Summary

I strongly support S.1549 in both my roles as an independent oil man and as a fiduciary of a university endowment fund. However, the bulk of my comments will reflect my experience as an investment officer and manager of tax-exempt assets.

The Petroleum Investment Committee, School of Earth Sciences, Stanford University, is an experienced and prudent group of fiduciaries who are familiar with oil and gas investments of all kinds. The group which was authorized by the Board of Trustees in the 1950's, fully understands the market for oil and gas properties, and I know that they believe oil and gas working interests provide a prudent investment vehicle for endowment funds. As a member of an investment committee for an endowment fund, I perceive my role as one demanding careful screening and structuring of all petroleum investments for their ability to 'produce steady, current income while providing the potential for capital appreciation through price increase on the sale of oil and gas or through reserve additions. Royalties and production payments can provide the former, but not the latter. S.1549 would provide much needed investment flexibility to accept and keep gifts of limited partnership interests or to solicit such gifts of working interests.

The cost of private higher education has been rising steadily, while grants and other financial support programs have been reduced. Income from endowment funds increasingly must help to finance daily operations and fixed costs of universities. Maintaining the high educational standards of an institution like Stanford University requires additional resources, and the institution has set up investment committees, like

the Petroleum Investment Committee to locate them. would like to see that quality maintained, and some

Successful alumni

are willing to

support the institution with gifts of oil and gas working interests in producing properties. I believe that one of the charges of the Petroleum Investment Committee includes solicitation of large gifts and earning at least a 20% rate of return. This can only be accomplished if S.1549 is passed.

Finally, as an independent oil man, I believe that S.1549 would open up another, much-needed source of capital to the independent oil industry. Pension funds and universities could benefit by the positive investment characteristics of owning oil and gas working interests while independent oil firms could finance the development and maintenance of the U.S. hydrocarbon resource base.

Oil and Gas Working Interests are Prudent Investments

Currently, the income from various passive sources, as defined by Sec. 512 of the Tax Code, is exempt from tax. Common stocks, bonds, oil and gas royalties, and production payments are considered passive sources of income. A decade or so ago, endowments would buy or receive gifts of these income sources and hold them forever. For a ten-year period ended December 31, 1983, endowment funds experienced a median rate of return of 7.5%, which just matched the general rate of inflation in the economy. No real gains were made in the size of the endowment from investment activity, although colleges made real efforts to solicit capital contributions from alumni in order to achieve that capital appreciation. Real (1967 $) voluntary support amounted to $251/student at 827 colleges and universities in 1966, and accounted for 9.5% of expenditures. By 1982,

real voluntary support per student was $140 and accounted for 6.4% of In 1966, $1.4 billion was contributed, and in 1982, $4.9 billion was gifted to colleges and universities. However, expenditures

expenditures.

Fundraisers and

were $15.2 billion in 1966 and $73.1 billion in 1982. investment managers who assist colleges have to run hard just to try and stay in place.

Nowadays, most fiduciaries manage endowment funds more actively in an effort to achieve both income and capital appreciation, while taking only moderate levels of risk. Total returns (income plus appreciation) have improved as investment managers alter the portion of their portfolios devoted to corporate stocks and bonds over the course of the changing business cycle. Median returns often approach the S&P 500 index returns, but more is needed to help the educational institutions as other forms of federal and state financial assistance diminishes.

Nonetheless, diversification to reduce risk and steady cash flow remain prime investment goals for endowment funds. Common stock dividends can fluctuate with corporate profits, and many stocks offer income yields only in the 4-68 range, like the S&P 500 index. Stock price appreciation, however, can be significant but highly variable, so that total rate of return is also highly variable. Bonds offer steady cash flows and higher yields than stocks (about 12% for AAA bonds, ncw), but their prices are also variable with changes in U.S. interest rates. Thus, their returns are also highly variable. If the issuing entity's public credit rating changes, the investor can experience a permanent capital loss, as well. Holding a combination of stocks and bonds will provide

reasonable income and reduce the risk inherent in each individual security. Royalties and production payments behave very similarly to bond interest income discussed above.

Diversification into real property like oil and gas working interests adds an important dimension to the standard investment portfolio in addition to its steady cash flow that's very competitive to bonds the potential for capital appreciation, along with much lower rates of variability in both income and capital value. Capital values of oil and gas working interests are largely based on proved and potential reserves in the ground and the production history of the wells, both of which do not vary significantly.

Legally, a limited partner holding a working interest cannot impact the daily operations of the oil and gas property or the general partner. Therefore, the endowment funds would be a passive investor who desired the special characteristics of this investment vehicle that reduces variability in total portfolio returns, good income yields, and the potential for steady capital appreciation in the long run.

diversification

Currently, endowments must quickly liquidate gifts of oil and gas working interests, or place their income tax-exempt status at risk.

Hurried sales

of oil and gas working interests don't bring top dollar for the gifted assets. Yet as an investment officer, it is difficult for me to understand why ownership of a working interest like a limited partnership gives tax-exempt funds a competitive advantage over taxable entities,

while a royalty interest or a production payment does not. Both investment vehicles bear the same degree of control over the asset or the general partner none. Both investments have similar cash flow characteristics.

The last decade has seen the development of various kinds of public offerings of oil and gas working interests. At the same time, endowment fund fiduciaries have become more active asset managers. Financial innovation has been a hallmark of the U.S. capital markets, and the Tax Code should be updated to recognize those changes by passing S.1549.

Potential Source of New Capital for the Oil Industry

The independent oil industry, which does most of the exploration and development drilling in this country, could benefit from the chance to attract passive investors like pension funds, foundations, and endowment funds. These passive investors would probably allocate some small portion of their $700-800 billion in assets to oil and gas.

S.1549 prevents these potential passive investors from controlling the limited partnership and the general partner. Accumulation of tax-free funds in royalties and production payments is currently permitted, and this concept conforms to the true investment characteristics of a limited partnership working interest. Thus, the bill supports the spirit and intent of current tax laws by recognizing financial change and the development of passive limited partnership interests in oil and gas over the last 10-15 years.