With A Wink And A Nod: How the Oil Industry and the Department of Interior Are Cheating the American Public and California School Children

Foreword

With all the talk in Washington about government reform and cutting waste --- corporations are making out like bandits. Government acquiescence to industry is becoming even more prevalent, and corporate welfare is rampant --- at a time when the political push is to eliminate oversight and safeguards in the rush to deregulate. The Project On Government Oversight (POGO) is a non-partisan non-profit organization that for fifteen years has been working as a government watchdog. Our mission is to investigate and expose abuse of power, mismanagement, and acquiescence to corporate interests by the federal government. The organization aims to refocus public policy from protecting the powerful to pursing public and environmental justice. Our goal is to change the way the government works by revealing examples of systematic problems, offering possible solutions and initiating change.

POGO’s methods include networking with government investigators and auditors whose finding have received little attention, working with whistleblowers inside the system who risk retaliation for exposing waste and fraud themselves, and performing independent investigations into areas we suspect are problematic.

According to an internal Department of Interior report, the federal government is owed as much as $856 million from ten oil companies – Texaco, Shell, Mobil, ARCO, Chevron, Exxon, Unocal, Phillips, Santa Fe, and Oryx. The money in question has accrued from uncollected royalties and interest owed to the federal government for their production of crude oil from federal lands in California from 1978 to 1993. Incredibly, despite the estimate of $856 million calculated by an independent consultant hired by the DOI, the agency is actually still considering whether to collect any of this money! (Appendix A) And every day that passes with no action taken only increases the amount that is owed to the government.

In April 1995, The Project On Government Oversight (POGO) released a report that estimated the total uncollected royalties and interest, going back to 1960, collected from only the first seven of these companies would total $1.5 billion.1 This was based on DOI’s own numbers. What are they waiting for? How many times does the DOI need to be told that it is being robbed?

The government is already writing off collecting the royalties and interest owed between 1960 and 1978. Now, there is even evidence that the government is trying to write off the money from 1978 up to 1990! What right do they have to give away this money?

If the $856 million is collected, approximately $165.50 million would actually be earmarked to go back to the California public school system. This is a system that is so strapped for funds that three of its school districts have gone bankrupt. If the federal government did collect this money, it would pay for the education of over 35,000 students for a year, or pay for over 4,100 teachers, at California’s rate of expenditure.

Why is the DOI more comfortable running a corporate welfare program for the oil industry, than doing its job and collecting what is due to the American people?

How The Scam Began

Crude oil is produced on federal lands by both the “integrated” and independent producers. Seven of the companies are actually responsible for creating the unusual environment in California that allows this scam to take place. Texaco, Shell, Mobil, ARCO, Chevron, Exxon and Unocal are “integrated” in California – which means they produce crude, in all but one case (Exxon) they own the pipelines that transport the crude to the refineries, and they own the refineries themselves. The only way for any oil producer to transport the crude to refineries efficiently is through the intrastate pipelines owned by these integrated oil companies. For decades, these companies have artificially depressed the price of crude oil, though their refined product prices are comparable to those in the rest of the nation. It makes economic sense for the integrated companies to push their profits downstream to the refinery end. This way the integrated companies squeeze out competition form the smaller independent producers and refiners, and pay the government less in royalties, as royalties are based on the price of the crude oil.

This California oil market is not a free-market with open competition. The “posted” price – the price integrated companies (as pipeline owners) offer to pay for crude oil at the well-head – does not reflect the market value of the crude oil. By law, federal royalties are to be based on the market value of crude oil. In practice, however, the federal royalties are based on the “posted” price of crude. This price is artificially low. As pipeline owners, and as major purchasers of crude oil, the integrated companies set the posted prices. They do not risk losing access to the crude oil by offering too low a price, because they control the only efficient means of transporting the crude oil to the refineries. Moreover, when they actually buy crude, they usually pay bonuses of their own “posting”, but the production end pays royalties only on the posted price. The integrated companies are interdependent, as none of them have sufficient pipelines to move all of their oil to their own refineries. They cooperate with each other and move each other’s oil to the refineries. Today, posted prices are primarily used only to compute royalties and to pay independent producers who have no alternative method of transporting the crude.

Of the three other companies, Phillips and Oryx are primarily offshore producers in California. They are not pipeline owners and have simply responded to the market that had already been created by the integrated pipeline owners. Santa Fe is a very large independent producer in federal land. It has openly asserted in its Annual reports that it is paid more of its crude oil than the posted price.

These ten are not the only oil companies that have come to take advantage of this system and were underpaying their royalties to the federal government. They have been targeted because the combined royalty payments from these ten oil companies make up 90% of the total royalties paid to the federal government.

For decades, the independent producers had no alternative but to sell their crude at the posted price, as they do not own an alternative economic means of transport. By the late 1980’s, posted prices became so meaningless, that even some of the larger independent producers began to be paid more than the posted prices for their crude. It is because of the unwillingness of the Department of Interior to recognize that it was the only defender of the system of posted prices – despite evident that these prices do not reflect value – that the federal treasury has lost out on at least $856 million in uncollected revenues.

The Department Of Interior Has Looked The Other Way

The DOI, the agency responsible for collecting these royalties, has been a willing partner in this corporate welfare program. The DOI has been warned again and again that it is looking the other way, as the oil industry makes off like bandits. At some point, the government bureaucrats have got to be held responsible as accomplices. Until now, DOI has ignored the following:

• The General Accounting Office – The average posted price of crude oil in California was about 20% lower than the price in the rest of the U.S. (for a sampling of 16 years between 1950 and 1985), yet the average price of refined oil products in California was almost exactly the same as the average price in the rest of the U.S. (0.38% higher) during those years. In other words, the margin between the price of crude and the total value of the refined product was almost 90% larger for California oil refiners than for refiners in the rest of the county. Even when accounting for the “gravity” – roughly meaning “quality” – of oil, the six-year average posted price of California Ventura was still 13% lower than West Texas Sour Oil.2

• The U.S. Department of Commerce – “It seems that all we have seen to this point clearly establishes that there is a problem. The companies themselves testified that posted prices did not represent value and that was why the exchanges were necessary…. Finally, there is certainly a prima facie case that a problem exists, which MMS (DOI’s Mineral Management Service) initially quantified as in excess of $400 million, exclusive of interest and penalties, from information from the California litigation. MMS needs to do something now to avoid creating the impression that these events have not occurred!”3

• These oil companies have already settled for over $350 million with the State of California for royalties owed to the State for the same reasons money is owed to the Federal Treasury. However, all the evidence used by the state to retrieve this money has been sealed by the courts at the request of the oil companies who feared “potentially prejudicial pretrial prublicity.”4

• The U.S. DOI Office of Policy Analysis – “I suggest that the Department proceed immediately to ascertain the amount of additional royalties due, including interest and criminal penalties, if any, and initiate collection procedures.”5

The Department Of Interior's Change Of Heart

As a result of the aforementioned August, 1993 DOI Office of Policy Analysis letter, DOI’s Minerals Management Service assessed the totals owed to the federal treasury.

“We have evidence that the major California oil producers may have undervalued California oil production by keeping posted prices low and thus underpaying the royalties based on them….The various available court documents, out-of-court settlements, discussions with attorneys, and the work of consultants lead us to conclude that we should pursue potential Federal royalty underpayments.”6

That memo concluded that the low estimate of unpaid royalties is $199 million and the high estimate it $422 million without considering interest.

This was too good to be true, however. In typical DOI fashion, the government looked for a way not to collect the money. A March 1994 internal MMS memo then completely reversed that decision, asserting:

“1. There is no clear or convincing evidence that oil posted prices were below market value or that they were invalid of royalty valuation process. 2. There is no clear or convincing evidence that the California oil market is noncompetitive.”7

DOI Asks Permission Not To Have To Look For The Money

Finally, an Executive Order reportedly drafted by the Department of Interior for President Clinton’s signature circulated in February 1996, reveals DOI’s true position. The DOI was asking the President to establish “a time limit for completing audits of federal lease royalty payments” so that DOI auditors would not have to look into oil companies’ records – and thus collet money – for royalties owed from crude oil production earlier than 1990.

When revealing this document, Representative Ken Calvert (R-CA) remarked:

“Just a few days ago it was brought to my attention that a draft Executive Order establishing a statute of limitations on oil and gas royalties was wending its way thought channels in the Department, and perhaps OMB. Guess what? That draft order would provide for a six-year limitations period, not the seven-year statue which the MMS Director insisted she must have in order to do her job well. Not only that, it more narrowly defines the lessee actions which would cause the limitations clock to toll than does the provision we negotiated with MMS. I want to give the agency the benefit of the doubt, but these revelations are making it very difficult for me.

Our Options

The December 6, 1995 internal Department of Interior options paper identifies as Option 1, the possibility of collecting $856 million for the federal treasury. In fact, this figure only accounts for money owed through 1993 – therefore the oil industry owes even more to the American public. And each additional day that goes by with bureaucratic inaction only increases the amount the oil industry is being allowed to keep for themselves. The government should have begun collecting at least the $856 million already.

Option 1, however, is only one of several options being presented to the Assistant Secretary for Land and Minerals Management. Each option is based on different characterizations of the transactions at issue. While Option 1 is by far the most lucrative for the U.S. taxpayer, the amounts collected quickly drop down finally to Option 7 – where nothing is collected from the oil companies. It appears that the inclination of the decision-maker at DOI will determine which course the government will take. This may not be good news for the American public.

It is pointed out in the “Notes to the Option List” that some of the money may not be able to be collected because the DOI has been in the process of completing “Global Settlement” with many of the oil companies in question. These Global Settlements cover a wide array of legal disputes that are largely unrelated to the royalty question. Three have been signed to date – with Exxon, Chevron and Mobil.

The Chevron settlement only absolves the company from having to pay royalties and interest before 1980, so that the vast majority of Chevron’s share would still be collectable.8 In Exxon’s settlement, the issue of royalties is not specifically discussed, but the structure of the agreement absolves Exxon of all further claims without special reservations. The fact that the DOI has already potentially waived the government’s right to collect some of this money indicates the seriousness with which they have taken this issue. In the Mobil settlement, the government did reserve its full right to collect unpaid royalties from the company.

What Would California Get? $165.5 Million

According to Section 35 of the Mineral Leasing Act as amended, 50% of all royalties accrued from oil produced on federal land is earmarked to be returned to the State from which the oil came. As can be seen through the charts from DOI’s Annual “Mineral Revenues: Report on Receipts from Federal and Indian Leases” (Appendix D), typically, onshore production accounts for approximately 1/3 of total royalties. In this case, 1/3 of $856 million is $285.33 million. The half of that due back to California from onshore production would be $142.67 million.

According to the Outer Continental Shelf (OCS) Lands Act Section 8(g), 27% of all royalties accrued from the production of oil within three miles of the seaward boundary of the State (or within 3-6 miles from the coastline) is earmarked for the State. While MMS does not release figures on the percent of OCS production that qualifies as 8(g), one can compare the total OCS royalties collected to those that were dispersed back to California. California generally receives roughly 4% of the total OCS royalties. The remainder of OCS royalties are kept entirely by the federal government.

In other words, approximately 2/3 of total oil production is accrued from OCS drilling, and 2/3 of $856 million is $570.67 million. Based on the segment of those OCS royalties dispersed back to California, approximately 4%, one can estimate that the total money owed from OCS production would be about $22.83 million. Combining onshore and OCS production, California would be entitled to about $165.5 million if the U.S. Department of Interior goes with Option 1. 9

Impact On California Public Sshool System

Beyond the obvious impact of losing more that $856 million that is owed to the federal treasury, this sweetheart deal with the oil industry has even more direct harms. By federal law, one half of all money collected by the federal government from onshore oil royalties is to be returned directly to the state from which the oil has been pumped. The State gets a smaller percentage of royalties from certain offshore leases.

In the case of California, there is a particularly ironic twist. California State law Sec. 12320 requires that “All money derived from bonuses, royalties, and rentals under the act of Congress referred to in this section and apportioned under the act to the state, shall be received by the State Treasurer and by him credited to the State School Fund.” (emphasis added)

It is this public school system in which there are currently three school districts that are officially and formally bankrupt – Richmond, Compton and Coachella.10 In 1993, California reported that 27 school districts were in serious financial trouble, and nearly half the districts were engaged in deficit spending.11

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Endnotes

[1] For more information, please see the April 1995 POGO Report, “Department of Interior Looks the Other Way: The Government’s Slick Deal for the Oil Industry.” All footnoted sources in this March 1996 report that are not included as appendices are included in the April 1995 POGO report.

[2] “California Crude Oil”, General Accounting Office Report GGD 88-114, Sept. 1988, pp. 30-32.

[3] “California Royalty Valuation Study”, Bernard Kritzer – Department of Commerce, to Dave Hubbard – Department of Interior, September 20, 1994, p. 2.

[4] ORDER RE PROTECTION OF CONFIDENTAL MATERIAL OF DEFENDANT TEXACO INC., THE PEOPLE OF THE STATE OF CALIFNOIA, et al. v. CHEVRON CORPORATION, et al., Superior Court of California, County of Los Angeles, Case No. C-587912, September 8, 1988.

[5] “California Common Carrier and Crude Valuation”, DOI internal memo from Bob Berman to Brook Yeager, August 6, 1993, p.1.

[6] “Potential Undervaluation of California Crude Oil” DOI Minerals Management Services internal memo, undated, p.1.

[7] “Transmittal of California Valuation Study”, Memorandum from Associate Director for Royalty Management, undated, p.i.

[8] Section 6(b) in the government settlement with Chevron provides that the government can collect royalties owed after 1980 if the posted prices are established “through collusion with third parties, fraud, or improper conduct which violates the lease obligations or the Mineral Leasing Act….” The fact that Chevron does not operate all its poplins as common carriers would qualify as “improper conduct which violates…the Mineral Leasing Act.”

[9] One caveat is that the State is only entitled to royalties from 8(g) leases that were signed since 1978. This might create a small reduction in the amount of royalties being directed to California from OCS production.

[10] Letter from Jean Ross, California Budget Project to Danielle Brian, Project On Government Oversight, January 23, 1996.

[11] “School Districts in Financial Bind – 6 in Bay Area”, San Francisco Chronicle, January 23, 1993, A13.