Offshore Oil and Gas: Opportunities Exist to Better Ensure a Fair Return on Federal Resources

Production of oil and natural gas from offshore leases is a significant source of federal revenue, totaling almost $90 billion from 2006 through 2018. BOEM is required to seek a fair return from offshore leasing and production activities in federal waters. Companies generally pay (1) bids for leases for the right to develop tracts, (2) rents on leased but undeveloped tracts, and (3) royalties on revenues from the sale of oil and gas produced from leases. BOEM holds auctions to award leases to the company offering the highest bid so long as the bureau determines the bid represents fair market value.

GAO was asked to examine issues related to offshore federal oil and gas leasing. This report, among other objectives, (1) describes the effect of oil prices and royalty rates on industry bids for leases and (2) examines the extent to which BOEM's valuation process assures receipt of fair market value. GAO reviewed laws, policies, and regulations; interviewed BOEM officials; and developed an empirical model using BOEM data to analyze the effect of royalty rates and other factors on industry bidding.

GAO's analysis indicates that changes in the price of oil and in royalty rates drive changes in the amount companies in the offshore oil and gas industry bid for leases (the amount paid upfront at auction for the right to explore and develop offshore tracts of land). Specifically, between May 1985 and June 2018, peaks in industry bidding coincided with higher oil prices. Additionally, when the Department of the Interior's (Interior) Bureau of Ocean Energy Management (BOEM) offered leases at lower royalty rates, industry bid somewhat higher amounts per acre. For example, certain leases were sold from 1996 through 2000 with no royalties on initial volumes of production, which GAO estimates resulted in BOEM collecting, at most, nearly $2 billion in additional bid revenue. However, bureau estimates indicate these leases resulted in about $18 billion in foregone royalties through 2018.

BOEM's valuation process might not fully assure receipt of fair market value, based on GAO's analysis of BOEM data. BOEM develops valuations for offshore tracts it assesses to be economically viable—assessments of their fair market value—and awards leases so long as the bid is greater than or equal to BOEM's valuation. BOEM's valuations for tracts were generally low relative to industry bids because, according to BOEM officials, they conservatively forecast to account for inherent uncertainties in, among other things, the quantity of oil and gas present as well as exploration and development costs. In addition, GAO identified two ways BOEM's valuation process results in lowering its already conservative valuations that might not fully assure receipt of fair market value:

Unreasonably high depreciation . BOEM forecast that tracts would lose a median of 23 percent of their value in between sales, leading the bureau to accept lower bids because it determined the tracts might be worth even less in the future. Bureau officials told GAO that lower future values are generally due to BOEM discounting the delayed collection of revenue. However, BOEM's forecasted depreciation increased even though tracts are now available twice as frequently as they were prior to August 2017, reducing the time for discounting. Officials said they were unaware of the high rates and the issue warrants further examination. Enlisting a third party to examine the extent to which the bureau's use of delayed valuations assures the receipt of fair market value, and making changes as appropriate, would help BOEM mitigate risks of continuing to accept bids based on poor information on tracts' future values.

Lowered valuations . BOEM officials told GAO that they lower some initial valuations that are “slightly above” industry's bids and which would therefore be rejected per procedures to assure fair market value. Officials said they prefer to accept bids unless there is high certainty that the bids are inadequate. However, GAO identified bias, or statistical anomalies, where BOEM lowered many valuations that were initially higher than industry's bids. Specifically, from March 2000 through June 2018, BOEM rejected 27 bids for tracts that it ultimately valued at up to double industry's bid whereas it accepted 359 bids in which industry's bid was up to double BOEM's valuation. Tracts for rejected bids are, on average, subsequently sold for more than twice the initial rejected amount, suggesting that BOEM could be forgoing hundreds of millions of dollars in bid revenue by accepting bids that are too low.

GAO is making four recommendations, including that BOEM (1) enlist an independent third party to examine whether the use of delayed valuations assures the receipt of fair market value and (2) take steps to ensure its bid valuation process is not biased toward lowering valuations. Interior disagreed with the first and partially agreed with the second, disagreeing with GAO's characterization of BOEM's process. GAO maintains the recommendations are valid as discussed in the report.

Production of oil and natural gas from leases on federal waters is an  important part of the nation’s energy portfolio, accounting for more than  50 percent of the oil and gas production on federal lands and waters. It is  also a significant source of revenue for the federal government. From  2006 through 2018, the federal government collected almost $90 billion in  revenue from the management of offshore oil and gas resources. These  revenues were generated primarily through (1) upfront cash payments  (bonus bids) for leasing rights to explore, develop, and sell oil and gas  resources; and (2) royalty payments as a percent of the value of oil and  gas produced.

An objective of the Outer Continental Shelf Lands Act (OCSLA) is that the  Outer Continental Shelf be made available for expeditious and orderly  development, subject to environmental safeguards while maintaining  competition for offshore resources. The act also directs the Secretary of  the Interior to conduct leasing activities to “assure receipt of fair market  value for the lands leased and the rights conveyed by the federal  government.” The Department of the Interior’s (Interior) Bureau of Ocean  Energy Management (BOEM) is responsible for managing federal  offshore oil and gas resources.

To assure receipt of fair market value, BOEM first sets fiscal terms for  leases to be sold at auction—including minimum bid amounts, rental rates  on undeveloped leases, and royalty rates on production—and then  evaluates the adequacy of bids. BOEM regularly holds auctions—called  lease sales—at which companies bid on a specific geographic area, or  tract, of unleased land made available for oil and gas development. Prior  to these lease sales, BOEM determines the fiscal terms that are applied  to the life of any lease sold as well as the duration of the leases. BOEM  has authority to change any of these fiscal terms, within the parameters  set by statute and in the bureau’s implementing regulations, and the  bureau has periodically done so. For example, between 2006 and 2008,  BOEM increased royalty rates from the statutory minimum 12.5 percent  for most depths to 18.75 percent for all depths, and in 2011 BOEM  increased minimum bids for tracts in waters greater than 400 meters from  $37.50 per acre to $100 per acre. According to bureau procedures, after  each lease sale, BOEM is to evaluate the adequacy of the highest bid  received for each tract, and award the lease to the highest bidder so long  as BOEM determines that the bid meets certain criteria, including that the  bid is greater than or equal to BOEM’s assessment of the fair market  value of the tract.

We added Interior’s management of federal oil and gas resources to our  High-Risk List in February 2011 based on challenges we identified with  several aspects of Interior’s oversight responsibilities, including that  Interior lacked reasonable assurance it was collecting a fair return in  revenue from oil and gas produced on federal lands and waters. In a  December 2013 report, we found that Interior had taken some steps to  better ensure a fair return but did not have documented procedures for  periodically conducting assessments of the offshore fiscal system—the  terms and conditions under which the federal government collects  revenues from oil and gas development—including for determining  whether and how to change new offshore lease terms. Among other  things, we recommended that Interior establish documented procedures  for determining whether and how to adjust lease terms for new offshore  leases, and BOEM developed such procedures in 2015. Due to ongoing  concerns regarding royalty determination and collection, among other  things, we included Interior’s management of federal oil and gas  resources in our 2019 update to the High-Risk List.

You asked us to review Interior’s oil and gas fiscal system. This report    (1) describes what effect, if any, oil prices and royalty rates have on  bonus bids for offshore leases, (2) examines how BOEM assesses  changes to fiscal terms, and (3) examines the extent to which BOEM’s  tract valuation process assures receipt of fair market value.

To examine the effect of oil prices and royalty rates on bonus bids for  offshore leases, we reviewed BOEM studies and our prior work, and we  conducted a literature search for oil and gas industry and academic  studies that analyzed factors affecting oil and gas bidding, including  changes to the fiscal system. To identify existing studies from peer- reviewed journals, we conducted database searches. We reviewed and  assessed factors affecting bidding activity from the nine studies published  between 2010 and 2017 that we identified through our literature search.  We also analyzed BOEM data on lease sales from May 1983 (when  BOEM started using competitive bids to award leases) through March  2018, the most recent data available for our analysis. Using these data,  we developed an econometric model to analyze the effect of royalty rates  and other key variables, such as the price of oil, on bonus bids for  offshore leases between 1985 and 2018 (we did not include data from the  first two years of competitive bidding because both BOEM and companies  in the offshore oil and gas industry were adjusting to the new bidding  system). Specifically, we analyzed how changes in royalty rates affected  the winning bids for offshore leases. (See appendix I for additional  information on our econometric model.) To assess the reliability of  BOEM’s lease sale data, we interviewed knowledgeable bureau officials,  reviewed documentation describing the data set, and electronically tested  the data to identify obvious errors with completeness or accuracy. We  found these data sufficiently reliable for assessing the factors that have  affected industry bidding activity. In addition, we used existing data  analysis from Interior to ascertain the effect of royalty relief on offshore oil  and gas revenues. We also interviewed BOEM officials, representatives  from a key industry organization, representatives from two private oil and  gas companies that agreed to be interviewed, and five academic  researchers to obtain their perspectives on the effect of royalty rate  changes on bonus bids. We identified these academic researchers based  on the results of our literature review and selected them because of their  relevant and recent work on this topic. Because this was a nonprobability  sample of industry representatives and academic researchers, their  perspectives are not generalizable to all industry and academia.

To examine how BOEM assesses changes to fiscal terms, we reviewed  the bureau’s annual and supplementary lease sale specific analyses that  informed fiscal terms for lease sales from March 2016 (when BOEM  began implementing a formal process for assessing changes to fiscal  terms) through August 2018, the time of the most recently completed  lease sale when we conducted our review. We compared these analyses  to BOEM regulations, policies, and procedures pertaining to BOEM’s  management of offshore oil and gas development. We interviewed BOEM  officials to discuss their perspectives on any benefits or challenges  regarding actions taken to amend the offshore fiscal system as well as  preparations for any planned changes. We reviewed BOEM’s progress in  developing legislative and administrative proposals aimed at improving  the return to the federal government from the sale of federal resources.  We assessed BOEM’s approach against standards for internal control in  the federal government, specifically for management’s definition of  objectives.

To examine the extent to which BOEM’s tract valuation process assures it  receives fair market value, we reviewed statutes; BOEM guidance,  including regulations, policies, and procedures; and interviewed BOEM  officials regarding the bid evaluation process. We also analyzed available  data from March 2000 through June 2018 related to BOEM’s  determinations on the adequacy of bids. These data included high bid  amounts, BOEM’s viability determinations, types of tracts leased, BOEM’s  resource and fair market value estimates, and oil and gas production. To  assess the reliability of these data, we interviewed knowledgeable agency  officials, reviewed documentation describing the data set, and  electronically tested the data to identify obvious problems with  completeness or accuracy. We found these data to be sufficiently reliable  for our purposes. We assessed BOEM’s process for evaluating bid  adequacy against BOEM’s procedures and federal standards for internal  control, specifically for management’s use of quality information and  establishment and operation of monitoring activities.

We conducted this performance audit from May 2017 to September 2019  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

Interior has oversight responsibility for the development of federal oil and  gas resources located under more than 260 million surface onshore  acres, 700 million subsurface onshore acres, and 1.7 billion offshore  acres in the waters of the Outer Continental Shelf. In this capacity, Interior  is authorized to lease federal oil and gas resources and to collect the  royalties associated with their production. BOEM has leasing authority in  offshore waters, including the U.S. Gulf of Mexico.

BOEM schedules lease sales on a 5-year planning basis. In January  2017, the Secretary of the Interior finalized BOEM’s 2017-2022 Outer  Continental Shelf Oil and Gas Leasing Proposed Final Program, which  included information for 10 planned lease sales in the Gulf of Mexico.  BOEM has traditionally held two lease sales per year in the Gulf of  Mexico region—one for the Central Planning Area and one for the  Western Planning Area. However, beginning with Lease Sale 249 in  August 2017, BOEM transitioned to offering all available tracts in the Gulf  of Mexico at each of its twice-yearly lease sales.

OCSLA, as amended, directs BOEM to establish minimum bid levels,  rental fees, royalty rates, and other related fees to assure receipt of fair  market value to the U.S. government for lands leased on the Outer  Continental Shelf and the rights conveyed by the federal government.  OCSLA directs BOEM to manage the leasing program in a manner that  considers economic, social, and environmental value, including the  potential impact of oil and gas exploration on other resource values of the  Outer Continental Shelf. Subject to the requirement to assure receipt of  fair market value, BOEM has the authority to change certain lease terms  within the oil and gas fiscal system. Specifically, BOEM has broad  authority to change bid terms for offshore leases, including the royalty  rate, the bonus bid structure, minimum bid amounts, lease duration, and  rental terms within parameters defined in OCSLA. Prior to each lease  sale, BOEM publishes a Final Notice of Sale that contains the specific  conditions and terms applicable to any leases sold at the lease sale,  including rental rates, minimum bid amounts, and royalty rates, each of  which may vary by water depth.

In some cases, lease terms have been defined in law. For example, in  1995, Congress passed the Outer Continental Shelf Deep Water Royalty  Relief Act, which waived or reduced the amount of royalties that  companies would otherwise be obligated to pay on the initial volumes of  production from certain deep water tracts leased from 1996 through  2000. In implementing the act for leases sold in 1996, 1997, and 2000,  BOEM 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. BOEM did not include these same price  thresholds for leases it issued in 1998 and 1999.

Figures 1 and 2 below show federal revenue from offshore oil and gas  leases from 2006 through 2018. Annually and in aggregate, royalties  constitute a majority of revenue from offshore oil and gas leases, followed  by bonus bids.

Industry Considerations in Oil and Gas Development

Industry develops oil and gas resources on federal lands within the  context of broader energy markets. Conditions in those markets— including commodity prices, competition, and technological  developments—can change rapidly. For example, the price of oil on the  open market has been volatile, ranging from about $39 to $136 per barrel  (in 2018 dollars) over the last decade. In addition, companies must weigh  potential offshore oil and gas investments against other potential oil and  gas investment options domestically and overseas. For example, some  companies have expanded the sphere of their development activities to  waters off Mexico, areas which now compete for investment against the  remaining oil resources in the Gulf of Mexico. Furthermore, technological  innovations—such as developments in seismic imaging and in drilling  technology—have affected where companies are able to locate and  develop resources in subsea areas.

According to bureau documentation, BOEM is to evaluate the adequacy  of bids in two phases of analysis—economic viability assessments and  tract valuations—that incorporate departmental economic and geologic  models. BOEM’s bid evaluations are intended to ensure that the bureau  awards leases only when the associated bid amount represents at least  fair market value to the federal government.

According to bureau documentation, after each lease sale, BOEM  evaluates the economic viability of tracts receiving bids to determine if  they require additional analysis before BOEM decides whether to accept  or reject the bids. To make these initial assessments, BOEM first  develops thresholds of the minimum quantity of oil or gas that must be  present to generate revenue that would offset exploration and  development costs—known as the “break-even threshold”—at the given  water depth, among other factors. Then, for each tract that receives a bid,  BOEM estimates a range of how much oil or gas may be on the tract— known as the tract’s “resource potential”—using geological and  geophysical data. This process incorporates collecting and analyzing the  most recently available seismic exploration and well data and any  information gathered from drilling in that geographical area.

BOEM is then to categorize tracts as viable or nonviable by comparing  the bureau’s estimated resource potential against the relevant break-even  threshold. Nonviable tracts are those for which BOEM’s resource  estimates are below the break-even threshold, meaning they are not likely  to have enough oil and gas to be profitably explored, developed, and  produced. For tracts that BOEM concludes are nonviable, BOEM  accepts the highest bid received as long as that bid is higher than the  minimum acceptable bid amount. Conversely, viable tracts are those that  exceed BOEM’s economic viability threshold and that BOEM considers as  having the potential to be profitably explored, developed, and produced.

BOEM subjects these tracts to further economic analysis in its next  phase, tract valuation.

According to bureau documentation, for tracts determined to be  economically viable, BOEM is then to conduct a more detailed economic  analysis to determine if the high bids represent fair market value.  Specifically, BOEM develops an acceptable bid threshold by modeling the  likely monetary value of production from a tract less the costs to explore  and develop it, including industry profit and payments to the government.  BOEM’s Fair Market Value Review Committee oversees the development  of tract-specific parameters—production potential, probability of geologic  success, economic projections, and development costs and timeframes— that the bureau uses in its proprietary discounted cash flow analysis  model. A discounted cash flow analysis is a valuation method used to  estimate the present value of an investment—in this case a tract of land— based on estimated future cash flows. As inputs to its model, BOEM uses  the oil and gas resource estimates it developed in its economic viability  assessments to estimate how much oil and gas could be extracted from  each tract, and it analyzes seismic and well data to determine the  likelihood of discovering oil and gas. BOEM also develops economic  projections for future oil and gas prices as well as projections for  exploration and development costs and time frames for each tract, based  on historical cost data, drilling equipment, technological innovation, and  other factors.

BOEM inputs these parameters into its proprietary discounted cash flow  model to generate a distribution of potential tract values. BOEM uses the  average of these potential values as representative of the present value  of the tract. BOEM also develops an estimate of each tract’s value at  the next scheduled lease sale—known as the delayed value. The delayed  value for the next sale is computed as the present value associated with  the delay in leasing under the projected economic, engineering, and  geological conditions—for example, by accounting for depletion of  resources due to extraction from a nearby tract that shares access to the  reservoir.

Based on its valuations, the bureau establishes acceptable bid thresholds  for the tracts. The acceptable bid threshold for each tract is the higher of:  (1) the lesser of the present value and the delayed value or (2) the  minimum bid per acre in instances in which BOEM’s present and delayed  valuations are below the minimum bid per acre. If the high bid exceeds  the acceptable bid threshold, BOEM concludes that the bid represents fair  market value and accepts it and awards a lease. Conversely, if the high  bid does not exceed the acceptable bid threshold, BOEM rejects the bid  as inadequate and the tract is made available for lease at the next lease  sale.

Changes in Oil Prices and Royalty Rates Are Key Drivers of Changes in Bonus Bids

According to our empirical analysis of BOEM data and interviews with  BOEM officials and industry representatives, changes in the price of oil  and changes in royalty rates drive changes in the amount industry bids for  offshore oil and gas leases. Specifically, the current and expected future  price of oil are key factors determining bonus bid amounts, in the context  of industry’s assessment of the expected presence of hydrocarbon  reserves for a given tract, the likelihood of success in developing those  reserves, and the uncertainties in geological and seismic information.  Specifically, our econometric model suggests a strong positive  correspondence between higher oil prices and higher bonus bids; that is,  when oil prices are higher, bonus bids tend be higher and, conversely,  when oil prices are lower, bonus bids tend to be lower. For example,  from 2006 through 2008, oil prices rapidly rose to historic highs. This  period corresponded with an increase in average bonus bids in deep  water from an average of about $275 per acre in 2006 to an average of  about $800 per acre in 2008. Figure 3 shows the relationship between oil  prices and per acre average bonus bids.

The results of our analysis are consistent with input from BOEM officials  and industry representatives who told us that the price of oil is a key  factor in industry bidding decisions. Specifically, these officials and  representatives explained that they use the current price of oil as a  baseline for expectations regarding future prices of oil—that is, the price  at which industry can sell the oil it produces. Therefore, high current oil  prices lead to higher projections of future oil prices, thereby driving up  bids. Likewise, they told us that industry bidding activity increases in high- price environments because production from existing wells provides  financial resources companies can use to invest in acquiring additional  leases. Moreover, according to these officials and representatives, higher  oil prices make some tracts economically viable to develop that had been  viewed as unprofitable at lower prices.

According to our analysis of BOEM data, changes in federal royalty rates  also drive changes in the amount industry bids on offshore leases. Our  econometric model indicates that increases in royalty rates lead to  decreased bonus bids and, conversely, decreases in royalty rates lead to  increased bonus bids. According to our model, during the royalty relief  period from 1996 through 2000, when royalty rates were effectively  zero, bonus bids increased between 34 percent and 60 percent over  what bonus bids would have been expected to be had the royalty rate  remained at the pre-1996 rate of 12.5 percent. Specifically, we found that  industry bid approximately 34 percent higher for leases sold in 1996,  1997, and 2000, when leases contained no royalty obligation until oil  prices rose above a certain threshold. Similarly, industry bid  approximately 60 percent higher for leases sold in 1998 and 1999, when  leases carried no royalties for the life of the lease. However, changes in  oil prices can work to counter the effect of royalty rate changes on bonus  bids. For example, between 2006 and 2008, royalty rates in water depths  greater than 400 meters increased from 12.5 percent to 18.75 percent.  Based on our model, this royalty rate increase would have a significant  downward effect on bonus bids. However, the rapid increase in oil  prices during this period resulted in the net effect of an increase in bonus  bids for these tracts by more than 150 percent.

Our findings are consistent with the views of BOEM officials and industry  representatives, who told us that lower royalty rates increase industry  bidding because lower royalties result in higher industry tract valuations.  Specifically, the smaller financial commitments to the government  associated with lower royalty rates increases the projected value of any  oil or gas produced. BOEM officials and industry representatives told us  that, in turn, the increased projected value of these tracts would lead to  increases in the dollar value of individual bids as well as the number of  bids submitted. For example, they cited the royalty relief period of 1996  through 2000 as responsible for a significant increase in bidding activity  during that time.

However, while decreases in royalty rates lead to higher bonus bids, they  may still lead to lower overall federal offshore oil and gas revenues.  Specifically, our model estimates and BOEM data show that eliminating  royalties for tracts leased between 1996 and 2000 would have increased  overall bonus bids for those tracts by at most about $1.98 billion over  what they would have been had royalty rates remained at their pre-1996  rate of 12.5 percent. However, forgone royalty revenue was more than  nine times greater. Specifically, Interior data show approximately $18.0  billion in forgone royalty payments on these leases through the end of  2018. Because most of these leases are still in production, this estimate  does not represent the final total of forgone royalty payments.

BOEM Regularly Assesses Potential Changes to Fiscal Terms but Has Made Limited Progress in Developing a Progressive Royalty Structure

BOEM regularly assesses potential changes to fiscal terms in annual and  supplementary lease sale-specific analyses. Additionally, BOEM has  advertised its development of a progressive, priced-based royalty system  for 6 years but has made little demonstrable progress toward developing  this system.

BOEM Regularly Assesses Potential Changes to the Fiscal Terms

Based on our review of planning documents for lease sales held from  March 2016 through August 2018, BOEM regularly assesses potential  changes to fiscal terms in annual and supplementary lease sale-specific  analyses. BOEM’s annual analyses consider various factors that can  affect the fiscal system, and its lease sale-specific analyses build on  those factors to inform fiscal terms for individual sales.

BOEM Conducts an Annual Analysis That Informs Fiscal Term Options

BOEM conducts an annual analysis of various factors affecting the  offshore fiscal system that informs its development of fiscal term options  for all lease sales to be held in the subsequent year. According to our  review of BOEM documentation and interviews with bureau officials,  factors BOEM considers include the following:

Resource potential. BOEM estimates the likely amount of  undiscovered recoverable oil and gas resources remaining in the  region based on the bureau’s most recent national assessment.

Market conditions. BOEM assesses trends in oil and gas prices as  well as forecasts from the Department of Energy’s Energy Information  Administration, the World Bank, and the Office of Management and  Budget. BOEM uses these assessments to estimate, under existing  fiscal terms, results for the lease sales covered by the analysis— including the amount of bonus bids collected and the number of tracts  sold—as well as resulting production and net economic value under  various price scenarios.

Leasing, drilling, development, and production activity. BOEM  reviews industry activity over the previous several years, including  leases purchased, companies participating in lease sales, exploration  and development drilling, new facility installations, and oil and gas  production trends.

Industry news. BOEM considers industry perception of its fiscal  terms by evaluating industry estimates of break-even thresholds (oil  and gas market prices at which production from a given area is cost- effective at current costs of production) and announcements of new  discoveries, projects, and production.

International considerations. BOEM reviews the fiscal terms of  international jurisdictions to assess how they compare with the U.S.  system.

Within this context, BOEM considers potential changes to its fiscal terms  by estimating their effects on outcomes including leasing activity,  production, and revenue at various oil and gas prices. For example, in its  annual analysis for its August 2017 and March 2018 lease sales, BOEM  analyzed the potential effect of five royalty rate changes from the 18.75  percent rate that had been in place since 2008. Two of the potential  changes were targeted to specific types of production or water depths  and three would apply to all production. For the targeted changes, BOEM  considered (1) a lower natural gas royalty and (2) a lower shallow water  royalty—both at the statutory minimum of 12.5 percent. The other  potential changes were to lower royalty rates on all production to (1) 12.5  percent, (2) 15 percent, and (3) 16.67 percent. For each of these  scenarios, BOEM modeled effects on overall production and revenue at  various market prices.

BOEM Conducts Lease Sale- Specific Analysis and Makes Recommendations

Based on our review of BOEM lease planning documents, BOEM  conducts additional lease sale-specific analysis before finalizing the fiscal  terms for each sale. For example, BOEM considered changes to each of  the fiscal terms for its August 2018 lease sale—minimum bid, rental rates,  and royalty rate—but recommended that they not change from the  previous sale. Specifically:

Minimum bid. BOEM evaluated lowering the minimum bid for tracts  in water depths of greater than 400 meters to account for the effects  of decreases in (1) oil prices since BOEM raised the minimum bid to  $100 in 2011 and (2) corporate tax rates per the Tax Cuts and Jobs  Act of 2017. BOEM found that, because of these changes, a $100  per acre minimum bid in 2018 was roughly equivalent to a $170 per  acre minimum bid in 2011 and that maintaining the $100 per acre  minimum bid in 2018 could reduce the number of tracts sold.  However, BOEM assessed that industry has recently shown a  preference for holding less acreage, evidenced by relinquishments  and bidding on fewer blocks. Therefore, BOEM determined that  lowering the minimum bid might not have the desired effect of  increasing tracts leased; instead, it could lead to the same number of  blocks being sold but with lower total bonus bid revenue.

Rental rate. BOEM evaluated adjusting the rental rate to account for  inflation since the last adjustment in 2009. It also evaluated increasing  the rental rate in water depths greater than 400 meters to $20 per  acre to provide additional financial incentive to explore leases.  However, BOEM did not recommend this option since it reported that  it expected the effects to be minor.

Royalty rate. BOEM evaluated the effect of lowering the royalty rate  to 12.5 percent for two scenarios: (1) tracts with water depths  between 200 and 400 meters and (2) all tracts. BOEM recommended  leaving the royalty rate at 18.75 percent for all tracts deeper than 200  meters. In doing so, the bureau cited little effect for lowering the rate  for tracts with water depths between 200 to 400 meters—it projected  less than a 0.1 percent increase in production and less than 0.1  percent decrease in revenue. BOEM also cited more substantial  projected drops in overall revenue of 17 to 19 percent, paired with  modest increases in production (1 to 2 percent increase in oil  production and 2 to 5 percent increase in gas production) for lowering  the royalty rate for all tracts. BOEM also found that these losses to  the federal government could be even more substantial if oil prices  rise in the future.

BOEM officials told us that, in general, they prefer to make minor iterative  changes to fiscal terms in order to better gauge their effects—that is, they  find it easier to measure the effects of a change to one term at a time rather than the effects of reconfiguring multiple terms—as well as provide  predictability for industry. In keeping with this approach, BOEM has made  one change to its royalty rate since 2012 (see table 1 for details on the  recent history of lease terms in the Gulf of Mexico). Specifically, in  advance of its August 2017 lease sale, BOEM announced a reduction in  royalty rate for tracts with water depths of less than 200 meters from  18.75 percent to the statutory minimum of 12.5 percent. According to  BOEM documentation, the driving factor for this decision was that shallow  water in the Gulf of Mexico has been largely explored, leaving generally  marginal tracts that either are largely depleted of resources or more gas  prone. In turn, the goal in reducing the royalty rate was to incentivize  additional industry interest in these more marginal shallow water tracts.

BOEM Has Made Little Headway in Developing a Progressive Royalty System

BOEM has publicized the development of a progressive royalty system  since 2013 but has made little demonstrable headway toward developing  such a system. Specifically, in its budget justifications for fiscal years  2014 through 2017, BOEM stated it was developing a package of  legislative and administrative proposals to, among other things, improve  the return to the federal government from the sale of these federal  resources. Among these proposed reforms was a price-based tiered  royalty rate to replace the fixed royalty rate structure that BOEM has used  since 1983. Under a price-based royalty system, the royalty rate would  depend on prevailing commodity prices, with lower prices having lower  royalty rates. According to BOEM documents, the current flat-rate royalty  system is regressive—that is, a fixed rate that does not adapt to market  conditions or the relative success of a lease—but a price-based royalty  would share more revenue risk with the lessee and reduce the regressive  nature of the system. A more progressive system would provide an  increased incentive to lessees to develop resources during times of low  oil and gas prices through lower royalty rates, while also ensuring that the  federal government receives a greater return for offshore resources when  prices are high. BOEM officials we interviewed told us that this type of  adaptive system could be more efficient and provide higher returns  relative to the existing fixed-rate system. That is, if properly designed, a  priced-based system could increase return to the federal government in  high-price environments while incentivizing continued industry investment  when prices are low.

According to BOEM documentation, a progressive, price-based royalty  rate could have the additional benefit of “future-proofing” the royalty  system because it would adjust the rate for whatever prices prevail in the  future and provide a stable, predictable market for industry. We reported  in September 2008 that the regressive nature of the offshore fiscal  system, among other factors, caused it to be unstable over time and  added risk to oil and gas investments that may reduce the total amount  industry is willing to pay for the rights to explore and develop federal  leases. BOEM officials told us such a system that automatically adjusts  could reduce the need for frequent revisiting and continual annual and  lease sale-specific evaluations because it would automatically adapt to  certain market conditions. According to these officials, a stable, long-lived  system would also reduce political pressure to restructure it or rely on  legislation—such as the Deep Water Royalty Relief Act—in the future.

Additionally, long-term stability in the royalty system could benefit  industry, according to a 2007 study. Specifically, industry may consider  fiscal system stability more important than the attractiveness of fiscal  terms, as the appeal of low government revenue—incorporating bids,  rents, and royalties—is limited if there is a high probability the terms will  change. In the context of the offshore fiscal system, this means that some  companies might prefer a flexible rate that lowers their royalty obligations  in low-price environments so long as BOEM clearly defines the specific  market conditions under which royalty rates would increase or decrease.

BOEM has continued to publicize its efforts to develop a price-based  royalty system—though it did not complete them—as follows:

July 2017: BOEM announced in a “note to stakeholders” that it was  continuing to analyze a price-based royalty system and would  subsequently engage stakeholders on this concept; however, it did  not do so.

January 2018: BOEM released the 2019-2024 National Outer  Continental Shelf Leasing Draft Proposed Program, which states that  the bureau was studying a priced-based royalty structure as an  alternative to the existing fixed royalty rate.

February 2018: BOEM’s memorandum documenting lease term  decisions for its March 2018 lease sale stated that the bureau was  evaluating a potential future option for a price-based mechanism that  would lower royalty rates at current oil prices while increasing rates  above the current 18.75 percent royalty rate as price conditions  warrant.

Spring 2018: In the Lease Term Reassessment Report covering its  August 2018 and March 2019 lease sales, BOEM indicated that the  statutory floor of 12.5 percent might not be low enough to encourage  new exploration and development, particularly for smaller fields for  which a lower royalty would have a reduced financial benefit and  effect on early cost recovery than for larger fields. As a result, BOEM  was considering incorporating into its price-based royalty the  suspension of royalty collection for a certain initial volume of oil or gas  produced to effectively lower the royalty rate below the statutory  minimum and incentivize the development of smaller, marginal fields.

However, BOEM has demonstrated little tangible progress in the 6 years  since it began publicizing the development of a more progressive royalty  system. BOEM officials told us that the general concept for a price-based  royalty is robust, but the bureau has not determined optimal parameters  for sharing risk when prices are low in return for a higher return when  prices are higher. BOEM drafted a Federal Register notice and  accompanying procedures for implementing a price-based royalty system  that the bureau intended to publish to obtain public comment. These draft  procedures include different permutations of royalty rates and price  thresholds. However, BOEM officials told us that feedback from within the  bureau included enough concerns about workability that the draft notice  and procedures were not published and the draft no longer reflects  bureau leadership’s position on the issue.

According to BOEM officials, the main challenges to a price-based  system are determining optimal rates and price thresholds for escalating  royalties and quantifying the benefits to the government at lower price  levels when government revenue would be lower than under the current  regressive system. BOEM officials also cited additional challenges,  including establishing price inflation parameters and developing  mechanisms for assessing and collecting royalty payments on a sliding  scale.

After the development of the draft Federal Register notice and  procedures, according to BOEM officials, they continued to work on a  price-based royalty model. However, they did not provide us  documentation of any progress made. BOEM officials told us that the  concept is too immature to consider testing implementation on a pilot  project basis and that there is not a time frame for when any decisions will  be made, including whether to proceed with developing the system.  According to federal standards for internal control, agency management  should define objectives clearly to enable the identification of risks and  define risk tolerances. This involves clearly defining what is to be  achieved, who is to achieve it, how it will be achieved, and the time  frames for achievement. Developing a documented plan for assessing  whether and how to implement a progressive royalty structure that  defines these aspects would help position BOEM to better understand    (1) the potential benefits such a structure could offer in terms of improving  fair return to the taxpayer while fostering diligent offshore oil and gas  development and (2) how to implement such a structure if it elects to do  so.

BOEM’s Tract Valuation Process Might Not Fully Assure Receipt of Fair Market Value

BOEM’s tract valuation process might not fully assure receipt of fair  market value, according to our analysis of BOEM tract valuation data and  documentation. BOEM’s valuations for tracts were generally low relative  to industry bids, largely due to the cumulative effect of three aspects of its  bid valuation process: (1) the bureau forecasts conservatively to account  for uncertainties, (2) the bureau forecasts unreasonably high levels of  depreciation, and (3) BOEM selectively further lowers many valuations  from its model to justify accepting bids it otherwise would reject. In  addition, BOEM conducts limited self-evaluations of its tract valuation  process and does not have a systematic mechanism to address  deficiencies, such as those described above.

BOEM’s Valuations Were Generally Low Compared to Industry Bids

BOEM’s valuations for tracts it determined to be economically viable were  generally low relative to industry bids. Specifically, from March 2000  through June 2018, BOEM’s acceptable bid threshold for the 2,035 tracts  on which it conducted valuations was, on average, about one-third of  industry’s high bid (about $2.26 million to $6.43 million, respectively, as  shown in table 2). BOEM accepted the high bid on about 85 percent of  tracts it determined to be viable (1,721 of 2,035), for a total of about $12.8  billion in bid revenue, and it rejected about 15 percent of high bids (314 of  2,035) totaling about $287 million. BOEM’s bid rejections generally  resulted in higher bids for the same tracts in subsequent lease sales,  significantly increasing bid revenue for these tracts and indicating that  industry viewed those tracts as more valuable than the original rejected  bid. Specifically, for the 314 bids worth about $287 million that BOEM  rejected, BOEM subsequently accepted bids for almost 70 percent of the  tracts (161 of 236) for about $667 million—more than twice (about 230  percent) the aggregate rejected value for those tracts.

BOEM’s acceptable bid thresholds were generally low relative to industry  bids due to three compounding aspects of its valuation process:             (1) BOEM conservatively forecasts the key parameters used in its  valuation model, (2) BOEM forecasts unreasonably high levels of  depreciation between lease sales, which further lowers acceptable bid  thresholds, and (3) BOEM alters many valuations—valuations that are  already low due to the two preceding aspects of its process—downward  further in order to justify accepting bids.

BOEM Conservatively Forecasts Key Parameters Used in Its Model

BOEM officials told us that they forecast conservatively to account for  uncertainties, which systemically lowers its tract valuations. Specifically,  they told us that they face significant uncertainties associated with the key  parameters that contribute to BOEM’s valuations: resource potential,  probability of geologic success, price of oil and gas, and cost and  scheduling estimates. They told us that they forecast each of these  parameters conservatively—that is, being cautious against overestimating  any factor that might unreasonably inflate the bureau’s valuation—so as  to not reject bids that might represent fair market value. BOEM’s  conservative approach is evidenced by its reluctance to reject bids of  significant value. Specifically, from March 2000 through June 2018,  BOEM rejected three bids of more than $5 million dollars—the highest  was for approximately $11.2 million—while accepting 570 bids of more  than $5 million. BOEM officials told us that this conservative approach  represents fair market value because the objective of the bureau’s tract  valuation process is to lease tracts and collect associated revenues  except when BOEM determines a tract is worth significantly more than  the highest bid received. That is, they told us that the bureau is more  inclined to accept bids and collect revenue—and facilitate exploration and  development via the award of leases—rather than reject bids. Moreover,  they told us that this approach also provides the bureau with greater  justification for rejecting the bids when it does so, which they said can  drive up subsequent bids for the same tracts.

BOEM Forecasts Unreasonably High Levels of Depreciation

BOEM forecasts unreasonably high levels of depreciation as compared to  the government’s recommended discount rate, which further depresses  acceptable bid thresholds that were already based on conservative  forecasting. As discussed previously, BOEM’s acceptable bid threshold is  generally determined by the lesser of BOEM’s present valuation and its  delayed valuation. For the 1,412 tracts with a positive present valuation  assessed from March 2000 through June 2018, BOEM forecast a median  loss in value on these tracts would be about 23 percent (about $494,000)  by the time of the next sale opportunity for those tracts.

BOEM officials told us that expected lower future values are generally  due to discounting the eventual collection of revenue. Specifically, BOEM  officials explained that the bureau’s model considers the delayed  collection of revenue—bonus bids and royalties—when developing its  delayed values. However, because tracts that received a rejected bid  would be available for sale during the next year—or, more recently, 6  months on average—the period of discounting is very short. Discounting  seems an unreasonable explanation of BOEM’s forecasted depreciation  rates for two additional reasons. First, BOEM’s forecasted depreciation  rates do not align with industry bidding patterns for tracts that were leased  more than once—where the lease for a tract either expired or the  leaseholder relinquished it and the tract was therefore available at a  subsequent lease sale. Specifically, for the 61 tracts that were leased  more than once from March 2000 through June 2018, bids actually  increased slightly over time (bids increased at a real average annual rate  of 0.2 percent, or about $6,700). Second, since oil prices are generally  forecast to rise, the underlying oil and gas resource values would be  expected to increase over time rather than decrease, suggesting a  smaller difference between present and delayed values should be  observed than is reflected in BOEM’s tract valuations.

Additionally, BOEM’s forecasted depreciation has increased even though  tracts are now available twice as frequently. Until August 2017, BOEM  held annual lease sales for each of two lease areas so that tracts were  available once per year. On average during this time, BOEM forecast that  the median loss in value for tracts with positive present valuations would  be approximately 23 percent (about $481,000) of their value in the year  between lease sales (see table 3). BOEM has since made tracts available  twice per year. Having less time between lease sales should decrease  the amount of forecasted depreciation, as there is less time for  discounting. Yet the average difference between present and delayed  value increased for biannual lease sales to about 27 percent (or about  $1.03 million per tract) for tracts with a positive present valuation.  BOEM’s depreciation for biannual lease sales is equivalent to an annual  rate of approximately 47 percent (or about $1.78 million annually per  tract), which is nearly seven times the Office of Management and  Budget’s annual recommended discount rate of 7 percent. That BOEM’s  forecasted depreciation has increased since moving to biannual lease  sales is also at odds with the concept of how discounting should affect  tract valuations, as shorter periods of time are generally associated with  lower depreciation than longer periods of time.

Under federal standards for internal control, management should use  quality information to achieve the entity’s objective. Yet, according to  our analysis of BOEM data, the bureau’s unreasonably large forecasts of  depreciation have increasingly been the deciding factor in decisions to  accept bids. Cumulatively, BOEM’s high forecasted level of depreciation  resulted in the bureau accepting 205 bids for about $672 million that it  would have rejected if its present valuations had been used as the  acceptable bid threshold. Based on the return BOEM has realized on  rejected bids, had BOEM rejected these 205 bids, it might have  subsequently collected more than $873 million in additional bid revenue  for these tracts, which would represent an increase in overall bid revenue  of about 6.8 percent for tracts BOEM determined to be viable.

BOEM officials told us that they were unaware that their model forecasts  such high rates of depreciation and that the issue warrants further  examination. However, BOEM officials did not indicate they had any plans  to conduct such an examination. Though BOEM is not required to follow  government auditing standards, these standards highlight that it can be  beneficial to consult an independent third party to assess issues that are  highly technical as a safeguard to eliminate threats to independence or  reduce them to an acceptable level. As BOEM developed and has used  its delayed valuations for at least 20 years, outside perspectives and  expertise could be beneficial. Enlisting an independent third party to  examine the extent to which the bureau’s use of delayed valuations  assures receipt of fair market value, and making changes—such as  terminating the use of delayed valuations as acceptable bid threshold  criteria or amending its model’s assumptions to develop more justifiable  depreciation rates—as appropriate, would help BOEM mitigate risks of  continuing to accept bids based on poor information on tracts’ future  values.

BOEM Further Lowered Many Valuations to Justify Bid Acceptance

Our analysis of BOEM data as well as BOEM testimony indicate that the  bureau changed its forecasting parameters, thereby lowering many  valuations and acceptable bid thresholds—which were already  systematically low due to its conservative forecasting and excessive  depreciation—in order to justify accepting bids. BOEM officials told us  that when bids are slightly below the bureau’s initial valuations—and  therefore would be rejected per BOEM’s procedures for ensuring receipt  of fair market value—BOEM reviews and adjusts its forecasting  parameters then reruns its model in order to produce new valuations,  which they told us can—and which the data indicate generally do—result  in lower valuations that justify accepting the bids. BOEM officials told us  that they would rather accept bids offered by industry—as well as any  associated rental and royalty revenue—than reject them and potentially  never recoup the forgone bid revenue.

We observed BOEM’s bias, or statistical anomalies, indicating BOEM  lowered a portion of its valuations in order to accept bids in our analysis  of BOEM tract valuation data from March 2000 through June 2018.  Specifically, we found that BOEM never valued a tract as being worth  slightly more than industry’s high bid (that is, instances in which BOEM’s  valuation is between 100 and 125 percent of the high bid). In contrast,  BOEM valued tracts at slightly less than the industry high bid (that is,  instances in which the high bid is between 100 and 125 percent of  BOEM’s valuation) about 10 percent of the time (117 of the 1,198 bids  subjected to valuation for which the acceptable bid threshold was above  the minimum bid level). This anomalous absence of any instances in  which BOEM valued tracts slightly more than industry is consistent with  BOEM officials’ statements that the bureau further lowered its initial  valuations when these valuations were only slightly higher than bids.

BOEM officials suggested that any pattern of adjusting valuations would  be limited to lower-value bids whereby smaller dollar-value changes  would represent greater percentage changes. However, the data do not  support this, as we found that BOEM’s bias toward lowering valuations  does not appear to be limited to those slightly above industry’s high bid,  but is nearly systematic for valuations up to double industry’s high bid  across all bid levels. Figures 4 and 5 show the distribution of BOEM’s  valuations compared with industry’s high bids, with green data points  reflecting accepted bids and blue data points reflecting rejected bids. In  particular, the middle two bars in figure 4 and the areas between the  dotted lines on figure 5 represent instances in which the relationship  between BOEM’s valuation and industry’s high bid—and vice versa— were relatively close (that is, BOEM’s valuation was up to double  industry’s bid for rejected bids, and industry’s bid was up to double  BOEM’s valuation for accepted bids). Within this range, BOEM’s  tendency to lower bid valuations to justify acceptance is clear due to the  relative abundance of acceptances (359) and the relative scarcity of  rejections (27)—a pattern of more than 13 acceptances for every rejection  that is anomalous within the data. This disparity would be even greater if  we had included in our analysis the 802 bids BOEM accepted because its  valuations were below the minimum bid level which is then used as the  acceptable bid threshold.

BOEM officials told us that they occasionally change valuations to  address the uncertainty inherent in the factors that comprise BOEM’s  tract valuation process, though doing so in order to justify bid acceptance  is inconsistent with BOEM’s fair market value procedures. Specifically,  officials told us that the point valuation developed by its discounted cash  flow model is not representative of the broadness of the distribution of  potential values—though it does represent the average of the distribution.  Additionally, these officials told us that the process is iterative—the  bureau adjusts its forecasts multiple times before deciding on final  valuations. Furthermore, officials said that valuations that are above, but  near, the high bids are subject to more iterations. Moreover, BOEM  officials told us that all forecasting parameters and valuations, including  those that are revisited more frequently, are evaluated and approved  through its Fair Market Value Review Committee, which is broadly  responsible for ensuring consistency in the application of the bureau’s  tract valuation process. Adjusting valuations comports with what BOEM  officials told us is their conservative approach and promotes accepting  bids unless the bureau has a high level of certainty that the tract is worth  more than the high bid. However, BOEM officials told us they were not  aware that their adjustments had effectively reduced the acceptable bid  thresholds of nearly all valuations that were initially up to double  industry’s high bid.

Given that BOEM already starts with a conservative approach to  valuation, which is compounded by its model generally forecasting high  levels of depreciation, this practice of introducing more conservative  assumptions in cases when initial valuations are above bids is not  consistent with the bureau’s fair market value procedures prescribed in  federal regulations, BOEM’s Bureau Manual for ensuring fair market  value, and in BOEM’s bid adequacy procedures. These procedures call  for BOEM to use the outputs of its discounted cash flow model as the  thresholds for determining whether to accept bids. In situations where  BOEM determines that its valuation results are not consistent with  programmatic goals, BOEM’s procedures allow for the bureau to develop  alternative bid evaluation protocols for a given lease sale, but BOEM has  not done so. BOEM’s procedures do not explicitly allow for valuations to  be adjusted based on how close they are to industry bids, nor is there an  allowance for adjusting valuations in an ad hoc fashion for uncertainty.  The practice of adjusting valuations this way undermines receipt of fair  market value by holding industry to a lower and potentially inconsistent  standard for purchasing leasing rights than those outlined in BOEM’s  valuation procedures.

The practice of lowering valuations also results in the potential loss of  hundreds of millions of dollars in revenue. We do not know how many  accepted bids would have been rejected based on their initial valuations  because BOEM’s data do not indicate which valuations were further  lowered. However, if BOEM had rejected 26 percent of the bids that were  up to double its valuations—which appears reasonable to interpolate  based on the distribution of the other bid-to-valuation relationships—the  bureau potentially could have subsequently collected approximately $567  million additional dollars in bid revenue for tracts it determined to be  viable (an increase of about 3.9 percent). Without taking steps to ensure  that BOEM’s bid valuation process is not biased toward adjusting  valuations downward based on their proximity to bids, the bureau risks  continuing to undermine the receipt of fair market value for the sale of  public resources.

BOEM Conducts Limited Self-Evaluations of Its Tract Valuation Process

BOEM conducts evaluations of some aspects of its tract valuation  process but does not comprehensively evaluate the accuracy of its  forecasting, the assumptions of its model, and their combined effect on  assuring receipt of fair market value. Specifically, since 2004, BOEM has  routinely conducted “lookback studies,” self-evaluations to identify  opportunities to refine or improve BOEM tract evaluations and  decisions. In these lookback studies, BOEM evaluates its performance  by comparing the quantity of discovered hydrocarbon resources with  BOEM’s pre-drill estimates of resource potential. However, the scope of  BOEM’s lookback studies is limited, which reduces the studies’ effectiveness in helping the bureau improve its valuation process. We  identified four main limitations, based on our review of the studies and  interviews with BOEM officials, as follows:

Resource discoveries are not updated. The lookback studies are  not necessarily representative of the total resources on a tract  because BOEM compares the forecast against the results of only the  first exploratory well and does not update its studies with the results of  further exploration. Therefore, BOEM officials told us, the studies  are a snapshot in time and are not representative of the total resource  that may ultimately be discovered and developed on a tract.  Consequently, the studies provide limited insight regarding the total  quantity of the resource discovered relative to pre-drill forecasts and  identify the causes of any significant differences.

BOEM does not assess certain factors. BOEM does not formally  assess other forecasted factors that are important in its valuations,  such as likelihood of success or cost and schedule estimates, or the  underlying assumptions and workings of its discounted cash flow  model. BOEM officials told us that the bureau periodically updates its  cost and schedule estimates based on available data and that it  makes adjustments to its model, but that these processes are  generally ad hoc and not consistently documented. As previously  discussed, BOEM’s model has produced unreasonably high projected  levels of depreciation between lease sales—suggesting that BOEM  could modify the model or its assumptions to be more consistent and  accurate. For example, BOEM has not assessed how depreciation  rates implied in its delayed valuations compare with actual  depreciation observed in tracts that have been leased multiple times.

BOEM does not systematically use the studies to improve  processes. BOEM’s lookback studies do not include a systematic  process for identifying and documenting steps the bureau plans to  take to improve the bid valuation process. BOEM does not use these  studies’ findings to systematically inform or document changes to  policies, procedures, or processes related to BOEM’s tract  evaluations. For example, BOEM officials told us that the lookback  database and the studies are used as training aids, the data are not  comprehensive, the studies are used as spot checks and to provide  lessons learned, and these studies are not a comprehensive effort to  assess BOEM’s valuation process (as BOEM conducts no such  comprehensive effort). In its written comments on this report, Interior  indicated that BOEM uses the results of its lookback studies to  improve aspects of its valuation process. However, Interior did not  provide documentation to support this claim.

Data do not reflect initial valuations. BOEM’s ability to measure the  accuracy of its tract valuation process—both its forecasting and the  performance of its model—is hindered because some of its data do  not reflect the bureau’s initial valuations but rather the adjusted  valuations it used to justify bid acceptance. Specifically, BOEM is  unable to observe the effect on revenues and sales bids when its  initial valuations—which were already low due to conservative  forecasting and generally high depreciation—indicated that bids  should be rejected when bids are only slightly less than BOEM’s  valuation. By altering the valuations to justify acceptance, BOEM is  unable to assess how industry would have responded to those  rejections in subsequent lease sales. What we observed indicates that  BOEM bid rejections for tracts it values as less than double the high  bid lead to almost the same average return in future sales as do  rejections in which BOEM’s valuation is many multiples of the bid. By  taking steps to ensure that BOEM’s bid valuation process is not  biased toward adjusting valuations downward based on their proximity  to bids, BOEM could better evaluate how its valuations relate to actual  outcomes, which would better inform the bureau as to the validity of  its forecasting, modeling assumptions, and the extent to which it is  assuring receipt of fair market value.

According to standards for internal control in the federal government,  management should establish and operate monitoring activities to monitor  the internal control system and evaluate the results as well as remediate  identified internal control deficiencies on a timely basis. Without  implementing a systematic process for comprehensively evaluating its  tract valuations, such as by expanding the scope of the bureau’s lookback  studies effort and remediating any identified deficiencies, the bureau does  not have reasonable assurance that its tract valuation process is working  as intended, and that opportunities to refine or improve the bureau’s  valuation process are identified and pursued to better assure the receipt  of fair market value for the federal government for offshore oil and gas  leases. Such a systematic process could provide BOEM a better  understanding of how well the bureau is able to forecast key factors  against actual results.

BOEM has policies and practices intended to ensure the bureau receives  fair market value for the hundreds of millions of dollars of offshore oil and  gas leases sold each year. This includes a process to assess fiscal terms  in advance of lease sales that has informed periodic changes to fiscal  terms over the years. However, we found that BOEM has made limited  progress in considering more fundamental changes. The bureau has  publicized the development of a progressive royalty structure since 2013  that may better share the risks and rewards of offshore energy activities,  but has made limited headway in developing one despite significant  potential benefits of such a system. The bureau has not defined what is to  be achieved, who is to achieve it, how it will be achieved, and the time  frames for achievement. Developing a documented plan for determining  whether and how to develop a progressive royalty structure that defines  these aspects would help position BOEM to better understand (1) the  potential benefits such a structure offers in terms of improving fair return  to the taxpayer while fostering diligent offshore oil and gas development  and (2) how to implement such a structure if it elects to do so.

After lease sales, BOEM has repeatedly rejected industry bids when they  were lower than the bureau’s assessments of a tract’s value, generating  significant additional revenue at subsequent lease sales. However,  BOEM’s valuation process might not fully assure receipt of fair market  value for sale of offshore oil and gas leases because it systematically  reduces the thresholds for accepting bids even though rejecting them  could lead to significantly increased revenue. We found that BOEM does  so by using a conservative approach to estimating tract values,  forecasting unreasonably high levels of depreciation in its delayed  valuations, and further lowering valuations in order to justify accepting  bids it otherwise would have rejected. Enlisting an independent third party  to examine the tradeoffs and benefits of the bureau’s continued use of  delayed valuations, and making changes—such as terminating the use of  delayed valuations as acceptable bid threshold criteria or amending its  model’s assumptions to develop more justifiable depreciation rates—as  appropriate, would help BOEM mitigate risks of continuing to accept bids  based on poor information on tracts’ future values. Furthermore, BOEM  generally lowers its valuations and thereby accepts bids as long as the  bid is at least half of BOEM’s initial valuation, which is inconsistent with  bureau procedures for ensuring receipt of fair market value. Without  taking steps to ensure that BOEM’s bid valuation process is not biased  toward adjusting valuations downward based on their proximity to bids,  the bureau risks continuing to undermine the receipt of fair market value  for the sale of public resources. Cumulatively, we calculate that taking  these steps could result in BOEM collecting approximately 10.7 percent  more in bid revenue for offshore tracts it determines to be economically  viable, which would reflect hundreds of millions of dollars in additional bid  revenue over the next decade.

BOEM’s ability to assure receipt of fair market value is further hindered  because it does not systematically assess its own performance and take  steps to improve it. For example, BOEM does not (1) assess how its  forecasts of key factors (e.g., reserves discovered, likelihood of success,  and oil prices) compared to actual results, (2) assess the assumptions  and accuracy of its discounted cash flow model results, such as how well  the model accounts for depreciation, and (3) collect information about  deviations between BOEM’s initial and final valuations that could provide  management insights into the frequency and implication of lowering  valuations. Without implementing a systematic process for  comprehensively evaluating its tract valuations, such as by expanding the  scope of the bureau’s lookback studies effort and remediating any  identified deficiencies, the bureau does not have reasonable assurance  that its tract valuation process is working as intended, and that  opportunities to refine or improve the bureau’s valuation process are  identified and pursued to better assure the receipt of fair market value for  the federal government for offshore oil and gas leases.

We are making the following four recommendations to BOEM:  The BOEM director should develop a documented plan for determining  whether and how to develop a progressive royalty structure that clearly  defines what is to be achieved, who is to achieve it, how it will be  achieved, and the time frames for achievement. (Recommendation 1)

The BOEM director should enlist an independent third party to examine  the extent to which the bureau’s use of delayed valuations assures the  receipt of fair market value, and make changes—such as terminating the  use of delayed valuations or amending its model’s assumptions—as  appropriate. (Recommendation 2)

The BOEM director should take steps to ensure that BOEM’s bid  valuation process is not biased toward adjusting valuations downward  based on their proximity to bids. (Recommendation 3)

The BOEM director should implement a systematic process for  comprehensively evaluating its tract valuations, such as by expanding the  scope of the bureau’s “lookback studies” effort, and remediating any  identified deficiencies. (Recommendation 4)

We provided a draft of this report to Interior for its review and comment. In  its written comments, reproduced in appendix II, Interior agreed with one  recommendation, partially agreed with two, and disagreed with one, as  discussed below. Interior also stated that it is concerned that certain  aspects of the draft report do not paint a representative picture of BOEM’s  valuation process and efforts to ensure receipt of fair market value.

Regarding the recommendation that BOEM should develop a  documented plan for determining whether and how to develop a  progressive royalty structure, the agency agreed and indicated that  BOEM will develop such a plan. Specifically, the agency stated that  BOEM would develop a plan to identify the theoretical and practical  benefits and drawbacks of a progressive royalty structure based on  existing research and prepare materials for management to determine  whether implementation of a price-based royalty would be beneficial.

Regarding the recommendation that BOEM enlist an independent  third party to examine the extent to which the bureau’s use of delayed  valuations assures the receipt of fair market value, the agency  disagreed. The agency stated it did not agree with our  characterization of BOEM’s delayed valuations and stated that BOEM  believes it is neither necessary nor cost effective to enlist an  independent third party.  However, BOEM agreed to (1) examine its  delayed value calculation, particularly as it relates to the impact of  biannual lease sales, (2) develop a plan to perform a comprehensive  internal review of delayed value calculations and make appropriate  changes, and (3) institute a peer-review process for all potential  changes. These actions may address some of the deficiencies we  identified, but our concerns regarding BOEM’s use of delayed  valuations are not limited to the move to biannual lease sales and the  agency has not provided any reasonable explanations for its high  levels of forecasted depreciation. BOEM forecast a median  depreciation of about 23 percent. This implies we should observe  significant declines in the actual value of tracts over long periods of  time, which is impossible to reconcile with actual trends in bonus bids.  The real average bonus bid per acre in 2018 was about the same as it  was thirty years earlier in 1988. Alternatively, such a high forecast of  depreciation implies either a long time frame between lease sales or a  high discount rate. But the time between lease sales has been one  year or 6 months, on average, and in our view, and the Office of  Management and Budget’s annual recommended discount rate of 7  percent would be more appropriate. Recognizing that Interior’s view  differs from ours in this regard, we continue to believe that enlisting an  independent third party to examine all aspects of the bureau’s use of  delayed valuations—not just proposed changes to address the move  to biannual lease sales—would better assure the receipt of fair market  value.

Regarding the recommendation that BOEM take steps to ensure that  its bid valuation process is not biased toward adjusting valuations  downward based on their proximity to bids, Interior partially agreed.  Specifically, Interior stated it agreed with the recommendation, but did  not agree with our characterization of BOEM’s bid valuation process.  Interior stated that the apparent anomaly—the lack of instances when  BOEM valued tracts up to double industry’s bid—is skewed because a  very large percentage of the data set comprise relatively low bids, and  BOEM-generated valuations relative to the bids are constrained by  the minimum bid amount. That is, Interior stated that the minimum bid  level created an artificial floor for BOEM’s acceptable bid threshold  even in instances in which BOEM’s valuation is substantially lower,  resulting in more bids being up to double BOEM’s valuation than  would be the case if BOEM’s acceptable bid thresholds were not  constrained by the minimum bid amount. However, as discussed  above, we removed all valuations for which BOEM used the minimum  bid level as its acceptable bid threshold from our analysis (that is, we  did not include instances when BOEM’s actual valuation was below  the minimum bid level). Had we included these valuations, the  asymmetry in the relationship between bids representing 100 to 200  percent of BOEM’s acceptable bid threshold (acceptances) and  BOEM’s acceptable bid threshold representing 100 to 200 percent of  industry’s bid (rejections) would have nearly doubled (see figure 6).  Moreover, even though we did not include these instances, the  minimum bid level only affects the distribution of instances when  BOEM’s valuation was less than industry’s high bid. As such, it does  not explain why there are so few instances when BOEM valued tracts  slightly more than industry. We continue to believe that taking steps to  ensure that its bid valuation process is not biased toward adjusting  valuations downward based on their proximity to bids would be  beneficial and will monitor BOEM’s efforts as part of our regular  recommendation follow-up.

Regarding the recommendation that BOEM implement a systematic  process for comprehensively evaluating its tract valuations, such as  by expanding the scope of the bureau’s lookback studies effort, and  remediating any identified deficiencies, Interior partially agreed.  Specifically, Interior stated it agreed with the recommendation, but did  not agree with our characterization of BOEM’s bid tract evaluation  process and review procedures. The agency identified two areas  where they did not agree with our characterization.  First, the agency  stated that our statement that “resource discoveries are not updated”  is inaccurate. According to its comments, BOEM develops  independent estimates of recoverable oil and gas contained within  discovered fields by conducting field reserve studies. However, any  updated estimates are not reflected in the lookback studies, which  represent BOEM’s formal mechanism for self-evaluation. For the  lookback studies, as noted above, BOEM compares their forecast  against the results of only the first exploratory well and does not  update its studies with the results of further exploration. Second, the  agency stated that we were incorrect to state that BOEM does not use  the studies to improve processes because it uses its lookback studies  to improve its valuations. However, BOEM did not provide  documentation to support this claim. We continue to believe that  implementing a systematic process for comprehensively evaluating its  tract valuations would be beneficial and will monitor BOEM’s efforts as  part of our regular recommendation follow-up.

In addition, Interior stated in its letter that it appeared that we did not  account for industry assumptions regarding the applicability of price  thresholds in comparing estimated increased bonus bid revenue and  forgone royalties for leases subject to deep water royalty relief sold from  1996 through 2000. However, as stated above, we based our  econometric modeling on the lease terms provided in Interior’s final notice  of sale documents for those leases, which reflect the expectations for  royalty relief that industry bid on at the time of sale. In addition, as  described in appendix I, we used several alternative model specifications  to test the sensitivity of our results to the possibility that industry had  different understandings of royalty relief than those contained in the sale  documents. Our results are robust across these alternative specifications.

As noted above, leases sold in 1996, 1997, and 2000 included provisions  for royalty relief subject to price thresholds (that is, lease terms indicated  that royalties would only be owed if the price of oil exceeded certain  thresholds). Leases sold in 1998 and 1999 did not contain price  thresholds (that is, lease terms indicated that no royalties would be owed  regardless of the price of oil). As evidenced by our econometric modeling  results, during the 1996 through 2000 period, we observed higher bidding  when no price threshold provisions were included in lease terms,  suggesting that industry accounted for the expectation of no royalties  when developing bids.

As noted above, in 2007, a federal court ruled that Interior’s attempt to  collect royalties through the application of price thresholds on production  under leases subject to the 1996 through 2000 royalty suspension was  unlawful. In its comments, Interior stated that industry bidding would have  been different had companies known at the time of sale that the price  thresholds would not apply, and as a result, the net amount of forgone  revenue—the difference between collected bonus bids and forgone  royalties—would have been lower. To account for this, we adjusted our  calculation of estimated additional bonus bid revenues so that it is more  comparable to BOEM estimated foregone revenues. This adjustment  increased our estimate of additional bonus bid revenues to $1.98 billion  (an increase of approximately $530 million), which is still subsumed by  the $18 billion in foregone royalties collected through the end of 2018.

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If you or your staff have any questions about this report, please contact  me at (202) 512-3841 or ruscof@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. GAO staff who made major contributions to this report  are listed in appendix III.

Appendix I: Econometric Model Methodology and Results

We developed an econometric model to analyze the effect of royalty rates  and other key variables on bonus bids for offshore leases between 1985  and 2018. Specifically, we analyzed how changes in royalty rates affected  the winning bids for offshore leases. Our analysis used data from 23,081  individual lease sales in the period from 1985 to 2018.

Our model analyzes the winning bid for each lease auctioned by the  Bureau of Ocean Energy Management (BOEM). We used the log of  the inflation-adjusted winning bid per acre for this dependent variable:  Where 𝑌𝑌𝑖𝑖𝑖𝑖 represents the inflation-adjusted (real) value of the winning  bid per acre and 𝑦𝑦𝑖𝑖𝑖𝑖 is its log value. 𝑦𝑦𝑖𝑖𝑖𝑖=log (𝑌𝑌𝑖𝑖𝑖𝑖) .

Our key set of explanatory variables was a set of indicator (dummy)  variables that captured the different levels of royalty rates that  pertained during our study period. We ran three alternative model  specifications to capture the effects of royalty rates and royalty relief  that occurred between 1996 and 2000. Each specification contained:

A dummy variable for the 16.67 percent royalty rate.

A dummy variable for the 18.75 percent royalty rate.

In addition to a 16.67 and a 18.75 royalty rate dummy, model 1  included two additional dummy variables: one dummy variable for  royalty relief that occurred in 1996, 1997 and 2000, which allowed  a 0 percent royalty rate until the oil price reached a specified  threshold; and a second dummy variable for royalty relief that  occurred in 1998 and 1999, which allowed a 0 percent royalty rate  in perpetuity.

In addition to a 16.67 and a 18.75 royalty rate dummy, model 2  included five additional dummy variables for each year from 1996  to 2000.

In addition to a 16.67 and an 18.75 royalty rate dummy, model 3  included a single dummy variable for the period 1996 to 2000.

The omitted royalty rate dummy variable category was a rate of  12.5 percent. The estimates of the parameters for the other royalty  rate dummies show the effect relative to this 12.5 percent royalty  rate.

Our model controlled for variables that were expected to be related to  potential lease production and profitability. These variables included a  dummy variable for whether the lease was determined by BOEM to be  viable or nonviable; a set of dummy variables for different values of  the number of bids, that is, 1 bidder, 2 bidders, 3 bidders, and so on;  and a variable for the amount of oil production in the area (protraction  area) of the lease’s location at the time of the lease auction.

We also controlled for various administrative factors. We used a  dummy variable to indicate when the winning bid was too low and was  rejected; the value of the minimum bid allowed for the auction; and a  set of dummies that captured the use of different royalty suspension  provisions, variation in rents charged and different amounts of deep  gas relief. To control for effects that vary over time, we included a set  of time dummy variables for each date of sale. These dummies  account for effects that vary over time but are fixed for any given date,  such as technology changes and oil and gas market conditions  including the price of oil and gas. Our objective was to control for as  many time-varying factors as possible. Attempting to include separate  effects of, for example, oil prices and exploration costs, would create  problems of leaving out important effects that are difficult to measure  or for which there are no data. Finally, we included a set of fixed-effect  dummies for each protraction area-block combination that account for  locational effects not measured by our other explanatory variables.  These fixed effects assist in controlling for unobserved heterogeneity.

The regression analysis employed an unbalanced panel model using data  for offshore BOEM lease auction sales between 1985 and 2018 as  follows: 𝑦𝑦𝑖𝑖𝑖𝑖𝑖𝑖=�𝑐𝑐𝑚𝑚𝐶𝐶𝑚𝑚 𝑦𝑦𝑖𝑖𝑖𝑖𝑖𝑖 is the dependent variable; namely, the log of the real winning  auction bid for lease j at location (protraction area-block combination) i  for sale date t.  𝑐𝑐𝑚𝑚 is a fixed effect parameter for its associated dummy variable 𝐶𝐶𝑚𝑚, 𝑔𝑔𝑖𝑖 is a fixed effect parameter for its associate dummy variable 𝐺𝐺𝑖𝑖 for for winning bidder, company m. 𝑓𝑓𝑖𝑖 is a fixed effect parameter for dummy variable 𝐹𝐹𝑖𝑖, for year t. location (protraction area-block number combination) i.

𝑋𝑋𝑖𝑖𝑖𝑖𝑖𝑖𝑘𝑘  is the kth characteristic associated with lease j at location i for  discussed above and 𝛼𝛼𝑘𝑘 is the parameter associated with each of sale date t. There is one of these for each of the control variables these variables.  𝜀𝜀𝑖𝑖𝑖𝑖 are the error terms.

We used xtreg in STATA to estimate our model. Our standard errors  are heteroscedasticity-robust and are adjusted for clustering at the  protraction area-block combination level.

In some cases, our model showed that leases sold when royalty rates  were lower had significantly higher winning bids. While not all the royalty  rate dummy variables were statistically significant, those dummy variables  that measured the largest differences compared to the omitted 12.5  percent royalty rate were statistically significant. Specifically,  In model 1, the royalty exemption for 1996, 1997, and 2000, when  producers expected zero royalties until oil prices rose above a given  threshold, corresponded with an increase in bonus bids of about 34  percent. Similarly, the zero-in-perpetuity royalty rate relief for 1998  and 1999 corresponded with an increase in bonus bids of about 60  percent.

In model 2, the royalty exemption dummy variables for each individual  year, 1996 to 2000, when producers expected royalty relief, were all  significant. The results for these parameter estimates range translate  into about 19 to 64 percent increase in real bonus bids.

In model 3, the royalty exemption dummy variable for 1996 to 2000  combined, when producers expected royalty relief, was significant.  The result for this parameter estimate translates into about a 40  percent increase in real bonus bids. We tested for the restriction on  the dummy variable parameters (all parameters equal) implied in  model 3 versus model 2. Our test rejected equal parameters in favor  of the specification in model 2.

The 18.75 percent royalty rate dummy parameter was statistically  significant and negative in all three models, which is to be  expected since the base (comparison) case is 12.5 percent. The  result for this effect translates to a drop in bonus bids of about 28  percent in all three models. However, the 16.67 percent dummy  variable was not statistically significant in any of the models.

We used a set of time-fixed effects for each sale date and, therefore, we  could not separate out the individual effects of time-varying variables  such as oil prices. These dummies show the effect on bonus bids of  conditions pertaining on that particular sale date, where a larger positive  value translates to higher bonus bids and a smaller or negative value  translates to lower bonus bids. Figure 7 compares oil prices and the  values of the sale date dummy variables over time and suggests a  correspondence between higher oil prices and the size of these dummy  variable estimates. This suggests that higher oil prices are likely to result  in higher bonus bids.

The set of dummy variables for the number of bids produced parameter  estimates that were statistically significant and for the most part were of  the expected size and sign. These suggest that greater interest (more  bids) is associated with higher bonus bids (the exception was the slight  deviation from this pattern for the 8 bids dummy). The number of bids  may not represent market concentration because anyone is permitted to  bid on a given lease, so potentially there are a large number of bidders.  This set of dummies is more likely to represent perceived quality of the  lease on the part of bidding firms.

Other key factors were either significant with the expected direction of  effect or else not statistically significant. Oil production in the protraction  area at the time of the auction was positive and significant. Rejected bids  were associated with smaller highest bids. Joint winning bids were  associated with higher bonus bids. Leases designated as viable by  Interior were associated with higher bids.

Our model contains no explicit consideration of market concentration  effects. Our use of the number of bidders in the model may capture  some market concentration effects but possible endogeneity issues  that may arise with the use of such measures are not addressed due  to lack of reasonable instruments.

Our model does not explicitly isolate the impact of oil prices because  we needed to include time-fixed effects (dummies). However, we are  able to evaluate the effect of oil prices indirectly by observing the  correspondence between the estimated values of the time dummies  and oil prices. Our tests for joint significance of the time dummies  rejected the null hypothesis of non-significance in all cases.

Our results showed a significant effect of royalty rates of 18.75  percent relative to 12.5 percent. However, our results did not show a  significant effect of royalty rates of 16.67 percent relative to 12.5  percent, which may be due to a lack of statistical power and that  relatively modest differences in royalty rates have only a small impact  of bonus bids.

The model has limited controls for geological conditions at the lease  location. We control for location imperfectly using fixed effects for  protraction area-block combinations, and by including the amount of  oil production on the date of the lease sale in that protraction area.  Our use of these protraction area-block fixed effects does not allow us  to control for water depth explicitly.

Our analysis used data from 1985 to 2018. Earlier data were  available, beginning in 1983, but initial tests of our model suggested  the 1983 and 1984 data were not well captured by the model’s  specification. BOEM’s system of using competitive bidding for leases  began in 1983 and there may have been an initial period during which  market operators learned how to bid efficiently under the new system.

Our model includes a control for the minimum bid but we did not  account for any censoring effects that may have arisen from setting  this threshold.

Ideally, we would have liked to establish whether there were different  responses of bonus bids to the control variables in deep versus  shallow water. However, separate models for deep and shallow water  leases produced mostly non-significant effects for royalty rates, which  suggested that splitting the sample in this way resulted in insufficient  statistical power to estimate these effects.

Appendix II: Comments from the Department of the Interior

Appendix III: GAO Contact and Staff Acknowledgments

In addition to the individual named above, Quindi Franco, Assistant  Director; Matthew Tabbert, Analyst-in-Charge; Natalie Block; Tara  Congdon; William Gerard; Cindy Gilbert; Michael Kendix; Michael Krafve;  and Dan Royer made significant contributions to this report.

Production of oil and natural gas in federal waters generated about $90 billion in revenue for the government from 2006 through 2018. The Bureau of Ocean Energy Management leases exploration rights to companies and sets royalty rates on production.

We found the bureau systematically underestimates the value of offshore oil and gas leases, resulting in the government collecting hundreds of millions of dollars less than it otherwise could.

We recommended ways the bureau could better ensure receipt of fair market value for these leases.

Management of federal oil and gas resources is a topic on our High Risk List.