Lone Star Lawsuit Takes On Oil Giants

US government joins suit accusing 15 oil companies of fraud on royalty payments.

A lawsuit filed in Texas federal court could cost the nation's largest oil companies billions of dollars and restructure the way Shell Oil Co., Amoco Corp., and a host of other oil giants pay back Americans who let them draw oil from their property.

The lawsuit, known as Johnson v. Shell Oil, charges that 15 major oil companies have repeatedly undervalued the price of their oil in order to pay fewer royalties for the use of federal or tribal lands.

While the complaint does not specify the amount of the alleged fraud, it has already caused reverberations throughout the industry, adding momentum to several bills in Congress to reform the way oil companies do business on federal and native American lands. It is the largest case to take on the issue of royalty fraud and could spawn dozens of imitators in states and towns where oil is a major source of income.

"This may be the next tobacco litigation," says Danielle Brian, executive director of the Washington-based Project on Government Oversight, which helped file the lawsuit on behalf of the federal government. "The entire industry was lying to the federal government about the value of the oil."

At issue is the industry's various methods of determining the value of oil on site, or "at the wellhead." (The calculation is critical because most lease agreements base royalties on the price of the oil at the wellhead.)

Often, the posted price is $1 to $2 lower than the market value of the oil. The companies maintain that this is because it is less valuable than the oil that has reached the market - it still needs to be shipped to wherever it's going, which costs money.

Critics note, however, that oil companies often sell to their own affiliates, which reap higher profits when they sell the same crude into the international market at full price.

"The government is not getting what it bargained for [in its oil leases]. It's getting what oil companies decide they want to pay," says Harrold "Gene" Wright, an independent oil producer from Tyler, Texas, one of the original litigants who brought the suit against the oil companies on behalf of the federal government. The Department of Justice recently decided to join the suit.

The industry's response

For their part, the oil companies offer only sparing comments on the case. "We are unaware of any criminal proceeding linked to the royalty dispute," says John Bennitt, a Conoco Inc. spokes-man in Denver.

But a handful of native American tribes have grown frustrated with what they see as a pricing shell game. Indeed one tribe, the Navajo nation, decided it was time to prove that their oil was worth more than the oil companies said it was.

In 1995, they took advantage of a provision in their lease agreement and accepted their royalty in barrels of oil rather than cash.

"We complained that the oil was being undervalued, but we were constantly running into companies with stonewalling tactics," says Perry Shirley, an auditor for the Navajos' minerals department in Windowrock, Ariz. So the tribe took the barrels of oil and sold them on the market. "We have gotten premiums over what we used to get," says Mr. Shirley.

As of right now, the Navajos and other oil-rich tribes have not joined the suit, since all of their leases are controlled by a federal agency within the Department of the Interior. But a number of tribes, including the Navajos, would certainly reap millions in back royalties if the federal government won its case.

Some tribal lawyers, however, say that the problems of underpayment will remain a fact of life as long as the federal government relies on an honor system, where oil companies determine an appropriate price and then calculate the royalties they owe.

"It's like the federal tax system: [the oil companies] will pay as little as possible," says Alan Taradash, an Albuquerque, N.M., attorney who represents the Navajos. "The only way to deter the problem is through an audit," and the Minerals Management Service, like the Internal Revenue Service, can only audit a tiny fraction of all transactions.

A date has not been set for the trial, but the dispute has already spawned two congressional plans for reforming the system. One bill, offered by Rep. Carolyn Maloney (D) of New York, calls for the industry to peg its royalties to the price of crude on the New York Mercantile Exchange (NYMEX).

"Our goal is simply to get the oil companies to pay up," says Ms. Maloney. "No tricks. No strategies. They should just pay the government what they owe."

Smaller reforms

Not surprisingly, industry representatives say the NYMEX-based plan is unworkable. The posted-price method may be flawed, they say, but it is a valid way of accounting for differences in the quality and location of oil.

"They have to acknowledge the costs associated with aggregating volumes and moving them downstream to market," says Ben Dillon of the Independent Petroleum Association of America, a Washington-based trade group that represents small oil producers.

If the system must be changed, Mr. Dillon adds, it should move toward a system proposed by Rep. William "Mac" Thornberry (R) of Texas. Under Mr. Thornberry's plan, companies would make federal royalty payments in barrels of oil, in an arrangement called "royalty in kind."

"The value is what you can get in the market," says Thornberry. "The federal government would take possession close to the well and sell it, and [it] can make more money that way."

Whether either the Maloney or Thornberry bill can gain support in an election year remains to be seen. That leaves most industry observers keeping their eyes on the federal court in Texas.