BNP Paribas Fortis North American energy monthly - Virtual Metals

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BNP Paribas Fortis/VM Group October 2009 | BNP Paribas Fortis North American energy monthly | 5 Focus Analyst: Paul Hannon VM Group Tel: +44 20 7569 5930 Email: paul@vmgroup.co.uk RIP for RIK The principle that oil and gas companies should pay royalties promptly to the US government was underscored in mid-September when Interior Secretary Ken Salazar announced he was phasing out the royalty-in-kind program. With plotlines reminiscent of a television soap opera, the drama surrounding the US government’s controversial royalty-in-kind (RIK) program has finally come to an end. It took years of warnings about the systematic abuse of an innovative royalty system before Ken Salazar finally pulled the plug on what he described as a blemish on the good name of the Department of Interior (DOI). At the root of the scandal, officials at the DOI’s Minerals Management Service (MMS) were deemed to have suffered ethical lapses that resulted in the government being shortchanged by millions of dollars. As with any in-kind system, the MMS program operated on payments of physical oil and gas rather than cash as royalties for production on federal property. Furthermore it relied totally on the integrity of the producing companies to report accurately their output. Set up in 1992 on a trial basis, the RIK program grew rapidly because it simplified the way in which oil and gas companies paid the government its cut of their production. In effect, it shifted the administrative load from the producers to the bureaucrats and it expanded to the point that about half of last year’s $12bn in royalties paid to the US government was paid on an in-kind basis. Administered from headquarters in Denver, Colorado, the scheme became the subject of allegations that some employees were engaged in sexual and drug-related practices with members of the oil industry. Dirk Kempthorne, Interior Secretary at the time, expressed his outrage at the lapse in standards but kept the program intact. Growth in RIK oil volumes 135,000 Growth in RIK gas volumes 900,000 130,000 125,000 800,000 Barrels/day 120,000 115,000 MMBtu/day 700,000 600,000 110,000 105,000 500,000 100,000 2006 2007 2008 2009 400,000 2006 2007 2008 2009 Source: US Department of Interior/ Minerals Management Service Source: US Department of Interior/ Minerals Management Service The final nail in the coffin of the RIK scheme surfaced in mid-September when a report by the Government Accountability Office revealed that the program had not collected $21m due to it last year, while a separate report revealed that producers may have underreported drilling revenue and underpaid $160m in royalties during 2006-07. Using these reports as a lever, Salazar acted quickly and decisively. The American Petroleum Institute (API) saw the loss of up to $21m in a different light. API President Jack Gerard described the existing RIK program as “an effective means of ensuring that the American people receive fair compensation for development of federal resources” and termination of it ran the risk of raising administrative costs for companies to determine the value of oil
6 | BNP Paribas Fortis North American energy monthly | October 2009 BNP Paribas Fortis/VM Group and gas output. However in sidestepping the issue of possible deliberate underreporting Gerard is at risk of ignoring the new mood in Washington. Federal onshore royalty estimates FY 2009 FY 2010 FY 2011 FY 2012 FY 2013 FY 2014 Oil volume (million barrels) 105 104 103 102 100 97 Oil royalties ($m) 560 632 687 713 739 767 Source: US Department of Interior/ Minerals Management Service Discrepancies in totals may occur due to rounding. Federal offshore royalty estimates FY 2008 FY 2009 FY 2010 FY 2011 FY 2012 FY 2013 Oil volume (million barrels) 478 553 696 813 844 812 Oil royalties ($m) 2,971 3,875 5,316 6,445 6,867 6,773 Source: US Department of Interior/ Minerals Management Service Open to abuse Several times during recent years, the RIK program has been cited as an area open to abuse and any system that relies on the integrity of companies to report accurately their extraction of government-owned resources on federal property will always draw a small number of operators who are tempted to muddy the figures. No discussion about royalty schemes in the US is complete without mention of Jack Grynberg. Dismissed by many as a professional litigant, Grynberg has long maintained that huge swathes of the oil and gas industry in the US have systematically underreported their production levels on which they pay royalties to the government. Having decades of experience in the industry himself, 77-year-old Grynberg says he knows how production flow meters can be tampered with without detection and that manufacturing standards of meters are so lax that they represent an invitation to defraud the government. Grynberg has a multi-billion dollar lawsuit pending under the False Claims Act, which if successful means he could be awarded up to 30% of the damages awarded by a court. So far Grynberg has sued 300 oil and gas companies, including Shell and ExxonMobil, in 73 separate suits. He has won more cases than he has lost and in the process earned millions of dollars in out-of-court settlements. His most recent victory occurred on 30 th September when a Denver District Court confirmed that Colorado-based integrated natural gas company Williams Production had to pay Celeste Grynberg (Jack Grynberg’s wife) $2.4m plus legal costs for underreporting of gas volumes and overcharging for transport services. Whether you like him or loathe him, Grynberg has been one of the most consistent critics of metering and monitoring practices on leases administered by the MMS. Without constant badgering from him and other vigilantes on the royalty issue, it seems highly unlikely that Salazar would have decided that the RIK system was fatally flawed. Variable royalty rates When Salazar announced the demise of the RIK system, which House Natural Resources Committee Chairman Nick Rahall described as “opportunity for mischief”, he also spoke of the DOI’s intention of introducing a more flexible royalty structure that would have a higher royalty rate on relatively-easy-to-find oil and gas assets, but a lower rate for wildcatting in areas where oil and gas have not yet been discovered. Twenty years ago, wildcatters usually had a one-in-five chance of striking oil or gas, but even then the size of the deposit might not be adequate to justify actual
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