Oil and Gas Royalties:

Litigation over Royalty Relief Could Cost the Federal Government Billions of Dollars

GAO-08-792R: Published: Jun 5, 2008. Publicly Released: Jun 5, 2008.

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Franklin W. Rusco
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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. 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.

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