A group of oil companies led by Chevron, which said last week that they had discovered a huge new oil field in the Gulf of Mexico, could avoid more than $1 billion in royalty payments to the federal government for the oil. The potential bonus to Chevron and its partners stems from a mistake the Interior Department made in signing offshore leases in the late 1990’s for drilling in federal waters … Chevron and its partners, Devon Energy and Statoil ASA of Norway, have six leases in the Jack oil field, about 175 miles off the coast of Louisiana. Two of the leases allow the companies to avoid royalties on as much as 87.5 million barrels of oil per lease. The benefit, known as royalty relief, was supposed to be halted if the price of oil climbed above $36 a barrel. But that restriction was omitted on all leases signed in 1998 and 1999, including the two held by Chevron and its partners. The exact value of the potential break on federal payments will depend both on the price of oil and how much of it comes from the two leases. At $70 a barrel, the Chevron group could save about $1.5 billion in royalties if the government agreed that both leases were contributing to Chevron’s production … The Chevron leases are the biggest, but hardly the only leases that allow oil companies to avoid royalties regardless of how high energy prices climb. Even before Chevron and its partners confirmed the discovery last week, the Government Accountability Office, the investigative arm of Congress, had estimated that the Treasury could lose as much as $20 billion over the next 25 years.
On the political side, Republicans might argue this occurred under Clinton’s watch – and it turns out that Congressional Republicans are as angry at the Interior Department as Congressional Democrats (if not angrier).
Back in November 2000, the CBO issued an interesting discussion entitled Reforming the Federal Royalty Program for Oil and Gas :
One-quarter of the nation’s crude oil production and one-third of its natural gas come from federal mineral leases. In recent years, oil and gas leases have generated federal revenues of between $5 billion and $6 billion a year, mainly in the form of royalties that leaseholders pay to the government as a percentage of the market value of the oil and gas they produce … The government assigns most federal oil and gas leases through competitive auctions, in which businesses bid an up-front payment (known as a bonus) and agree to pay rents on undeveloped lands and royalties on any future production. After production begins, the lessees pay royalties based on the market value of their sales, as reported each month to the Minerals Management Service. Federal lessees generally pay 12.5 percent (one-eighth) of the value of production from onshore leases and 16.7 percent (one-sixth) of the value from offshore leases as royalties. However, lower rates may apply for onshore production from marginally profitable fields and for offshore production from deep waters and certain largely unexplored areas of the Atlantic coast. In some cases, the government may even waive royalties on oil and gas from low-output wells if market conditions warrant. In recent years, the royalties paid by lessees have averaged less than 10 percent of the value of oil from onshore leases and 15 percent of the value from offshore leases … Federal lessees calculate their royalty payments as their proceeds from the sale of oil and gas, minus certain costs that the government allows them to deduct, times the applicable royalty rate. The calculation is not straightforward, however, because of the difficulty of estimating sales proceeds and deductible costs. Sales proceeds reflect the marketable volume of production from the lease site and the unit market value of the product (the value per barrel of oil or cubic foot of natural gas). Under current regulations, marketable product is oil and gas that is sufficiently free from impurities to be acceptable to a typical buyer in that region. Market value reflects the price that a competitive market would establish for the product. That value depends on the location of the market (the point of sale) and the quality of the product at the time of sale. The value may differ from the sales price, depending on the competitive relationship between the buyer and the seller … To ensure that the sales prices reported by lessees reflect a competitive market value, current regulations also consider the relationship between the market participants. If the buyer and seller have competing interests – that is, the sale is an arms-length transaction – and the transfer of ownership takes place at the lease site (or central accumulation point), MMS considers the market value to be the actual sales price. For crude oil, the actual price is often the posted price for the oil field. For an arms-length sale that takes place elsewhere, regulations provide two options for calculating royalty payments. One is based on an actual price for a reported competitive transaction in a nearby oil or gas field. The other estimates the value back at the lease site by deducting from the actual sales price the costs of moving the product from the lease site (or central accumulation facility) to the point of sale. Two-thirds of federal oil and gas is sold to marketers, pipelines, or refiners that are affiliated with the lessee and, hence, do not have competing interests. For those non-arms-length transactions, a new regulation published on March 15, 2000, requires that lessees impute a unit value at the lease site on the basis of prices published for regional spot markets, with discounts for differences in location and quality.
Two takeaways from this discussion: (1) the government is attempting to base royalties on the market value of the rights owned by the government; and (2) the government is aware that vertically integrated energy companies can game the system through transfer pricing manipulation. The appropriate royalty structure is an issue that transfer pricing economists (calling OldVet) might wish to ponder and I can see why one would wish to have no royalties if the price of oil fell below its production costs (e.g., $36 as a proxy?) – perhaps with a higher royalty rate imposed on the economic rents from oil extraction. But despite the efforts to insure companies such as Chevron pay the market price of the rights to these offshore oil fields, someone in the government found a way to give away a lot of taxpayer wealth to these energy companies.