TESTIMONY OF
Cynthia L. Quarterman, Director
Minerals Management Service
Department of the Interior
Before the
Committee on Resources
Subcommittee on Energy and Mineral Resources
House of Representatives
May 21, 1998
Madam Chairwoman, I am pleased to return before the Subcommittee today to continue discussing issues related to royalty in-kind (RIK) programs for Federal oil and gas leases. First, I would like to offer some perspective on several issues that surfaced during the Committee March 19, 1998 hearing. I will then summarize our detailed analysis of H.R. 3334, which we provided last week.
I think it is important to recognize how far we have come in a short time in royalty management by providing some historical background on the reasons for the creation of the Minerals Management Service (MMS). As you know, MMS was created some 16 years ago. Prior to that time, the Department of the Interior (DOI) was repeatedly criticized for mismanaging the royalty program, because of its failure to collect potential underpayments of hundreds of millions of dollars in royalties every year. An independent Commission on Fiscal Accountability of the Nation’s Energy Resources (Linowes Commission) was formed to address those allegations. The Linowes Commission recommended creation of an independent royalty and minerals management agency to ensure effective accounting, production verification, royalty collection and enforcement. Accordingly, MMS was established and has since resolved all the issues identified by the Linowes Commission. In addition, along the way, MMS’s royalty management program has accumulated an enviable array of awards and commendations, including The President’s Council on Management Improvement Award for management excellence. Just this past month MMS reached the $2 billion mark in audit and compliance collections from companies who have underpaid their royalties.
It is necessary to refer to this historical context because at the time of MMS’s creation, the Linowes Commission urged that the "oil and gas industry should carry out its obligation, as lessee, to pay royalties in full and on time." This statement goes to the very heart of our concern with this Bill, which is that it disregards the Commission’s recommendation -- or more pointedly, its admonition -- by forgiving the oil and gas industry of its lease obligations to pay royalties in full and on time. By relieving the industry of their long-established obligations and denying the public of its rights under the lease, this legislation will return us to the days of when the public was not assured of getting fair market value for its mineral resources.
To fully understand the current debate, I believe that we must look back at the original bargain struck between the United States, as custodian of the public’s lands, and the oil and gas industry, as lessee. In that bargain, the United States entrusts oil and gas lessees with the right to explore for, develop, and produce minerals from federal lands. The lessee benefits by retaining most of the mineral proceeds from those lands. In exchange, the lessee agrees to care for those lands and return to the United States a small portion of the proceeds in value or in-kind, whichever the government prefers. In addition, the lessee agrees contractually to be bound by the government’s reasonable determination of what that value is. To eliminate the government’s choice in royalties would deny the public its rights under the lease and, ultimately, return less than the fair value due and owing.
It is instructive to look at an illustration of why that happens under this Bill:
First, a 100 percent royalty in-kind program forces the government to accept oil and gas in those circumstances where everyone agrees we would lose money compared to accepting royalties in value. In accordance with the Administration’s initiatives to run government more like a business, MMS has begun to identify the conditions under which it is prudent from a financial or business standpoint to exercise its lease contractual rights to take royalties in-kind. The Texas General Land Office recently informed the Subcommittee that it follows the same policy. This is simply the most responsible and businesslike way to proceed. To do otherwise would abdicate our stewardship responsibilities over the public’s land. Where it is not prudent to take royalties in-kind, we will simply continue to require lessees to honor their obligations to pay royalties in-value pursuant to their lease contracts with the United States.
Second, this legislation relies on an unproven premise that aggregating crude oil volumes taken as in-kind royalty would enhance royalty revenues, including revenues from leases with de minimis production. Contrary to that premise, MMS has been told repeatedly by many producers that aggregating crude oil does not significantly enhance value, and we concur in that assessment. As Phillip Hawk of the EOTT Energy Corporation testified last month, crude oil value depends on a long list of characteristics related to individual properties. It is precisely such an assessment that makes us move cautiously when choosing which properties to include in -- and which to exclude from -- an oil royalty in-kind pilot. Aggregation of de minimis volumes could theoretically increase value, but the administrative costs of taking small volumes from numerous leases would almost certainly more than offset any revenue enhancement. That is probably why the Texas General Land Office does not take royalties in-kind from wells producing less than 10 barrels per day and why the Alberta crude oil RIK program requires the producer to bear those administrative costs. Most of our onshore Federal oil leases are de minimis leases, and most also have low royalty rates. Therefore, we may be forced to take one-half a barrel or less of royalty oil per day from thousands of leases at large administrative costs. Since MMS or its marketer would be only aggregating 10% or less of the volumes taken from these de minimis leases, MMS necessarily must do at least 10 times the cost per unit to realize the same revenues as the producers. This is simply not cost effective. In these situations, it would be virtually impossible to obtain a revenue gain over what the producer, who owns and transports over 90 percent of the production, obtains. The risks to royalty revenue and the costs that reduced oil and gas revenue to the government will also reduce annual state revenue sharing of oil and gas revenues. H.R. 3334 shifts to the taxpayer extend to all Federal oil and gas producing areas.
Last week, we provided the Subcommittee a detailed analysis of the bill. Before answering any questions, I would like to briefly summarize our conclusions concerning the bill.
MMS ANALYSIS OF H.R. 3334
In summary, this Bill would drastically reduce the options and legal rights of the Federal Government as mineral lessor and hinder the Government in its duty to assure a fair return to the public for its oil and gas resources.
Ambiguities and vagueness in many areas of the Bill make it difficult to discern exactly how certain provisions operate. Certain provisions of the Bill, such as those addressing transportation cost reimbursements, will maximize costs to the Government and reduce royalty revenues commensurately. We estimate that the Government’s costs of just storing processing and transporting the oil and natural gas to the buyer, as proposed in the Bill and which are now the responsibility of the lessee, are at a minimum in the hundreds of millions of dollars per year, while the administrative cost savings are less than $8 million per year in the first 8-1/2 years. Our estimates for potential revenue effects vary from negative numbers to tens of millions in theoretically possible gains. However, any such potential revenue gains can be realized without this legislation. MMS's existing right to take royalties in-kind and our capability to do so -- being developed through our RIK pilot programs -- allows us to realize all of the possible revenue gains for the taxpayer without the costs associated with this legislation, and without revenue losses from areas where RIK is not a feasible option. Thus, as I testified earlier, H.R. 3334 will have a substantial negative annual cost impact on the Treasury and will not enhance revenue compared to current statutory authority.
It is also important to note that our analysis of the costs associated with this Bill are very conservative and do not include a number of clearly negative provisions that we could not quantify in the time available. In contrast, the administrative cost savings figures used in the analysis are very liberal because they do not take into account the costs necessary to start up and implement the royalty in-kind provisions of the Bill. Additionally, the costs of contracting, overseeing, and auditing qualified marketing agents (QMA) under this Bill could easily wipe out the $8 million in cost savings. Another $6.2 million in revenues could also be lost through the net receipts sharing provisions of the bill. Since the Bill does not explicitly rule out potential QMA conflicts of interest situations, our auditing and litigation costs are likely to increase. The opinion submitted by the Department of Justice (DOJ) on this Bill to the Office of Management and Budget (OMB) agrees. Finally, the potential revenue enhancements figures used in the analysis are extremely generous because we assume ideal conditions for this royalty in-kind program despite provisions of the Bill which provide the opposite.
The following summarizes the major issues that concern the Department with respect to H.R. 3334.
1. Mandatory Royalty in Kind
The Bill requires the Government to take royalty volumes of both oil and gas in-kind for all Federal leases onshore and offshore. Requiring RIK for all Federal oil and gas production virtually guarantees revenue losses because:
o The value of the current option of taking in-kind and taking in-value in areas where each are economically justified is eliminated.
o Taking de minimis volumes of production in remote areas is administratively inefficient and will be a revenue loser compared to the current system.
o Oil and gas markets in some regions are limited and oversupplied. Adding another major player to such markets without infrastructure will not add value.
2. Imposition of a Rigid Statutory System
H.R. 3334 would impose a rigid "one size fits all" statutory scheme that eliminates the ability of the Executive Branch to use its existing RIK authority to develop jointly with affected parties a flexible system that works best for individual areas/situations. Just a few examples of the Bill’s inflexibility are:
o Sales would only be made by marketing agents, precluding direct sales to Government facilities without marketing agent involvement and costs.
o No provisions exist to address when no bids or unacceptable bids are submitted.
o State in-kind programs for just the State’s share are not allowed.
3. Technical Provisions
H.R. 3334 contains a variety of technical requirements for gathering, transportation, treatment, and processing that in sum transfer obligations to the Government and increase many of the costs and responsibilities historically borne by producers.
a. Marketable condition
The Bill would replace the current requirement for lessees to place production in a condition acceptable to purchasers with a requirement for acceptance by transporters. This is a significantly less stringent condition that would now require the U.S. to begin paying for sweetening, treating, and conditioning services. The initial transporter is often owned by the lessee or its affiliate. Thus the Bill creates the potential for the lessee to self-define marketable condition.
b. Gathering
Although the distinction between gathering and transportation in the Bill is confusing, the overall effect will be to move the dividing line between gathering and transportation closer to the wellhead, thereby shifting costs from producers to the Government. It appears that under the Bill all movement is transportation (i.e., costs borne by the Government) except movement of bulk, unseparated production on the "lease premises." Approximately 25% of offshore and 50% of onshore crude oil movement and 10% of offshore and 25% of onshore natural gas movement upstream of the royalty meter now paid for by lessees would be paid for by the U.S.
c. Transportation
The Bill would require the U.S. to begin paying for transportation of non-royalty-bearing substances (e.g., water) in bulk production volumes moved from the lease. Movement of bulk production downstream of the lease is a growing phenomenon that would require the U.S. to assume an increasingly large cost burden compared to today. Further, the rates that the U.S. would be required to pay for transportation under the Bill would also increase dramatically compared to those currently paid by lessees. The U.S. would in some cases be required by the Bill to pay the highest rates charged to third parties.
d. Processing/Treating
Taken together with a redefined "marketable condition," the Bill would shift to the Government much of the cost of cleaning, decontaminating, and other field services. Further, the substantial amount of production currently processed by lessee’s affiliates at actual (relatively low) costs would be processed at much higher, commercial rates under the Bill.
e. Marketing
All costs to market oil and gas production would be assumed by the U.S. under the Bill, whereas, under the current royalty system, these costs - which are substantial - are now borne by lessees. Ironically, the Bill would actually create marketing costs (to be borne by the U.S.) in many cases where there now are currently no such costs (e.g., for the substantial volumes of crude oil production simply moved from major producers to their own refineries).
4. Negative Revenue Impacts
H.R. 3334 will have a substantial negative annual impact on the Treasury. Specifically, we estimate increases in costs to the U.S. at a minimum of between $183 million and $368 million per year, depending on assumptions used. This estimate is comprised of the following items, summarized in the charts you see before you:
1. Transportation: Government costs would increase due to the assumption of payment for gathering, and to increases in the price paid for transportation. The total increased cost to the U.S. ranges from $77 to $136 million annually.
2. Processing: Costs will increase some $4 to $8 million annually due to payment of higher commercial rates rather than the lessee’s actual costs.
3. Treatment: Government costs will increase due to the assumption of field treatment processes beyond the delivery point, estimated at $85 to $178 million annually.
4. Marketing: Costs will increase some $17 to $46 million per year due to Government assumption of marketing costs.
These cost increases, plus several additional relatively minor cost increases, are offset by only a maximum of $7.3 million in annual administrative savings and $36 million in maximum theoretical annual revenue uplift due to RIK implementation. Again, we can realize any revenue uplift from RIK without this legislation, and its substantial costs, under current authorities, using a more deliberate approach.
Other provisions of the Bill having negative revenue impacts which we could not quantify because of the many unknowns associated with them include:
The requirement that the Government must offer 40 percent of royalty oil to eligible small refiners at the lowest prices prohibits the Government from receiving the highest and best price for 40 percent of royalty oil. This requirement alone almost completely undercuts the assumption on which the Bill’s proponents’ claims of increased revenues are founded.
Increased litigation costs. The Department of Justice believes that H.R. 3334 may impose serious new litigation burdens on it.
Imbalance provisions that are biased heavily in favor of the producer.
Price manipulation between a QMA and its affiliate.
CONCLUSION
From the above comments, it should be clear our position on the Bill remains unchanged from our 3/19/98 hearing statement. You have also heard concerns about this legislation expressed by officials from the States of Texas and New Mexico. DOI staff and I have also heard negative comments from officials in Louisiana, California and Alaska. We believe the time has come to agree to a more productive course in our mutual desire to improve royalty management systems and to experiment with royalty-in-kind options.
In this spirit, I would like to reiterate our request that people directly involved in oil and gas production, marketing, and accounting, rather than lobbyists or lawyers, both advise MMS on its pilots and offer independent opinions to the Subcommittee as we all explore how we can best use the RIK option to everyone’s advantage.
This concludes my prepared remarks. I would be pleased to answer any questions you may have.