52 per
thousand cubic feet, MMS estimated that between $5.3 billion and $7.8
billion may be lost in future royalties. The low estimate assumes that
reserves do not grow, and the high estimate assumes that reserves do
grow over time.
Because oil and natural gas prices increased substantially since the
study we completed in 2007, we developed an additional scenario with
higher oil and natural gas prices. We used the same methodology as that
in our April 2007 study, updating only the oil and natural gas prices.
[Footnote 11] At an oil price of $100 per barrel and a natural gas
price of $8 per thousand cubic feet, a low production level yields
potential losses of $8.7 billion. With the same prices and a high
production level, potential losses climb to $14.7 billion. It is
important to note, however, that there is no assurance these recent
high oil and natural gas prices will be sustained over the lives of the
leases, about 25 more years. For more information on this scenario, see
enclosure II.
Kerr-McGee's Challenge of Interior's Authority to Include Price
Thresholds in DWRRA Leases Could Result in Refunding Royalty Payments:
As of September 30, 2007, leases issued under the DWRRA in 1996, 1997,
and 2000 have generated $1.13 billion in royalties for the U.S.
government, according to MMS. If the Kerr-McGee decision is upheld on
appeal and is applied to all 1996, 1997, and 2000 DWRRA leases, the
federal government may be required to refund these royalties. As of
November 2007, 57 of the leases issued in 1996, 1997, and 2000 under
the DWRRA have produced oil and natural gas upon which royalties have
been paid. Only eight of the leases issued in 1996, 1997, and 2000 are
expected to produce oil and gas in excess of their royalty suspension
volumes. The amount of this excess production is expected to be about
14 percent of the total production from all the leases issued in 1996,
1997, and 2000 that are producing or expected to produce.
In early 2006, Kerr-McGee filed the suit challenging the Department of
the Interior's authority to include price thresholds in its DWRRA
leases. In effect, this suit sought to remove price thresholds from
leases issued in 1996, 1997, and 2000 because Interior did not include
price thresholds on leases issued in 1998 and 1999. 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 resumed. In October 2007, the U.S. District Court for the
Western District of Louisiana ruled in favor of Kerr-McGee.
The court held that price thresholds in leases issued under the DWRRA
from 1996 through 2000 to Kerr-McGee for oil and gas production below a
threshold volume were unlawful. According to the court, "The Interior
has no discretion to enact a price threshold requirement that applies
to volumes below the minimum volume of royalty-free production." The
DWRRA specifies that royalties are not due on certain amounts of
production, referred to in the ruling as "the minimum volume of royalty-
free production" and referred to by others as royalty suspension
volumes. The court agreed with Kerr-McGee's interpretation that the
section of the DWRRA that requires mandatory royalty relief prevents
Interior from enacting price thresholds for volumes below the royalty
suspension volumes.
Senior Interior officials and many congressional leaders disagree with
the decision. They believe that Congress intended for royalty relief to
apply only during times of low oil and natural gas prices and that the
DWRRA grants Interior the authority to set price thresholds for new
leases. In December 2007, the Department of Justice filed a notice to
appeal the decision.
Congressional leaders are seeking legislative remedies for the absence
of price thresholds in DWRRA leases issued in 1998 and 1999. Sections
7502 and 7504 of H.R. 3220, the New Direction for Energy Independence,
National Security and Consumer Protection Act, would provide
legislative avenues for addressing the absence of price thresholds.
Section 7502 proposes that holders of leases issued in 1998 and 1999
under the DWRRA can request the Secretary of the Interior to amend
these leases to include price thresholds. This would formally allow
Interior and the lessees to renegotiate these leases. Interior and some
companies began negotiations in late 2006 to apply price thresholds to
future production from 1998 and 1999 leases. To date, 6 companies have
formally agreed to terms, but 44 have not agreed to terms. Section 7504
would exclude parties that hold an interest in DWRRA leases issued from
1996 through 2000 from acquiring new oil and gas leases in the Gulf of
Mexico unless the party renegotiates the leases to include price
thresholds. This section would also impose a fee on oil and gas
production from the Outer Continental Shelf lands in the Gulf of Mexico
if these leases are not subject to price thresholds. Section 223 of S.
701, the Strategic Energy Fund Act of 2007, contains an identical
provision, as do H.R. 2809 and several other bills.
Kerr-McGee's Challenge Could Also Cost the Government Billions in
Future Forgone Royalty Payments:
If the Kerr-McGee ruling is upheld on appeal and applied to all DWRRA
leases issued in 1996, 1997, and 2000, the potential loss of royalties
from future production is likely to be in the billions of dollars, but
the exact amount will depend on future energy prices and production
levels. MMS estimated in October 2004 that forgone royalties on the
1996, 1997, and 2000 leases could be as high as $60 billion. In 2006,
we reviewed MMS's assumptions and methodology for estimating the
potential forgone revenue and found them to be reasonable. However,
because much has been learned about the productivity of the leases
since that initial estimate and because oil and natural gas price
expectations have changed, we believe that this estimate needed to be
updated. In particular, we found that estimates for reserve growth were
overly optimistic in light of a more recent MMS study on reserve growth
in the Gulf of Mexico. MMS's 2004 estimates on the size and number of
future discoveries also appeared overly optimistic, given historical
statistics on field size, a 2006 assessment of the availability of
drilling rigs in the Gulf of Mexico, and a smaller number of leases
available to drill in 2008 than were available in 2004. MMS concurred
with our observations.
In February 2008, MMS released an update on its October 2004 estimate
of potential losses from the 1996, 1997, and 2000 leases. MMS estimated
a range of potential future forgone revenue between $15.7 billion and
$21.2 billion, based on assumptions about oil and natural gas prices
and future production levels. MMS used OMB's prices of $80.92 per
barrel of oil and $8.70 per thousand cubic feet of natural gas, as
cited in OMB's Economic Assumptions for the 2009 Budget. For future
production levels, 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. We
reviewed these assumptions and the methodology and found them to be
reasonable.
Nonetheless, 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. These scenarios are similar to those we used to
illustrate forgone royalty revenue from the 1998 and 1999 leases. To
illustrate the uncertainty surrounding potential forgone federal
royalty revenues, our scenarios use a range of values for oil and
natural gas prices and future production volumes. Because oil and
natural gas prices have been volatile and high during 2007 and 2008, we
selected oil prices of $70 and $100 per barrel of oil and $6.50 and $8
per thousand cubic feet of natural gas. In our analyses, we assumed
that price thresholds would rise 2.1 percent per year, based on their
average annual increase over the past 12 years. Similarly, our
scenarios included low and high volume estimates for future oil and
natural gas production from these leases. In these scenarios, as might
be expected, the estimated forgone royalty revenues vary significantly.
For example, an oil price of $70 per barrel and a natural gas price of
$6.50 per thousand cubic feet and low production volumes result in
$15.1 billion in forgone royalties. With the same prices but higher
production volumes, this estimate increases to $27.2 billion.
Alternatively, with $100 per barrel of oil and $8 per thousand cubic
feet of natural gas, the low production volume assumption yields
forgone royalties of $21.2 billion and the high production volume
assumption yields $38.3 billion. For more detailed information on each
of the scenarios and the estimated potential forgone royalty revenue,
see enclosure III.
Of the 84 leases issued in 1996, 1997, and 2000 that are currently
producing or are capable of producing in the future, 76 do not appear
capable of producing amounts of oil and gas that will exceed the
royalty suspension volumes. The total amount of oil and gas for these
76 leases below the royalty suspension volumes represents about 86
percent of the estimated amounts that the1996, 1997, and 2000 leases
will collectively produce over their productive lives. Thus, only about
14 percent of the production from leases issued in 1996, 1997, and 2000
would be royalty bearing should Interior lose on appeal and the ruling
in the Kerr-McGee suit is applied to DWRRA leases issued from 1996
through 2000. In addition to the impact on receiving fewer royalties in
the future from the 1996, 1997, and 2000 leases, losing the appeal
could also adversely affect the government's negotiation of price
thresholds for the 1998 and 1999 leases. Some companies have suspended
or delayed negotiations, pending outcome of the Kerr-McGee suit.
Agency Comments:
We provided a draft of this report to the Department of the Interior
and the Minerals Management Service (MMS) for review and oral comments.
In commenting on the report, they generally agreed with GAO's
methodology and conclusions. In response to their comments, we added
clarification as to why the potential for future forgone royalties from
the 1996, 1997, and 2000 leases with grown reserves appeared higher
than they anticipated. We also incorporated their technical comments as
appropriate.
We are sending copies of this report to appropriate congressional
committees, the Secretary of the Interior, the Director of the Minerals
Management Service, 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 [hyperlink,
http://www.gao.gov].
If you or your staffs have any questions about this report, please
contact me at (202) 512-3841 or ruscof@gao.gov. GAO staff who made
contributions to this report include Ron Belak, Glenn C. Fischer, Mark
Gaffigan, Dan Haas, and Barbara Timmerman.
Signed by:
Frank Rusco:
Acting Director, Natural Resources and Environment:
Enclosures:
[End of correspondence]
List of Requesters:
The Honorable Jeff Bingaman:
Chairman:
Committee on Energy and Natural Resources:
United States Senate:
The Honorable Carl Levin:
Chairman:
The Honorable Norm Coleman:
Ranking Member:
Permanent Subcommittee on Investigations:
Committee on Homeland Security and Governmental Affairs:
United States Senate:
The Honorable Ron Wyden:
Chairman:
Subcommittee on Public Lands and Forests:
Committee on Energy and Natural Resources:
United States Senate:
The Honorable Nick J. Rahall:
Chairman:
Committee on Natural Resources:
House of Representatives:
The Honorable Darrell 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 Jon Kyl:
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 Carolyn B. Maloney:
House of Representatives:
[End of section]
Enclosure I: Scope and Methodology:
To update our scenario that illustrates the potential loss of royalties
from leases issued in 1998 and 1999, we revised oil and gas prices
upward to $100 per barrel and $8 per thousand cubic feet. The
methodology is similar to that described below for leases issued in
1996, 1997, and 2000 under the Outer Continental Shelf Deep Water
Royalty Relief Act of 1995 (DWRRA).[Footnote 12]
To determine the fiscal impacts of price thresholds that may no longer
apply to oil and gas leases issued in 1996, 1997, and 2000 under the
DWRRA, we first met with Minerals Management Service (MMS) personnel in
the Economics Division in Herndon, Virginia. We reviewed their October
2004 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 that
they had generated the estimate in good faith. Since this estimate,
however, additional information became available, and we believed their
estimate needed to be updated. MMS concurred. Differences between our
current estimates and MMS's 2004 estimate are due to changes in oil and
gas prices, updated information on the size of deep water oil and gas
fields that have been discovered but are not yet producing, the growth
of oil and gas reserves over time, and the availability of drilling
rigs in the Gulf of Mexico. MMS updated its 2004 estimate to address
these issues and released this updated estimate in February 2008. We
also reviewed this estimate and similarly found that it followed
standard engineering and financial practices and was done in good
faith. During the course of our work, we visited MMS's Gulf of Mexico
regional office in New Orleans and interviewed engineers and geologists
about technical aspects of oil and gas production in the deep waters of
the Gulf of Mexico. In addition, we contacted industry representatives
for their opinions on oil and gas exploration and development in the
deep waters of the Gulf of Mexico.
Within MMS's Technical Information Management System (TIMS), we
identified all 3,401 leases issued under the DWRRA, 2,369 of which were
issued in 1996, 1997, and 2000. From this database, we were able to
identify the status of these leases, the extent to which they had been
explored and developed, and the production that had occurred on some of
them. As of April 2008, a total of 94 of the leases issued in 1996,
1997, and 1999 have produced, are currently producing, or are expected
to produce oil and gas in the future under DWRRA provisions. Ten of the
94 leases have either stopped producing or appear to be no longer
capable of producing significant amounts, 47 are still producing, and
37 are expected to commence production at some future time. As of
January 1, 2008, we estimate that about 135 of the additional 1996,
1997, and 2000 leases were still active but had not yet been tested for
oil and gas. We also collected pertinent information from TIMS, current
through September 2006, on the estimated reserves of leases that are
currently producing 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
updated these production data with additional production amounts
through December 2007 when these data became available. 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.
We considered 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. However, because only the sales price of $6.50 for natural gas
is expected to fall below price thresholds during the time frame of our
scenarios, this time is projected to be January 2024, and royalty
revenue from gas production after January 2004 is anticipated to be
less than 1 percent of total gas royalty revenue, we did not adjust
production volumes.
To project production from future discoveries on 1996, 1997, and 2000
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 will 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
for such deep water leases drilled from 1974 through 1995, which was 28
percent. Third, we scheduled the expiration dates of the 1996, 1997,
and 2000 leases for each year through 2010 and calculated for each of
these years the percentage of all untested deep water leases below 800
meters that would be 1996, 1997, and 2000 leases. We assumed 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 2008 through
2010, we assumed the number of field discoveries on 1996, 1997, and
2000 leases would be between zero and five. 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 an
estimated percentage of all deep water leases that will be active
untested 1996, 1997, and 2000 leases, and by also multiplying by the
assumed historical success rate of 28 percent. We doubled this number
in order to account for the average field consisting of two leases and
rounded the resulting high number to five. 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.
With these assumptions, we developed several scenarios that illustrate
that the potential for forgone royalties is highly dependent upon
prices and production volumes. We chose prices of $70 for oil and $6.50
for gas because these were in the range of common prices during late
2007. We also chose prices of $100 for oil and $8 for gas because these
prices are close to prices common in early 2008. We did not escalate
oil and gas prices over the time period of our scenario. 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, which we corrected in several instances when cumulative
production through December 2007 exceeded estimated reserves projected
in July 2006. Our high production assumption is equal to the sum of the
estimated reserves for each lease multiplied by its corresponding
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 zero discoveries,
and our high assumption is five discoveries. We did not multiply
production assumptions from future discoveries by growth factors, but
such growth is possible.
[End of section]
Enclosure II: Scenario Illustrating the Sensitivity of Forgone
Royalties to Changes in Future Production Volumes from 1998 and 1999
DWRRA Leases at High Oil and Natural Gas Prices:
Scenario 1 illustrates possible forgone 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.
This scenario updates the upper limit of prices chosen for our previous
scenarios that we published in April 2007. In those scenarios, we used
oil prices of $36, $50, and $70 per barrel and natural gas prices of
$4.50 and $6.50 per thousand cubic feet.
Scenario 1 uses an oil price of $100 per barrel and a natural gas price
of $8 per thousand cubic feet and retains these prices over the lives
of the leases (see table 1). We illustrate the forgone royalties with
both low and high volume estimates of future oil and gas production. In
this scenario, the productive time frame is from August 2006 through
the lives of the leases, which are about 25 years. In the low
production volume estimate, we use MMS's "ungrown reserve" estimates
and assume five additional leases are discovered to be productive in
the future. Our scenario results in $8.7 billion in forgone royalties.
This estimate increases to $14.7 billion in the high production volume
case, which uses MMS's "grown reserves" and 10 future discoveries.
Table 1: Scenario 1 Assumes That from 1998 and 1999 Leases, Oil Would
Be Sold for $100 per Barrel and Natural Gas Would Be Sold for $8 per
Thousand Cubic Feet.
Forgone royalties on future production from producing and producible
leases:
Ungrown reserves and five future discoveries: $7.3 billion;
Grown reserves and 10 future discoveries: $11.3 billion.
Additional forgone royalties on future production from leases with new
discoveries:
Ungrown reserves and five future discoveries: $1.4 billion;
Grown reserves and 10 future discoveries: $3.4 billion.
Total forgone royalties:
Ungrown reserves and five future discoveries: $8.7 billion;
Grown reserves and 10 future discoveries: $14.7 billion.
Source: GAO.
[End of table]
[End of section]
Enclosure III: Scenarios Illustrating the Sensitivity of Forgone
Royalties to Changes in Oil and Natural Gas Prices and Future
Production Volumes from DWRRA Leases Issued in 1996, 1997, and 2000:
The following two scenarios illustrate the range of possible forgone
royalties that could result if price thresholds are no longer
applicable to leases issued in 1996, 1997, and 2000.
Scenario 2 illustrates possible future forgone federal royalty payments
if price thresholds are no longer applicable to these leases during
times when oil and natural gas prices exceed the price thresholds (see
table 2).[Footnote 13] Specifically, we selected an oil price of $70
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
production time frame is from January 2008 through the lives of the
leases, which is about 25 years. In the low production volume estimate,
we use MMS's "ungrown reserve" estimates and assume that no additional
leases are discovered in the future. This scenario results in $15.1
billion in forgone royalties. The estimate increases to $27.2 billion
in the high production volume case, which uses MMS's "grown reserves"
and five future discoveries.
Table 2: Scenario 2 Assumes That from 1996, 1997, and 2000 Leases, Oil
Would Be Sold for $70 per Barrel and Natural Gas Would Be Sold for
$6.50 per Thousand Cubic Feet.
Forgone royalties on future production from producing and producible
leases:
Ungrown reserves and no future discoveries: $15.1 billion;
Grown reserves and five future discoveries: $26.2 billion.
Additional forgone royalties on future production from leases with new
discoveries:
Ungrown reserves and no future discoveries: $0;
Grown reserves and five future discoveries: $1.0 billion.
Total forgone royalties:
Ungrown reserves and no future discoveries: $15.1 billion;
Grown reserves and five future discoveries: $27.2 billion.
Source: GAO.
[End of table]
Scenario 3 illustrates possible forgone royalties with higher oil and
natural gas prices. Using similar assumptions on production volumes as
in Scenario 2, $100 per barrel of oil and $8 per thousand cubic feet of
natural gas yield $21.2 billion in forgone future royalties for the low
production estimate and $38.3 billion in forgone future royalties for
the high production estimate (see table 3).
Table 3: Scenario 3 Assumes That from 1996, 1997, and 2000 Leases, Oil
Would Be Sold for $100 per Barrel and Natural Gas Would Be Sold for $8
per Thousand Cubic Feet.
Forgone royalties on future production from producing and producible
leases:
Ungrown reserves and no future discoveries: $21.2 billion;
Grown reserves and five future discoveries: $36.9 billion.
Additional forgone royalties on future production from leases with new
discoveries:
Ungrown reserves and no future discoveries: $0;
Grown reserves and five future discoveries: $1.4 billion.
Total forgone royalties:
Ungrown reserves and no future discoveries: $21.2 billion;
Grown reserves and five future discoveries: $38.3 billion.
Source: GAO.
[End of table]
The $36.9 billion in forgone royalties on future production in table 3
is $15.7 billion greater than MMS's highest estimate of $21.2 billion
released in February 2008. About half of this difference is attributed
to the higher oil and gas prices we used in table 3. The other half of
the difference is because we anticipate greater reserve growth than
MMS.
[End of section]
Footnotes:
[1] These leases are covered under Section 304 of the act, which
applies to leases issued between November 28, 1995 and November 28,
2000. However, since no leases were issued in 1995, we refer to these
leases as DWRRA leases issued from 1996 through 2000.
[2] Royalty suspension volumes establish cumulative production volumes
above which royalty relief no longer applies. Royalty suspension
volumes vary according to depth, ranging from a minimum of 17.5 million
barrels of oil equivalent in water depths of 200 to 400 meters to a
minimum of 87.5 million barrels of oil equivalent in water depths
greater than 800 meters.
[3] By forgone royalties, we mean royalties that would be payable if
Congress had not authorized royalty relief under the DWRRA.
[4] Kerr-McGee Oil and Gas Corp. v. Allred, No. 2: 06-CV-0439, 2007
U.S. Dist., Lexis 83424 (W.D. La. Oct. 18, 2007).
[5] GAO, 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,
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-590R] (Washington,
D.C.: Apr. 12, 2007).
[6] One barrel of oil equivalent equals one barrel of oil or 5.62
thousand cubic feet of natural gas.
[7] As oil and gas reserves are developed and more knowledge of the
field is obtained, proven reserves generally experience some growth.
[8] 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 3 years. As such, we believe the
scenarios are reflective of plausible possibilities, but we do not
assign any probabilities to any of the scenarios.
[9] 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.
[10] It should be noted that if prices were to fall and remain at or
below $36.40 per barrel for oil and $4.68 per thousand cubic feet for
natural gas in real 2007 dollars, 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.
[11] See enclosure II in 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-07-590R.
[12] See [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-590R],
enclosure 1, page 8.
[13] In scenario 2, gas prices drop below price thresholds in the
latter years of the producing lives of the leases, but this revenue is
anticipated to be less than 1 percent of total gas royalty revenue.
[End of section]
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