In January, State Attorney General Frank Kelley filed a lawsuit against Terra Energy for $1.4 million in withheld public royalties and more than $900,000 in interest. Terra denies that it has done anything wrong, and has counter-sued for $250,000 the company claims it overpaid the state.

Thomas Benson, chief of the DNR's Office of Internal Audit, said in an interview that accountants from the agency's Real Estate Division first became aware of the royalty underpayments when they "ran across" an unusual gas supply agreement that Terra Energy had negotiated in 1992 with several of its customers.

Mr. Benson said, "The Real Estate Division did everything they could to inform management," and auditors sent a letter to the Attorney General. Neither agency reacted until the wrongful withdrawals were discovered by citizens, and the state media began reporting on the issue.

A state audit released in September concluded that Terra sold natural gas from its extensive network of Antrim wells on state land in northern Michigan to Howard Energy, an intermediary company, for $1.24 per thousand cubic feet, well below the market price. Terra then immediately bought the gas back from Howard and sold it again to MichCon for $3.15 per thousand cubic feet. All of the transactions occurred simultaneously, with no processing of the gas to justify the price increase.

The result was that Terra avoided making a full payment to the state by basing the royalty on the first sale price of $1.24, not the higher one paid to MichCon.

The difference in royalty payments in Terra's favor on just 10 of its Antrim gas production units from 1992 to 1994 was $831,435, according to the audit. In addition, the audit found that Terra withheld $608,205 from the same 10 units as a result of deductions it took for operating expenses -- otherwise known as "post production costs." (See "Terra Energy Siphoning Millions of Dollars from Taxpayers" in the Summer 1997 Great Lakes Bulletin.)

In response to these revelations, Traverse City-based Terra Energy has launched a public relations campaign. Company executives told the Natural Resources Commission they did nothing wrong, and that such gas supply agreements are routine in the energy industry. Executives also have been busy visiting reporters and editorial boards around the state to explain their complex financial transactions.

The Terra audit is part of an investigation of all Michigan gas producers that the DNR began in October 1996 when it hired Martindale Consultants, a private auditing firm from Oklahoma. In addition to the $1.4 million owed by Terra, auditors have found that five other companies shortchanged the state for a total of $628,218. To date, the DNR has recovered $480,926, from these companies.

Terra is right when it says that such royalty and tax diversions are common in the energy industry. According to Business Week magazine, the U.S Interior Department has billed nine companies nearly $400 million for unpaid royalties on federally-owned lands. Texas has filed suit against oil companies to recover unpaid royalties. And six other energy producing states are investigating improper royalty payments.

Neither the state nor energy industry executives know how widespread the royalty diversion problem is in Michigan. So far the state has audited just six of the 31 companies that operate on state-owned land. There also has been no investigation of how much has been lost in underpaid severance taxes -- a state tax collected when oil and gas is "severed" from the ground -- which industry observers say could equal the amount diverted from royalties.

In addition, almost nothing has been done to account for the money diverted from private mineral owners, who have leased rights to drill nearly 3,500 Antrim wells. In all, the funds diverted by the industry in Michigan easily could reach into the tens of millions of dollars.

CONTACTS: Thomas Benson, Chief of the Office of Internal Audit, Department of Natural Resources, 517- 373-0755; Chris DeWitt, Director of Communications, Michigan Office of the Attorney General, 517-373- 8060; Kelly Farr, Attorney, CMS/NOMECO-Terra Energy; 231-941-7919.