The Dirt on Drilling

Collecting oil and gas royalties from public land leases generates as much controversy as revenue.

Timing is everything. On Sept. 8, the Minerals Management Service released a report to Congress that showed taxpayers were getting significantly better value from the agency's in-kind collection of oil and gas royalties than from cash collections from energy companies drilling on public land or offshore.

"Fiscal year 2007 was a dynamic year for the RIK [royalty-in-kind] program," the report noted. That was an understatement. The next day, Interior Department Inspector General Earl Devaney released three reports documenting widespread misconduct, including contract rigging, improper sexual relationships and criminal drug use between 2002 and 2006 in the office responsible for collecting in-kind royalties.

While the behavior chronicled in the reports occurred more than two years ago and agency leaders worked closely with Devaney to remove offending employees without compromising the investigation or violating employment laws, the sensational revelations raise questions about the premise of the program.

Some of the most serious allegations involved three senior executives accused of steering lucrative contracts to a company that one of them created. The most salacious accusation involved Greg Smith, director of the RIK program office near Denver, who allegedly had sexual relationships with subordinates and used cocaine. While Smith was working for the government he also moonlighted as a contractor for engineering firm Geomatrix Consultants Inc., marketing its services to the oil and gas companies he did business with at MMS, the IG found. Nearly one-third of the employees in the 55-person office Smith ran reportedly accepted gifts and gratuities from energy companies.

Interior Secretary Dirk Kempthorne pledged swift action against employees identified by the IG, and Congress has launched its own efforts to "sniff out the bad actors in the Bush administration's oil division," in the words of Rep. Edward Markey, D-Mass.

As Interior Department officials grapple with the fallout from Devaney's investigation, it's important to consider the background of the royalty-in-kind program and the role Smith played in its expansion, says Danielle Brian, executive director of the Project on Government Oversight, a nonprofit watchdog group. POGO has tracked royalty collection activity since the 1980s and in September published a report documenting the program's history.

Historically, energy companies that leased federal or tribal land met their royalty obligations by paying the government a percentage of the cash value of the oil and natural gas they drilled. But in the late 1990s, a series of investigations found that companies were abusing the royalty-in-value program by undervaluing the fair market price of the oil and gas they drilled, and therefore underpaying the government. As a result, the Minerals Management Service proposed more stringent rules for determining the value of oil and gas produced on federal land.

Before those rules went into effect, industry representatives, with the support of key members of Congress, proposed the royalty-in-kind program as an alternative to cash royalties. Instead of collecting a percentage of the cash value of the crude oil or natural gas produced by commercial companies on federal or tribal land through offshore and onshore leases, the government takes a share of the commodity and then sells that oil or gas on the open market. The Minerals Management Service reluctantly adopted a pilot program to test the concept in 1997, according to Brian. The Congressional Record shows that program officials and government auditors worried that taxpayers would lose their fair share of revenue under the program. "This was an industry-created idea, an industry-promoted idea and an industry-corrupted idea," she says.

The pilot program flew under the radar for a number of years and then in 2003, MMS contracted with the Lukens Energy Group to assess the royalty-in-kind program. Lukens concluded that it had "performed remarkably" and recommended its expansion. Based on that independent review, MMS decided to expand the program. Now 72 percent of crude oil royalties and 45 percent of natural gas royalties are collected in kind, and MMS wants to expand the program further in 2009. Such a decision could have enormous consequences. In 2007, the government collected more than $9 billion in royalties, representing the second-largest source of revenue after taxes.

But the independent review that Lukens provided wasn't all that independent, Brian says. Fred Hagemeyer, a Lukens vice president, had chaired the industry's Royalty Strategy Task Force from 1998 to 2000, which promoted the royalty-in-kind program. And according to the inspector general, Hagemeyer was a "trusted adviser" to Smith, the RIK program office director. During the same period Lukens was bidding for the contract with MMS, the IG found that Hagemeyer was helping Smith market Geomatrix.

Smith retired from MMS earlier this year before Devaney's office completed its investigation, and the Justice Department declined to prosecute him for criminal misconduct, as the IG recommended.

MMS is standing by the royalty-in-kind program. In its September report to Congress it cited the program's lower administrative costs and the time value of money-because RIK sales contracts require earlier payments than RIV contracts, taxpayers earn more money on earlier receipts. In addition, MMS maintains that it received higher sales values for RIK production because it pays lower operational costs for transporting and processing the oil and gas.

"This report demonstrates that the RIK program continues to deliver solid and measurable benefits through increased financial returns to the American public, decreased administrative costs and shortened compliance cycles," Randall Luthi, director of MMS, said when it was released.

MMS reported that the U.S. Treasury accrued $63 million in additional revenue under the in-kind program over what it would have received in cash royalty payments. For Brian and other skeptics, the problem with MMS' assertion is it's based on a fair market value benchmark established by Lukens.

When asked if the misconduct he uncovered resulted in any losses to taxpayers, the inspector general told the House Natural Resources Committee it's impossible to know. "The contract files were in terrible shape," Devaney said. "They were unauditable."

"It is breathtaking that Justice declined to prosecute Smith," Brian says. "This is an extraordinary conflict."