Royalties in Kind

It almost reads like the latest thriller. Just as the Congress is about to consider compromise legislation to expand the portions of the US offshore that are available for oil and gas drilling, and with another major hurricane headed directly for the center of gravity of the nation's energy industry, we learn of a scandal involving government employees responsible for collecting oil & gas royalties. The only element that doesn't fit the plot is that oil prices continue to falter, despite a big decline in US inventories, resulting from most of the production in the Gulf of Mexico having been shut in in preparation for Hurricane Gustav, two weeks ago. I'll reserve my comments on the energy compromise until I see the text of an actual bill, but the MMS scandal demands attention, because of its perceived relevance to the drilling debate.

The subject of oil and gas royalties is not one that ordinarily conjures up images of licentious behavior; it's normally the realm of accountants and auditors. I'm sure millions of Americans are wondering why a group of MMS employees in Denver was even in a position to have been offered lavish entertainment and allegedly to have engaged in conduct unbecoming to a public servant. Historically, most federal royalties were collected in the form of a check, based on the deemed market value at the wellhead of the portion of oil or gas--typically either 1/8th or 1/6th--to which the government was entitled under the terms of a specific production lease. (A notable exception is the late-1990s leases that waived royalties, in order to encourage companies to take the risk of drilling in very deep water, at a time when oil prices had fallen nearly to single digits.) But the problem with verifying the royalty amounts on oil is that the fair market value isn't always obvious, particularly for fields that differ in quality from West Texas Intermediate, or are not accessible by pipeline. The principle behind the Royalty in Kind Program is that if the government takes title to the oil, with volumes verified by a Lease Area Custody Transfer meter, and then sells it itself, there should be no dispute about fair market value.

It is thus ironic that the problems cited by the Inspector General of the Department of the Interior should have arisen from a policy that was designed to reduce the risk of the government receiving less than the full royalty amounts to which it is entitled, for oil and natural gas produced on federal lands or in the federal portions of the offshore. In fact, the Minerals Management Service (MMS) had just reported to Congress that RIK generated $63 million of additional revenue for the Treasury in FY 2007, over and above what it would have collected, had it taken these royalties in cash.

Participating in the oil market to the extent of 190,000 barrels per day, around 4% of total US production, made the MMS a very big player in a segment of the energy business that is highly social. You need to trust the people you do business with, because you must be able to rely on their help when you have a problem, and vice versa. Often, that trust is built by getting to know them over a meal, or at a sporting event. As I've mentioned many times, I traded oil and petroleum products for Texaco on the West Coast during the 1980s and early 1990s. Although I certainly never witnessed or heard of the kind of excesses noted by the Inspector General, I believe that in the absence of a strict organizational and personal code of conduct, the opportunities for someone to go seriously astray in that environment remain significant.

Every year, Texaco's legal department would meet with the company's traders and pipeline schedulers to warn us about conflicts of interest and the requirements of anti-trust law and other regulations. One of our best lawyers would sternly advise us, "Avoid the appearance of evil!" by which he meant, never engage in anything, the legitimacy of which we could not easily explain in a court of law without requiring the benefit of the doubt. Some of the MMS folks and their oil company counterparts might have benefited from such a speech.

My purpose in this posting is not to excuse misbehavior--not a bit of it. However, the stakes in the current energy crisis are too high to permit this incident or the broad generalizations it will spawn to influence the policies that determine how much energy the US will produce for itself in the years ahead, and how much we must continue to import, to the detriment of our trade balance and financial health. The events in question, however distasteful, by no means prove that royalties cannot be collected properly, or that oil companies can't be trusted to deal fairly with the government. All that is required for RIK to work on an arms-length and professional basis is clear and frequently-articulated policies and determined oversight. So by all means, ferret out those responsible, punish anyone who broke the public's trust, and ensure that the Treasury collected what it was due. But exploiting this incident to hold back domestic oil and gas production will cost the US public far more in the long run than any malfeasance that might be uncovered in the MMS.