TABLE 18 ESTIMATED DOMESTIC EXPLORATION AND DEVELOPMENT EXPENDITURES Estimated Impacts of Oil Price Decontrol and Windfall Profits Taxation on United States Oil Producers A Statement Submitted to the Senate Judiciary Committee by Emil M. Sunley, Deputy Assistant Secretary (Tax Analysis) Department of the Treasury I am pleased to have the opportunity to respond to your request for a review of the projected impacts of oil price decontrol and the Windfall Profits Tax on the financial position of the oil industry as these bear on the aims of S. 1246. That Bill would prohibit acquisitions of other businesses with assets exceeding $100 million by the 16 oil companies that controlled, or had an interest in, 35 million barrels of oil produced domestically in 1976. As you know, the Administration generally supports such legislation. The Department of Justice, as the qualified spokesman of the Administration on anti-trust matters, has already submitted the Administration's proposed modifications of the Bill. In this statement, therefore, I shall not discuss the substance of S. 1246 nor the proposed modifications. Rather, as your invitation to me suggested, I will devote my testimony to materials that may provide you perspectives and background information useful in your continuing deliberation on Beasures to restrain merger activity on the part of oil companies. Determinants of oil company size The first point to bear in mind when considering policies that will affect the oil industry is that, altogether, petroleum extraction and refining only accounts for about 2.6 of the Gross Domestic Product and that, since 1970, its real share of product has tended to decline. Notwithstanding this modest importance of the petroleum sector in the U.S. economy, and the further fact that at least 65,000 unincorporated businesses and 10,000 corporations are directly engaged in it, the industry is dominated by 25-30 corporations with assets of more than $250 million. And this is the characteristic of the industry which has captured public attention and the interest of this Committee. There are three principal reasons why the U.S. oil business is dominated by corporate enterprises that are abnormally large: geological, technological, and international. Oil and gas deposits, more so than any other videly used mineral, are not uniformly distributed beneath the earth's surface. This means that oil and gas fields are difficult to find, which is to say they are costly. Because the location of producible quantities is hard to establish, the aim of the discovery process is not merely to find some quantity of oil but, rather, to find those deposits which are geologically endowed with the characteristics of large volume propelled by natural fluid pressures. These relatively rare deposits are called "giant" fields, defined as those with more than 100 million barrels of recoverable reserves and which will support production rates of 50-100 thousand barrels a day or more. Being rare, such fields are costly to find and extremely valuable when found. The finder of a giant field is thus likely to become a giant company. Moreover, as a matter of simple arithmetic, relatively few giant fields will inevitably produce a very large fraction of total output, within the U.S. or world-wide. Doubtlessly, one of the reasons oil companies that succeeded in finding giant fields have continued to produce 60 percent or more of U.S. oil output year-in and year-out is that the prospect of gain from such successes is so great, those who have tasted that success are both willing and able to invest the huge sums in geological and geophysical work necessary to locate prospects that hold the promise of additional large recoverable reserves. Thus, to minimize over-all discovery costs of establishing giant fields requires a company with specialized skills and large capital resources. over Moreover, however prolific an oil and gas field may be, the reserves discovered at large cost can be withdrawn only an extended period of time at rates governed by the field's geology, the state of technology and oil market economics. In effect, extremely large inventories of producible underground reserves, the value of which is the capital investment that was required to establish the reserves and develop productive capacity, must be maintained to support oil and gas production. Additionally, oil field equipment, such as pumps, gathering and storage facilities, must be installed and maintained to produce oil. As a consequence of these economic aspects of oil and gas geophysics, entities heavily engaged in the oil production stage of the industry are extremely capital intensive, which is to say, "large" in terms of sales and assets, both. I will return later to an important implication of this characteristic of oil producers. Technologically, transportation and refining of petroleum are also capital intensive. That is, aside from the crude oil itself that is moved by ship and pipeline and processed in refineries, the only additional significant costs of transportation and refining are capital costs. This means that not only are "independent" oil transporters and refiners "large" in terms of assets employed, there is an inherent tendency toward direct and indirect integration between stages. Finders of prolific oil productive capacities, in order to assure themselves of markets, and recognizing that only additional capital investment to transport and process their oil is all that is required to add the final elements of value to the resource they already own, commonly have made that additional investment-integrated forward. Alternatively, producers will seek to commit their production to purchasers on the basis of long-term supply contracts. In this case, the purchaser, usually a refiner, acquires an implicit economic interest in the crude producer's inventory of reserves. Indirectly, the refiner has integrated backward into production. Of course, the refiner might integrate backward more directly by merging with a former "independent" producer, or, he might undertake to establish his own productive reserve capacity, motivated by the same considerations that cause producers to integrate forward. Many "integrated oil companies have thus evolved. Obviously, combinations of capital intensive activities already "large" by conventional asset criteria are still larger than integrated firms in other industries characterized by lower capital/output ratios. In other mineral activities, which are also integrated for technological and logistic reasons, labor in mining and processing is a significant contributor to total minerals value added. Finally, due to the historical precedence of the U.S. oil industry, U.S. companies were in the forefront of overseas exploration and development. They were among the most successful discoverers and developers of oil fields throughout the world and as the volume of world trade in oil and oil products expanded over the past 35 years, their foreign investment and income also grew. As the U.S. industry sector with the largest volume of foreign investment and trade, U.S. oil companies' consolidated worldwide balance sheets and income statements appear still more gigantic as compared with those of other U.S. corporations. For the same reasons, from the points of view of other countries, their Own multinational oil companies also appear to dwarf their other corporations. The economics of the oil industry as determined by geologic and technologic forces produces enterprises of large size. This may, or may not, result in noncompetitive market behavior. If it does, this means that public policies aimed toward constraining the sizes of oil companies to reduce perceived noncompetitive outcomes and that are predicated on size alone, unconditioned by tests of market behavior, are not without potential social cost. For example, restrictions on the use by corporations of their own resources imposed solely on the basis of those corporations' association with large daily oil production in the United States must tend to degrade the expected reward for successful discoveries of large reservoirs and thereby reduce the intensity of search for them. Since these are the discoveries that will continue to dominate future domestic crude supplies, policies which deter their coming on stream have potential long run implications. In this instance, as in other public policy choices, achievement of one goal may be purchased only by some sacrifice of another. I will not pause here to make the balance sheet comparisons between oil companies and other U.S. corporations that show their greater capital intensity, although comparative balance sheets may be found in Appendix 1. Instead I will directly turn to the cash flow and investment questions you expressly requested me to review. Sources of oil companies' funds. The annual flow of resources, actually "funds" or claims, to a business enterprise is conventionally divided into two categories, internal and external. In the broadest sense, internal funds are derived from sales of product and interest and dividends received on securities held. But, since these funds are gross of all uses of resources consumed in producing the output sold, it is customary to reduce this flow by the outlays, or obligations incurred, in producing the output. This net source of funds is called "cash flow" and represents that source of funds resulting from the business operations of the enterprise--"internally generated" funds. External funds are then simply the proceeds of long term borrowing or issues of new shares. the In principle, cash flow consists of two elements: after-tax income which might be distributed to shareholders and leave the corporation's earning capacity unchanged, and the amount representing the using-up of the corporation's capital assets which, if not reinvested in income-producing assets, would impair the earning capacity of the corporation. As a practical matter, standard accounting procedures for estimating depreciation and, for oil companies particularly depletion, provide no reliable measure of the capital used-up during the year. Thus, the normally reported division of cash flow as between capital consumption and "net income" may prove misleading when making inter industry comparisons. Total cash flow arising from operations is a more reliable figure than either of its principal parts. The unreliability of financial measures of "net income" is particularly notorious in the cases of oil companies with large interests in oil production from their own properties. As I have noted, the discovery of a prolific oil reserve is costly, and because the oil will flow at low lifting costs per barrel, the value of the discovery is extremely high. Under the accounting conventions followed in the industry, |