When companies drill for federally owned oil and gas—whether offshore, on federal land, or under private land to which the federal government owns the mineral rights—they pay the government a royalty, usually 12.5 percent of the value of the oil and gas extracted. Last year, the government collected nearly half of these royalties "in kind"—taking a percentage of the actual oil or gas produced, and then turning around and selling it, often back to the very same oil company. Earlier this month, after news of sex, drugs, and industry-funded vacations for royalty-in-kind employees broke, a lot of people started asking whether the government got cheated on some of these deals. But the bigger question is why the royalty in kind program exists in the first place. After all, the government won't let you pay your income taxes in baseball cards or antique furniture. Why doesn't it demand cash from the oil companies?

Until recently, it did. The current royalty in kind program took shape in the past decade, starting as a pilot program in 1996 and expanding to full scale after 2004. It's the result of industry lobbying that started when the Clinton Interior Department decided to end the traditional practice of calculating royalties based on "posted price"—the price at which refineries make a standing offer to buy oil—and calculate them instead on actual spot prices paid for oil, which are generally higher. The oil companies complained bitterly about this change, and instead proposed a royalty-in-kind system—which doesn't require the government to calculate the price of oil before deciding what to take in royalties—as the solution to their concerns. They had an ulterior motive. Under the royalty-in-kind system, the government takes its share—generally 12.5 percent—of the oil or gas as soon as it comes out of the ground. It then has to pay the marketing and brokerage costs associated with selling it to a refinery. The oil company loses 12.5 percent of its gross revenue, but it also gets to cut its brokerage costs by 12.5 percent by shifting those costs to the federal government. Under the old royalty system, the oil company would lose 12.5 percent of its revenue without any corresponding reduction in costs. Shifting a fraction of brokerage costs onto the federal government may not sound like a big deal—given that brokerage costs themselves are only a small fraction of the price of a barrel of oil—but on billions of dollars worth of oil each year it starts to add up.

The royalty-in-kind program, for its part, claims that it's actually making money for the government, partly because of reduced litigation over how much royalty to charge and partly because it is sometimes able to negotiate for higher prices by selling large amounts of oil or gas at once. But these claims were suspect even before we discovered that royalty in kind employees were snorting meth off their toasters. In 2004, the GAO found that the royalty-in-kind program had made money in Wyoming and lost a larger amount of money in the Gulf of Mexico, but that it wasn't keeping detailed enough records to tell whether there was an overall loss or gain. The problem is that it would take some pretty creative trading to make up for letting the oil companies shift 12.5 percent of their brokerage costs to the federal government. And that's why even if there was a way to magically remove the possibility of corruption, taking royalties in kind would be a bad idea.

--Rob Inglis, High Country News