Washington (Platts)--16Sep2009/1208 pm EDT/1608 GMT

US Interior Secretary Ken Salazar on Wednesday said he plans to end a program that has allowed oil and gas producers on federal lands to pay royalties owed the government in product rather than cash.

In testimony to the House Natural Resources Committee, Salazar said the royalty-in-kind program "has been a blemish...on this department."

Interior's inspector general issued a report last year that criticized the RIK program as inefficient and disclosed that some employees of the Minerals Management Service, which is responsible for administering the program, had engaged in unethical behavior, including engaging in sex and illegal drug use, with employees of companies whose leases they are responsible for administering.

And on Monday, Government Accountability Office released a report that found MMS had failed to receive full royalties owed on natural gas production from RIK program participants.

"I do intend to terminate the royalty-in-kind program," Salazar told the committee, adding that the program may be replaced may be replaced with measures designed to simplify the royalty collection process.

Salazar said the RIK phaseout would be conducted in the context of other "fundamental" changes to MMS' royalty programs, aimed at making royalty collection more transparent and accountable.

Committee Chairman Nick Rahall, a West Virginia Democrat, who has been a long-time critic of the RIK program, welcomed Salazar's decision.

Rahall said it would "end the opportunity for mischief, or the temptation for it," and ensure taxpayers of a better return for use of oil and natural gas on federal land.

Rahall last week introduced a bill that would, among other things, have terminated the RIK program. Wednesday's hearing was scheduled to take testimony on the bill (H.R. 3534).

Though the program had many critics in Congress and within the government accountability community, it was popular with the petroleum industry. The American Petroleum Institute said in a statement Wednesday that Salazar's decision "runs the risk of raising administrative costs and adding additional layers of paperwork required to determine the value of oil and gas production."

API president Jack Gerard said MMS had in the past found that RIK had boosted the efficiency of royalty collection and reduced litigation.

"We urge Secretary Salazar to carefully weigh the impacts his 'fundamental restricting' of the royalty system could have on US production of oil and gas, American jobs and revenue to the government," he added.

In addition to eliminating RIK, Rahall's bill would make a number of other dramatic changes to energy leasing at Interior including combining the energy-related activities of MMS and the Bureau of Land Management under the auspices of a newly-created office.

In his opening testimony, the secretary advocated greater coordination between BLM and MMS, though he stopped short of endorsing a merger of the two bureaus.

--Jean Chemnick, jean_chemnick@platts.com