Background

In 1975, the State of California and the City of Long Beach pursued litigation (hereinafter referred to as Long Beach I) against seven major oil companies operating in California. They alleged that these companies had conspired to keep posted prices low and that they had been damaged because their oil revenues depended on posted prices. Historically, posted prices were widely accepted as market value by both producers and refiners as well as by both the State and the Federal Government for royalty purposes. Private royalty owners also typically utilized posted prices to measure market value.

In 1984, the U.S. District Court for the Central District of California granted summary judgment dismissing the allegations of conspiracy in Long Beach I. Later in 1986, the State of California and the City of Long Beach filed a second lawsuit (Long Beach II), which alleged that six oil companies violated various state laws by using posted prices that did not reflect real market values and refusing to operate their pipelines as common carriers. During that period, MMS contacted State of California officials and others to obtain information on the State's allegations of improper valuation. After reviewing that information, MMS did not find evidence of under pricing. The basis of MMS's decision not to join in Long Beach II or begin its own investigation was the fact that the State and City had been unsuccessful to that point in their claims against the companies.

Shortly thereafter, the General Accounting Office (GAO), Arthur D. Little (under contract with the Internal Revenue Service (IRS)), and the Department of Energy (DOE) conducted similar studies and reviews to determine whether California posted prices reflected market value. In addition, the Justice Department (DOJ) considered whether to pursue antitrust violations against the companies. These agencies found that occasionally there were differences between posted crude oil prices the major oil companies used to pay some producers and the prices of crude oil sold at auction. The MMS, GAO and IRS did not conclude that posted prices did not reflect market value; however, the DOE study raised questions about the higher levels of refining profit margins in California. None of the studies contained conclusive evidence of illegal activities or undervaluation. The IRS and MMS concluded that, because the posted prices were utilized in many arm's-length transactions by parties unaffiliated with the posting companies, posted prices appeared to reflect market value. The GAO did not dispute that conclusion. DOJ chose not to pursue an investigation.

By 1991, following the Ninth Circuit's reversal of the District Court's summary judgment order, six of the companies involved in the Long Beach litigation (ARCO, Shell, Chevron, Mobil, Texaco, and Unocal) reached settlements to end court actions alleging undervaluation on State and City leases as well as other issues relating to pipelines . A seventh defendant, Exxon, went to trial. On January 31, 1995, the Ninth Circuit upheld the U.S. District Court for the Central District of California ruling in favor of Exxon in a law suit covering 1971 to 1977. Another appeal covering a later time period is still pending.

During the late 1980's and early 1990's, the Minerals Management Service (MMS) and, under its delegated audit authority, the State of California Controller's Office, have conducted routine audits of the same companies' payments on Federal leases in California. The audits have addressed a wide variety of issues for periods back to the late 1970's. Because the records reviewed by the auditors were not necessarily conclusive in establishing that posted prices actually refelected market value, the issue was generally left open.

In 1993, the MMS was asked by the Department of the Interior's Office of Policy Analysis to reevaluate the issue in light of the State of California's and the City of Long Beach's settlements. The MMS initially reviewed the amount of potential underpayments to determine if it was worth a major reevaluation. MMS also contacted the IRS to access records that IRS had obtained during its investigation. However, the IRS would not release its records unless there was a Federal criminal investigation. Since the MMS had no apparent basis for criminal action, it did not obtain the IRS records. Additionally, MMS requested help from California in obtaining access to the documents in Long Beach II. These documents, however, were not available to MMS, as they were sealed by the court. Using estimates from the State of California's legal counsel and their consultants, MMS estimated that underpayments could be as much as $422 million (excluding interest) for 1960-1992. This scoping exercise was the basis for MMS's decision to reevaluate its 1986 conclusion not to pursue this issue further.

MMS began its reevaluation in early 1994 by examining publicly available data for the period 1986-1992. That period was initially evaluated and preliminary conclusions were reached in April 1994. MMS shared its preliminary conclusions with the State of California. The State suggested and MMS agreed that MMS should review data under court seal in the California litigation before concluding its evaluation.

In June, 1994, MMS formed an interagency task force with some of the agencies that had reviewed the matter previously -- DOE, DOJ and the Department of Commerce. The purpose of the task force was to obtain any additional data that would enable a final determination to be made regarding whether the major oil companies wrongfully undervalued crude oil from Federal leases. An important source of information was the court-sealed documents, which had been subpoenaed from companies involved in the Long Beach II litigation. The team was able to gain access to the materials by signing a confidentiality agreement with the companies involved in that litigation.

Those documents, which reflected activities that occurred between 1980 and 1989, showed that California crude oil pricing practices required closer scrutiny. The task force recommended that a special audit be performed to determine if Federal lessees in California received revenues above posted prices that should be subject to royalties. This proposed special audit would differ from conventional audits because it would look beyond intracompany transactions that occurred at posted prices to determine whether any additional revenues may have been received by an affiliate in a later transaction. Previous audits generally relied on posted prices.

However, during several previous audits, MMS had ordered major oil companies in California to provide its affiliates' records to ensure that royalties were paid on gross proceeds. These oil companies refused and filed administrative appeals. In one of these cases, the Interior Board of Land Appeals (IBLA) held that MMS was not entitled to review the affiliates' records.

Before MMS could gain access to records of transactions of oil companies' affiliates, it was necessary to request that the IBLA reconsider the decision that prevented MMS from obtaining affiliate records. Upon reconsideration, IBLA held on May 11, 1995 that MMS may access third-party sales records. That decision is currently under appeal in the District Court for Delaware. The IBLA's decision should enable MMS to better evaluate total proceeds received by integrated firms and make better-informed judgments about oil valuation in general.

The special audit plan was developed by MMS audit staff in consultation with the California State Controller's Office. The special audit included examination of two companies' Federal oil production in California for three, one-year periods. The auditors looked beyond posted prices to determine whether those companies were receiving premiums above postings and paying royalties based on postings.

While MMS was conducting the special audit, team members also performed a more detailed review of the court-sealed documents. The team discovered that most of the oil in California moves internally within the major oil companies, and that premiums above posted prices were often paid in arm's-length transactions. These findings were confirmed by the MMS special audit.

The results of that special audit were utilized by the task force in formulating its recommendations. In addition, the MMS retained two private consultants to provide additional information on undervaluation of California crude and the value of Alaska North Slope (ANS) crude compared to California crude.

In December 1995, the team briefed the Assistant Secretary for Land and Minerals Management, Bob Armstrong and me on options for addressing the royalty undervaluation issue, ranging from simply modifying the oil valuation regulations prospectively to valuing past oil royalties in California at a price comparable to that of imported ANS crude oil. The Assistant Secretary and I asked the team to develop a final report including recommendations.

Recommendations of the Interagency Task Force

The interagency task force delivered its final report on May 16, 1996. In accordance with the confidentiality agreement covering the Long Beach documents, the final report was sent to companies involved. Congress was provided with copies of the task force report on May 21, 1996, and the report was made publicly available on May 30, 1996. Let me briefly summarize the task force recommendations.

All task force members unanimously recommended that:

The oil companies undervalued crude oil produced from Federal leases onshore and offshore in California; MMS should concentrate collection efforts on those ten companies producing at least 90% of Federal crude oil in California; MMS should compute royalties owed based on premiums paid on arm's-length contracts for oil produced from the same field or area for periods starting with the effective date of MMS's most recent valuation regulations, March 1, 1988; and MMS should modify its oil royalty valuation regulations to place less emphasis on posted prices.

The task force did not reach consensus on a recommended approach for periods prior to March 1, 1988. The representatives from the Departments of Energy and Commerce recommended valuing California crude oil based on ANS prices beginning with 1980. The Interior representatives recommended that the task force's approach be used for all periods and suggested MMS and Department of the Interior management decide how far back to pursue collections.

The DOJ did not participate in writing the task force's final report. The DOJ representative left the team in late 1995 because its member believed its input related only to antitrust issues, and the team did not foresee action on that basis.

Crude Oil Royalty Valuation Nationwide

In 1988, MMS revised its oil valuation regulations after a long and complex process, which involved States, Indians, industry, and other interested parties. The intent was to clarify and reorganize the regulations, provide valuation criteria resulting in reasonable values, and create more certainty in royalty payments that would correct some of the royalty deficiencies of the past. Although the new regulations provided much more detail than the old ones, the basic principle stayed the same: royalty value is to be based on not less than the gross proceeds accruing to the lessee.

Under the 1988 regulations, royalty value depends on whether the Federal production is disposed of at arm's-length. If so, the proceeds under the arm's-length contract generally represent royalty value. If not, a series of non-arm's-length "benchmarks" represent royalty value. These benchmarks rely heavily on arm's-length posted or contract prices. But, in no case is the lessee's royalty value to be less than its gross proceeds. This means, for example, that if a lessee is reimbursed for a service that it is required to perform at no cost to the lessor (e.g., gathering), its royalty value should be increased by that amount. Furthermore, in general, premiums would be part of gross proceeds.

Under both the current and prior regulations, industry posted prices were relied on heavily as royalty value indicators because traditionally they were thought to represent the purchase prices offered for oil from a particular location. But in recent years, various studies by the Department of the Interior and others have led us to question the continued validity of posted prices as royalty value. This is particularly important where crude oil moves internally within major companies and royalties are paid based on postings. Typically, companies have taken the position that the first intracompany transaction, which often is at a posted price, should govern royalty value under MMS's regulations.

However, since the regulations require that royalty be based on not less than the lessee's gross proceeds, MMS has been seeking records of affiliate sales to third parties where the first movement of Federal crude is between affiliates. The first arm's-length transaction may represent the lessee's true gross proceeds, or at least contribute to the gross proceeds determination. Companies generally have resisted MMS's attempts to obtain these records, but several recent IBLA and court decisions have all supported MMS's right to review such records to aid in valuation determinations.

MMS has also begun to address continued regulatory reliance on posted prices in Federal oil royalty valuation. Last December, Assistant Secretary Armstrong signed an Advance Notice of Proposed Rulemaking that was published in the Federal Register (60 F.R. 65610 (December 20, 1995)), which sought input on crude oil valuation. Specifically, we asked whether commentors believed oil posted prices represent market/royalty value and, if not, what alternative valuation methods would be appropriate.

We received a variety of comments from states, industry, Indians, and individuals on this matter. States, Indians, and individuals generally stated that postings do not represent value and that some form of index pricing would be preferable. Industry comments were limited, primarily because of non-Federal litigation they are involved in related to posted prices throughout the country. They generally stated postings represent value, and asked that MMS delay any rulemaking effort until their litigation is completed.

Next Steps

As I mentioned previously, the task force submitted its final report to Assistant Secretary Armstrong and me on May 16. We are reviewing the team's recommendations to plan appropriate follow-up actions. However, because the team differed on a few key recommendations, we cannot immediately implement all of the interagency team's recommendations. We also need to confer with our Solicitor's Office and the DOJ so as not to affect adversely other potential royalty collections. Although we have not yet committed to a specific course of action, please be assured that we will implement an aggressive, comprehensive plan as expeditiously as possible.

As I also mentioned earlier, we have received comments from various parties regarding the Advance Notice of Proposed Rulemaking and possible changes to our oil royalty valuation regulations. We are currently evaluating options for new regulations that provide alternatives to posted prices to value Federal oil. Regardless of whether industry is willing to participate in a joint rulemaking effort with MMS, states, Indians, and others, we will proceed expeditiously to revise MMS crude oil valuation regulations.

Current MMS oil valuation audit policy conforms with the existing regulations, but we plan to look beyond posted prices to insure that royalties are properly paid. That is, valuation of arm's-length contracts will be determined by the sales contract and revenue accounts representing revenues actually received. Any differences between posted or contract prices and revenues actually received may represent premiums paid for valuing crude oil production, and royalty value will include this additional revenue or any other revenue that is part of gross proceeds to the lessee. Often this will mean that MMS will have to obtain records of affiliate sales to third parties and not rely on intermediate transactions between affiliates. In valuing oil not sold at arm's-length, royalty value is determined by using the first applicable regulatory benchmark. This usually means reliance on arm's-length posted or contract prices for significant quantities of production sold in the field or area. The total consideration received must be determined; royalty value cannot be less than the lessee's gross proceeds. Furthermore, we will insure that any premiums are included in the arm's-length contract prices relied on to value non-arm's-length production. We are currently auditing company records covering the last six years and will apply these new guidelines to those periods.

In closing, let me state that the Department of the Interior takes its responsibility to manage public resources very seriously. MMS will aggressively pursue any instances in which oil has been undervalued in California or elsewhere.

Mr. Chairman, this concludes my prepared remarks. However, I would be pleased to answer any questions you or Members of the Subcommittee may have.

• (621K) - Table of Contents through Page 12 (Overview & Executive Summary)
• (797K) - Pages 13 - 31 (History of Issue/Interagency Team & Summary of Team Activities)
• (775K) - Pages 32 - 51 (Summary of Team Activities, continued & Team's Overall Findings)
• (732K) - Pages 52 - 71 (Recommendations)
• (605K) - Pages 72 - 88 (Recommendations, continued)
• (927K) - Appendices I - III