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COLUMN-U.S. oil and gas royalties at high risk of misreporting: Kemp
April 10, 2013 / 2:40 PM / in 5 years

COLUMN-U.S. oil and gas royalties at high risk of misreporting: Kemp

(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, April 10 (Reuters) - Collection of royalty payments from production of oil and gas on federal lands is one of the government programmes most at risk from fraud, waste and mismanagement, according to congressional investigators.

“The Department of Interior does not have reasonable assurance that it is collecting its share of revenue from oil and gas produced on federal lands, and continues to experience problems in hiring, training and retaining sufficient staff to provide oversight,” according to the Government Accountability Office (GAO) in a report sent to Congress.

Royalty collection is one of just 30 functions from across the federal government on the 2013 High Risk List compiled by GAO, headed by the comptroller and auditor-general, and often called the “congressional watchdog” for its role in highlighting waste, fraud and inefficiency in federal agencies and programmes.

Other programmes named and shamed on this year's list include contract management at the Defense Department, protecting federal government computers from cyber attacks, and restructuring the troubled finances of the U.S. Postal Service (here).

GAO has published the list every two years since 1990 to coincide with the start of each new Congress, with the aim of focusing policymakers’ attention on programmes the agency judges present an especially great danger of waste and fraud, or most in need of transformation.

Just 55 programmes have appeared on the list since 1990, and 23 have been removed after problems were rectified. Typically it takes 5-15 years for the government to make sufficient progress to convince GAO to remove a programme (though Defense Department and NASA procurement, as well as Medicare and tax enforcement are hardy perennials and have remained on the list since the beginning).

Normally, GAO puts programmes on the list if amounts of at least $1 billion are considered at risk.

Management of federal oil and gas resources first hit the red list in 2011, following the Deepwater Horizon disaster and persistent concerns about the verification of production and collection of royalties by the Minerals Management Service (MMS) (offshore) and Bureau of Land Management (BLM) (onshore).

The MMS has since been reorganised into three separate separate functional agencies: the Bureau of Ocean Energy Management (BOEM) (responsible for leasing), the Bureau of Safety and Environmental Enforcement (BSEE), and the Office of Natural Resources Revenue (ONRR).

But congressional investigators remain deeply concerned about high-levels of staff turnover, inadequate production audits and lack of assurance that the proper royalties are being paid.

THE GOVERNMENT‘S DIME

The federal government collected $10 billion in both fiscal 2010 and fiscal 2011 in oil and gas royalties. It receives money from more than 28,000 leases, and petroleum royalties are one of the largest sources of non-tax revenue.

Under lease terms, producers must submit monthly reports specifying their output (and its division between oil and gas) as well as royalties due. The government conducts detailed audits and more routine compliance reviews to check the accuracy and reasonableness of the data.

In addition, BLM and BOEM inspectors conduct onsite checks (typically reading oil and gas meters and verifying their calibration) and review production records.

But in 2008, GAO warned data management problems and reliance on self-reported data were putting revenue collection at risk.

Interior Department agencies were not conducting the annual checks on all leases producing “significant” amounts of oil and gas required by law, according to GAO, in part because they could not cope with the increased amount of drilling and because staff were still dealing with clean up following hurricanes Katrina and Rita.

“Officials ... told us that some inspection and data-entry staff are relatively inexperienced and do not always record the inspections in their databases as procedures require,” GAO wrote. In many instances, GAO found agencies relied on self-reported or third-party documents to see if production data looked “reasonable” without carrying out detailed verification to ensure they are accurate.

In Colorado, Montana, New Mexico, Utah and Wyoming, which have more than 95,000 wells on federal lands, only 8 of 24 BLM field offices had carried out all the annual checks required on high-producing leases or those which have a history of reporting violations, according to the 2008 report. Offshore inspectors met targets just once between 2004 and 2008. Onshore inspectors achieved their targets only about a third of the time over a 12 year period.

In 2010, GAO warned the “Department of Interior’s oil and gas production verification efforts do not provide reasonable assurance of accurate measurement of production volumes.” GAO made 19 detailed recommendations for improvement, of which the Interior Department accepted 16 and partially agreed with the remaining 3. But so far just 5 have been implemented.

Interior agencies are struggling to hire and retain skilled geophysicists, geologists and petroleum engineers. Low pay compared with the private sector and the high cost of living in energy boom towns have all contributed to turnover problems.

In 2012 and 2013, Congress provided extra money to raise minimum pay rates for offshore inspectors in the Gulf of Mexico by up to 25 percent for key positions. But hiring remains difficult. There is no long term funding for higher salaries. Nothing similar has been done to authorise or fund higher pay for onshore inspectors.

GUESSTIMATING ACCURATELY

It is impossible to measure oil and gas production with 100 percent accuracy; both producers and regulators rely on a variety of estimating and metering techniques to produce estimates.

The important thing is that estimates should be free from bias and should not consistently over-estimate or under-estimate production. Given that royalties are assessed on the marketed value of production, it is vital for regulators to check the natural tendency to under-report volumes.

It is also vital that the quantities of dry natural gas (methane) and natural gas liquids (ethane, propane, butane and natural gasoline) are correctly recorded. Liquids have a much higher value so royalties owed on them are significantly higher.

With the growing output of natural gas liquids from wet gas plays, and the six-fold gap between gas and oil prices (on an energy content basis), it is more important than ever to measure liquids production accurately.

However, GAO found significant inconsistencies in the way the different Interior agencies measure oil and gas production offshore and onshore, as well as between different field offices of the same agency. The agencies have struggled to get access to meter readings on dry gas and liquids from natural gas processing plants.

There have been inconsistent approaches to approving requests from commingling. Production from several different leases may be combined for metering purposes, measured on a unified basis, then allocated back to the individual leases. Commingling can cut down on metering and is often advantageous for producers and may be encouraged by regulators, but it also makes accurate measurements much harder.

GAO has also found agencies confused about their respective roles. In 2009, BLM admitted it had not inspected meters or checked volumes at natural gas plants because it assumed this was the responsibility of MMS, which was not checking either.

“When we discussed gas plants with BLM staff at field offices, some petroleum engineer technicians did express some concern about the accuracy of royalty payments based on how products were both handled and measured downstream beyond the BLM’s point of measurement,” GAO wrote in 2010. “However, most BLM staff were not concerned because they considered anything past their point of measurement beyond their jurisdiction.”

BLM staff have been so busy supervising drilling of new wells, and coping with hiring and retaining inspectors, they have insufficient time to complete all the inspections required by law. An official at one field office told GAO in 2010 it was “de facto” policy not to complete production inspections. The number of meter readings and tank-gauging operations witnessed by BLM inspectors has been falling for the last decade.

The Interior Department is working with GAO to address the shortcoming identified in 2008 and 2010. A progress review is currently underway. But the GAO is still waiting to be convinced. Accurate production reporting and royalty collection therefore remains at the top of the federal auditor’s concerns and high on the congressional radar.

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