the Petroleum Investment Committee to locate them.

Successful alumni would like to see that quality maintained, and some 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 expenditures. In 1966, $1.4 billion was contributed, and in 1982, $4.9 billion was gifted to colleges and universities. However, expenditures 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.

Fundraisers and

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 4-6% 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, now), 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 diversification

that reduces variability in total portfolio returns, good income yields, and the potential for steady capital appreciation in the long run.

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 portion of their $700-800 billion in assets to oil and gas.

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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.

Mr. MOORHEAD. I am vice chairman of the Petro-Lewis Corp. I think an adequate description of Petro-Lewis and its activities in oil and gas operations and investment management is pretty abundant in the prepared testimony. I am also the chairman of an ad hoc committee called The Investment Equity Committee, formed of people in the securities, pension fund management and advisory industries, to forward this legislation, believing it is in the public interest. I am also a governor of the Oil Investment Institute, a trade association which has endorsed this legislation in principle, and will meet next Tuesday to specifically consider, and I trust, endorse the specific legislation represented by S. 1549.

Rather than try to summarize the testimony in prepared form submitted previously, I would like to comment on a few highlight issues. The temptation has been from the opponents, including Treasury this morning, to compare this legislation to some ideal standard rather than to the practical circumstances that exist today. As a practical matter, there is no impediment now for tax exempts to invest free of the UBTI problem. There is simply an impediment to doing so in conventional formats, the conventional format being investing through limited partnerships which own working interests. That is the standard form of nonindustry participation in the oil industry, and it is denied to the tax exempt industry under present law because of the tax impediment. Further, the opponents choose to compare the abuse standard to some ideal. There is the full potential for abuse, and I think abuse is invited, under the situation that exists today with substantial amounts of money being channeled from tax-exempt institutions into oil and gas investments through tax avoidance structures rather than the straightforward conventional way the industry has developed over the decades. We would favor any improvements that can be offered. We would be prepared and are prepared to work with Treasury and other opponents to the bill as presently written to achieve the elimination of the abuse potential that has been alleged.

Finally, the bill does include-specifically addressing the Treasury's concerns-a provision that Treasury should promulgate regulations and rules that would tend to obviate some of the abuses that have been set up, perhaps as strawmen. The issue here I believe is one of competition. Petro-Lewis undertook this legislative initiative because we believed that there was no reasonable basis for anyone to oppose it. We find, to our dismay, that there are people who oppose it, as nearly as we can tell, because of a preference for keeping the situation as it is and avoiding further competition. We personally believe that competition and the access to the industry to new sources of capital is going to be very healthy for this country and for our industry in the long term. With that, sir, I invite your questions in the appropriate time.

Senator ARMSTRONG. Thank you, Mr. Moorhead. Mr. Brumley?

STATEMENT OF I. JON BRUMLEY, PRESIDENT, SOUTHLAND ROYALTY CO., FORT WORTH, TEX.

Mr. BRUMLEY. Thank you, Mr. Chairman. My name is Jon Brumley. I am president of Southland Royalty Company. I am here on behalf of Southland Royalty Company to testify against S. 1549, a