As oil enters the ninth month of sub-$50 per barrel prices – and natural gas languishes below $3 per MMBtu – the oil and gas industry confronts a challenging time of transition. Layoffs have already happened (or are imminently looming) for some exploration and production companies. Non-core assets have been sold or are on the chopping block. And some companies are staring down credit events and potential bankruptcy. Adding to the doom and gloom, the federal government has recently increased its audit and enforcement efforts to aggressively collect federal oil and gas royalties due and heavily penalize companies for both minor and major infractions.

The government’s increasing enforcement coinciding with companies’ reduction in overhead costs creates a messy collision. On the one hand, the government’s expansion of its audit review and scrutiny over more producing areas has resulted in more frequent compliance orders and penalty assessments. On the other hand, the commodity-price environment has forced (or may soon force) companies to cut staff to the bone – accounting and compliance departments included. The result is that many companies find themselves struggling to adequately and accurately respond to government audits and inquiries without essential personnel, particularly personnel knowledgeable about old assets and assets sold during the downturn.

Although there is no easy answer, there are ways to soften the transition into a low-price operating environment. Early due diligence and preparatory work between internal staff and outside counsel can help ensure that a reduction in force or a non-core asset sale goes smoothly without exposing the company to unnecessary audit and enforcement risk.

By way of background, the Office of Natural Resources Revenue (ONRR) – an agency within the United States Department of the Interior – collects and disburses revenues from energy production on federal and Indian lands and the Outer Continental Shelf. In general, ONRR verifies production reporting, conducts audits, and enforces laws, regulations, lease terms, and orders.

If a company is found to be (or is believed to be) in noncompliance, ONRR can issue heavy civil penalties, starting at $500 per violation per day and increasing to up to $10,000 to $25,000 per day per violation for more serious offenses. The most egregious offenses can also result in criminal penalties and False Claims Act liability.

TABLE OF RECENT ONRR PENALTIES

Click here to view table.

Source: ONRR website: http://onrr.gov/

Although the royalty payment and audit process are nothing new to energy companies, the status quo seems to be changing. As shown trending in the prior table, ONRR has drastically increased its civil penalty assessments over the past year. Underlying these higher penalties are more frequent and more stringent audits.

Here is the rub: ONRR’s increasing enforcement comes at a time when many companies have been forced to cut significant numbers of experienced – often crucial – accounting and compliance employees. Obviously, the loss of any experienced employee is a blow, but the loss is felt even more when those employees are the only ones with specific knowledge that dates back to the inception of an audit or that is related to an asset that may have been sold.

By regulation, companies are required to maintain all records supporting production, development, sale, and royalty reporting for at least six years. Because of this, audits can and often do involve assets and documentation no longer under a company’s control and no longer within the immediate knowledge of current personnel. This creates burden and confusion.

Although it is difficult for any company to do more with less, the negative impacts of a low-price operating environment can be mitigated:

  • First, before a reduction in force occurs, a company should consult more than just its employment lawyers. Engaging a multidisciplinary legal team to assess the cumulative risks a company will likely face from the loss of institutional knowledge related to producing assets is crucial to overcoming audit and enforcement risk.
  • Second, before selling producing non-core assets, companies should develop a specific plan to ensure that the necessary accounting and compliance employees are and will remain familiar with the production and royalty reporting of those assets. Audits can reach back several years, leaving ample time for institutional knowledge to grow stale after an asset is sold. A plan for document and record retention must be addressed.
  • Third, when a reduction in force occurs, a company should ensure that personnel who are knowledgeable about each producing asset and any pending audits remain.

Undoubtedly, a low-price operating environment strains any industry. But the oil and gas industry seems to be facing not only challenging times with commodity prices but also substantial government scrutiny. To help manage the transition, before a reduction in force or non-core asset sale occurs, some extra due diligence and preparatory work can save a lot of regulatory headache, including avoidable legal fees and avoidable penalties, down the road.