Greasing the Deal: A Royal(ty) Scam

by Mandy Smithberger

In many U.S. states, if you drive away from a gas pump without paying for filling your tank, you face fines, jail time and a suspension of your driver’s license. At the very least, someone from the gas station is going to try to stop you. Big Oil and gas station owners expect to be paid for the gasoline they provide.

But the oil companies may be looting U.S. government-owned oil and gas reserves on a far greater scale than any miscreant driver — while suffering at most minimal penalties and no criminal sanctions. In some cases, the companies are sneering at the government for technical mistakes in their contracts, and refusing to pay billions in royalties they would otherwise owe.

In 2002, the Project on Government Oversight (POGO) identified more than $11 billion in lawsuit settlements that the oil and gas industry had reached with states, tribes, the federal government and private parties concerning royalty underpayments. “Dozens of cases involving gas and oil royalty underpayments illustrate that a variety of players in the oil and gas industry may be engaged in widespread oil and gas royalty fraud,” says Beth Daley, director of investigations for POGO.

Now new evidence is emerging of similar underpayments in the period since 2002, aided and abetted by managerial irresponsibility at the Minerals and Management Service (MMS), an agency housed in the Department of Interior. MMS’s collections from its auditing and compliance division have declined in recent years — in the four years from 2002 to 2005, MMS’s auditing and compliance program collected an average $48 million annually, less than a third the average $176 million collected annually in the 1990s. Top MMS officials are allegedly pushing tough auditors out of their jobs, forcing them to try and recover monies for the government in their personal capacity.

To top it off, a mistake in hundreds of government leases with oil companies, discovered in 2000, remains unfixed, and could cost taxpayers billions over the next two decades.

A Multibillion Dollar Mistake

Perhaps the most significant single cause of concern — and surely the most egregious abuse — is deep-water oil leases in the Gulf of Mexico. In the late 1990s, the federal government signed more than 1,000 leases allowing oil companies to drill in the Gulf. Due to the expense and risk associated with deep-water drilling, the U.S. government agreed not to collect its standard royalties of 12 to 16 percent. When leases are competitively bid, the federal government sometimes collects in excess of 35 percent as the royalty.

However, the deep-water leases were supposed to include a provision requiring companies to pay royalties if oil prices rose above $36 a barrel. This provision was mistakenly omitted from the leases.

With oil prices skyrocketing, the error is already estimated to have cost taxpayers $1.3 billion in royalties. In March, the Government Accountability Office (GAO) estimated that the cost to the federal government over the next 25 years will be at least $20 billion.

Some members of Congress have tried to pressure the Interior Department to demand the royalties. “The money belongs to the federal government and must be collected,” wrote Reps. Tom Davis, R-Virginia, and Darrell Issa, R-California, in a September letter to Interior Secretary Dirk Kempthorne.

But Interior officials say that they have no legal recourse and therefore have no plans to recover that money. They do say they are trying to negotiate changes in the leases so that royalty payments would be required in future production under the 1998-99 leases. Discovered in 2000, the error remains unremedied.

The industry says that companies should have the choice about whether to re-negotiate the contracts and remedy the errors. “We think negotiations over the exiting  lease should be voluntary, with the agreement of all sides to enter into negotiation,” says Bill Bush, spokesperson for the American Petroleum Institute. “In general, we think these  agreements should be voluntary. This is a matter between individual companies and the government. Some companies have entered into  agreements with the MMS, and this demonstrates that agreements can be  reached on a voluntary basis.”

Department of Interior Deputy Secretary Lynn Scarlett told the House Government Reform Committee at a September hearing that since the discovery of the missing price thresholds in the 1998 and 1999 contracts, the Department has ensured that price thresholds are included in all of its regulations. “Under our supervision, the situation that occurred in 1998 and 1999 has not yet happened again, and we are working diligently to make certain that it will not happen again,” said Scarlett.

It remains unclear exactly how the error could have occurred. “The person responsible for directing the preparation of the leases said he was told by those in MMS’s economics and leasing divisions to take the price threshold language out of the leases,” Earl Devaney, the Inspector General of the Department of Interior, told the House Government Reform Committee at its September hearing. (Inspectors general are independent investigators with responsibility for investigating wrongdoing at particular agencies.) The economics and leasing divisions denied giving the instructions. “The attorney involved … conceded to an MMS official that he should have spotted the omission, but did not.”  All of the MMS directors who were in place at the time denied knowing about the omission until the New York Times reported it in 2000.

“Unless we come across something entirely unexpected, this appears to be an example of bureaucratic bumbling, of the stove-piping of various responsibilities involved in a complex undertaking, reliance on a surname  process which dilutes responsibility and accountability by including virtually every official involved, having no one person ultimately responsible for the quality assurance of the final product,” said Devaney. “Although we have found massive finger-pointing and blame to go around, we do not have a ‘smoking gun;’ we do, however, have a very costly mistake which might never have been aired publicly absent the New York Times.”

The Under-Reporting Ruse

The more traditional means for oil companies to evade royalty payments is to under-report the value of the oil and gas they extract, including by selling it to affiliated companies at discount rates.

MMS auditors have found considerable evidence that this practice persists — but their superiors have blocked them from pursuing investigations.

Several auditors have filed suits in their personal capacity against oil and gas companies, seeking to force the companies to pay the government what they owe. These suits are filed under the False Claims Act, which permits private parties to sue those who defraud the government. If the plaintiffs prevail, the government collects what it is owed, with a share of the award going to the party that brought the case.

Bobby Maxwell, a much-praised former auditor in charge of the Gulf of Mexico, has filed one of those suits. He charges that senior officials in Washington urged him not to press claims that the Kerr-McGee Corporation cheated the government out of $12 million.

Maxwell’s complaint describes a marketing deal between Kerr-McGee and a company called Texon. Texon paid Kerr-McGee at $1 to $3 a barrel below market prices in exchange for Texon providing marketing and administrative services; Kerr-McGee did not pay royalties on the services portion. A few days after Maxwell raised concerns about this practice, lawyers in the Interior Department’s solicitor’s office insisted that he drop the case. “Although I did not understand the reasoning, it was made clear to me that the agency did not want the order issued,” said Maxwell in an affidavit for his suit.

Louisiana auditors — who investigated the same practices in connection with royalties on state-owned land — demanded more than $1 million in additional royalties from Kerr-McGee. Louisiana officials eventually settled for $600,000.

Maxwell was fired a few weeks after his suit was unsealed in January 2005. Interior officials have questioned the auditor’s claims, noting that Maxwell would personally profit from a successful suit.

If Maxwell and other auditors filing False Claims Act suits “believed there were fraud and or false claims on the part of the companies they were auditing, they should have followed the proper procedures,” the Interior Department said in a written statement. “Instead, they opted to pursue private lawsuits under which, if they prevail, they could receive up to 30 percent of the monies recovered from the companies.”

Kevin Gambrell, the former director of the Federal Indian Minerals Office in Farmington, New Mexico was successful at MMS until he was pushed out for raising concerns about whether MMS was fulfilling its duty to collect royalties for Indians. Gambrell was able to renegotiate settlements between MMS and the oil industry in order for the Navajos to receive eight times more than MMS determined was owed. According to Gambrell, MMS did not rely on audits to determine what the oil industry owed the Navajos. In February 2003, he began disclosing his concerns to the court-appointed Special Master overseeing the Indian Trust Fund. (The Indian Trust Funds hold monies earned through royalties or other means from appropriated Native American land.) In September of the same year, he was fired.

Critics of MMS believe Maxwell and Gambrell were fired in retaliation for seeking to improve royalty collections. “Firings such as that of Mr. Gambrell and Mr. Maxwell have a chilling effect on employees at the MMS,” says POGO’s Daley. These firings “reinforce a culture where wrongdoing is covered up rather than addressed.”

Inspector General Earl Devaney describes a systemic problem of good oversight being “dynamically disregarded” by the Department of Interior. Devaney claims that ethics failures by senior department officials are routinely dismissed “with a promise ‘not to do it again.’”

“Short of a crime, anything goes at the highest levels of the Department of the Interior,” says Devaney.

Bush Administration Complicity

Meanwhile, MMS has slashed its auditing and compliance staff by 45 full-time employees, or 15 percent of its staffing level in 2000. “Cut backs in the number of auditors at this particular juncture are hard to justify,” says Daley.

Those staff that remain are being diverted away from full-fledged audits.

In a May 2006 letter, MMS Director R.M. “Johnnie” Burton responded to inquiries from Representative Carolyn B. Maloney, D-New York. “While we remained committed to the strategies,” Burton wrote, “MMS has not yet made full use of random audits and referrals as means to improve our compliance processes.”

Burton reported in the letter that MMS conducted 13 random audits in fiscal year 2002 — 1 Indian, 9 offshore and 3 onshore — and has 49 random audits underway or planned for fiscal years 2006 and 2007. Overall, audits declined 22 percent from fiscal years 2000/2001 to 2004/2005, from a total of 595 to 461.

There are 27,000 producing federal and Indian mineral leases under MMS’s jurisdiction. MMS is auditing less than 2 percent of them.

The reduced audit level “sends a clear signal to oil and gas companies that they can steal oil and gas,” says Daley.

Instead of audits, MMS resources are being directed to “compliance review,” a computerized checking system based upon information provided from the industry. In fiscal year 2000, MMS spent $22 million on auditing and $12 million on compliance review. In fiscal year 2005, the agency reversed priorities, spending $12 million on auditing and $22 million on compliance review.

In his May letter to Maloney, MMS Director Burton claimed that compliance review enhances the agency’s oversight capabilities. “Compliance reviews have helped MMS cover more revenue dollars and complete compliance work more contemporaneously,” wrote Burton. “By including compliance reviews, strategically integrated with audits, we believe the overall compliance program is much stronger.”

A December 2006 report from the Inspector General’s Office agreed that compliance reviews served a useful purpose. But the report emphasized that such reviews are not a substitute for audits, which are more thorough and do not rely on industry data.

“A compliance review is an analysis that determines the reasonableness of company reported royalty and production data,” explained the inspector general’s report. “An analyst compares the company reported data to MMS’s ‘expected values.’ If the reported data are not within a reasonable range, the variance is pursued with the company. Unlike audits, compliance reviews are not conducted in accordance with the Government Auditing Standards. Compliance reviews generally do not obtain and review company source records, review company systems or internal controls, or result in formal reports. … In fact, MMS may not contact companies at all when compliance reviews are conducted, unless discrepancies are found.”

But the IG’s devastating criticism of MMS focused less on its use of compliance reviews and more on the shortcomings of its compliance review process.

Compliance review data is “inaccurate and incomplete,” according to the IG, meaning that MMS “cannot effectively use existing systems for day-to-day management and reporting purposes,” or even state how much its compliance activities had collected in royalties that otherwise would have gone unpaid.

The IG report walked through step after step of the compliance review process, and issued a withering critique of how MMS is mismanaging virtually every phase. Under its current procedures, the report found, MMS “has no assurance that the reported production amounts are reasonable,” and the agency inadequately assesses whether companies improperly claim transportation and processing deductions. MMS does not even “have procedures to verify that underpayments identified by compliance reviews are actually billed and collected.”

“This report makes it pretty clear that the Bush administration is leaking a steady stream of money that is owed to the taxpayers,” says Representative Carolyn Maloney. “Instead of doing real audits, the government basically moves paper around in these ‘compliance reviews.’ They don’t even bother doing the necessary work to make sure adequate royalties are being paid.”

“A Troubling Culture”

Inspector General Devaney has issued blistering criticisms of the ethical culture at the Department of the Interior, in areas including but not limited to oil royalty collection. (Remember that much of Jack Abramoff’s influence-buying related to actions by the department.) “I have watched a number of high-level Interior officials leave the Department under the cloud of [Inspector General] investigations into bad judgment and misconduct. Absent criminal charges … they are sent off in usual fashion, with a party paying tribute to their good service; wishing them well, to spend more time with their family or seek new opportunities in the private sector,” said Devaney. “This charade does not go unnoticed by the career public servants, many of whom have been witnesses in our investigations.”

Interior Department Secretary Dick Kempthorne, who took office in May 2006, insists that he is taking Devaney’s “allegations concerning issues dating back to 1998 very seriously.” On his first day, Kempthorne sent a letter to Interior employees titled “Our Ethical Responsibilities.” He told Time magazine that since then, he has advised his workers that if they are unsure whether something is ethical, “if in doubt, don’t.”

But this pledge to higher standards evokes skepticism, at best. “I am hopeful that somehow the Congress, Secretary Kempthorne and I can work together constructively to disassemble this troubling culture at Interior and replace it with a strong, sustainable culture of ethics, responsibility and accountability,” said Devaney.

Perhaps more legitimate hope for reform lies not within the agency, but in Congress. The new Democratic majority has pledged in its first 100 hours in power to “roll back the multi-billion dollar subsidies for Big Oil.” Forcing collection of unpaid royalties is probably the easiest way to begin to make good on that pledge. 

Mandy Smithberger is a former intern with the Washington D.C-based Project on Government Oversight