STATEMENT OF JAMES T. JENSEN, SUBMITTED TO THE U.S. SENATE COMMITTEE ON INTERIOR ON FEDERAL LEASING AND DISPOSAL POLICIES Arthur D Little, Inc. I appreciate the opportunity to comment on a number of items in your hearing outline concerning questions and policy issues in energy resource leasing. Rather than discussing specific points in the detailed outline, I would like to address my comments to two broad policy areas. They are 1) the implications of the concept of fair market value as a guide to successful leasing policy and 2) relative merits of various alternatives to the traditional cash bonus fixed royalty bidding system. Fair Market Value as a Guide to Federal Leasing Policy Throughout the outline the concept of fair market value for mineral leases appears. For example, item A-3, Attachment B, explores some of the factors in determining fair market value for the leasing of any resource. Clearly the idea that there is a fair market value for any given mineral lease has great appeal. It implies that the administration of the Federal leasing program can be conducted in such a way that the public gets its fair share of the value of the mineral properties while at the same time, the exploration process can go forward expeditiously. Fair and simple though the concept may seem, however, it can be a hindrance to an effective leasing program if it is misunderstood and, therefore, misapplied. The problems are: 1. 2. That it is of limited usefulness in judging the value of That if there is a danger that it will be used retrospectively a good job, it is unworkable and may inhibit the effective Since one of the most critical needs of the Federal leasing program at the present time is to enhance our natural energy resources by promoting more exploration and by stepping up activity in new energy technology areas such as shale, it is critical that the fair market value concept not be misused to impede these national goals. Arthur D Little, Inc. The concept of a market value applies most readily to identical commodities in which it is possible to record a sufficient number of transactions between willing buyers and sellers in order to establish the "market". This would apply to such diverse items as shares of American Telephone and Telegraph traded on the New York Stock Exchange or as wheat futures traded on a commodity exchange. Each represents a large number of transactions in identical items and a means is provided for recording each transaction. Establishment of market value--even though it may fluctuate from day to day--is comparatively simple. In the case of a mineral lease, however, these two criteria of effective markets are violated on both counts. Leases are not commodities. Two blocks of acreage adjoining one another may be valued totally differently by knowledgeable observers trying to value them. Since the blocks themselves literally are not the same, it is hard to establish a measure by which a large number of transactions between willing buyer and seller can establish the "market". The nearest it appears to be possible to come to "market valuation" for mineral leases occurs in the buying and selling of proved mineral properties--particularly oil and gas properties--where it is possible to obtain an independent engineer's valuation of the lease. If the information is available publicly (rather than just held confidentially between the buyer and seller), the "market" value of properties can be stated as the trend or current pattern of percentage of the engineer's valuation actually reached in a group of transactions. However, even here there are problems as different engineers' valuations of the same properties may differ, and rarely is enough public data about transaction values, relative to the valuations, available to provide realistic "market" information. There may be rules of thumb occasionally referred to in industry papers, but no real marketplace data exists. The reservoir engineer's evaluation is done by estimating the reserves underlying the acreage--determining the physical factors that will establish the rate of production of those reserves in each future year to economic exhaustion. Then by estimating operating costs. and revenues from the future mineral production, it is possible to develop a cash flow profile year by year into the future until reservoir exhaustion. Arthur D Little Inc. The cash flow profile can be discounted at current interest rates to calculate the discounted present value of the future cash flows from the property. Since companies are generally unwilling to put their money in oil properties to yield a return equivalent to current interest rates (preferring to invest them in a bank directly instead) the property trading values are usually reduced from the engineer's figure. Conceptually, at least, the process of valuing a discovered, but undeveloped lease (such as an offset block in a drainage sale, for example) or a rank wildcat exploratory lease is much the same. In the first case, the proved valuation must be adjusted for the cash outflows for drilling and development. Since the lease has not been fully developed, the estimates of underlying reserves are less certain and it should be further discounted for the resulting risk. In the case of the wildcat block, probabilistic estimates of the chance of a discovery will sharply reduce the prospective value (calculated on a discovered basis). This is particularly true in new areas where little information may be available to estimate the nature of a successful discovery. In practice companies often approach the estimating of wildcat block values in quite different ways, reflecting their substantial uncertainty. A further complication in a sealed bid lease sale, such as those held in the OCS, is that companies may further superimpose a bidding strategy on their own valuation so that they can expect to win some fraction of the leases they actually bid for in competition with other companies having basically the same fundamental information. What does all of this mean to the administration of a leasing program? Since the leases offered are either development or exploratory the lease administering agency is usually faced with determining "fair market value" in the latter two more difficult cases. The Bureau of Land Management, for example, is often faced with determining whether the fair market value test has been met in an OCS lease sale where unproved acreage is up for bid. There is only one "seller" but several "buyers" to determine the market for a given block. BLM, therefore, has two options: 1. It can assume that the highest bidder has set the fair Arthur D Little, Inc. 2. It can develop its own independent judgment of what it thinks is fair market value, and accept or reject the high bid depending upon its view of whether the bid has or has not met that test. The Department of the Interior seems to be moving in the latter direction by developing its own judgment of the mineral value of each lease utilizing not only data which is supplied by other leaseholders but also participating in offshore seismic programs in order to get advanced geophysical data of the type which the bidders use in order to determine their own bid values on leases. Since individual reservoir engineers can disagree on the underlying data which are used to calculate the present value of proved properties and therefore get differing estimates, of even fairly risk-free properties, the more the input information is of an exploratory or speculative nature (as would be the case of exploratory acreage) the more room there is for disagreement on the basic assumptions and therefore the estimate of different values as between companies. This is evident in the bidding data from sealed bids that have been conducted publicly to date. companies will disagree significantly and there will be a substantial spread in value of bid between different companies at a given sale. Often Sometimes companies' bids can be fairly close together as was the case in the September 1969 Alaskan lease sale where two companies bid within $200,000 of one another on a $72 million bid for Block No. 57. In contrast in the same sale, one group with adjoining acreage one side of Block No. 37 bid $42 million, where a competitive group having a lease also adjoining, placed the second highest bid of $2 million for the same Block No. 37--a difference of $40 million. Obviously, where the two companies so significantly disagreed on their bid values, how could any leasing agency feel very confident with the "fair market value" test? Similarly, in the offshore Texas sale of May 1968. one company bid $44 million for Brazos Block 506 and the second highest bidder came in at $16 million based on a quite different judgement of the geological prospects from this wildcat acreage. Clearly to the extent that the Department of the Interior must estimate "fair value" based on its own assessment of the geological prospects on a given block, it would be subject to the same broad uncer Arthur D Little Inc |