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	OPTIMUM RESERVE BASE FOR PETROLEUM COMPANIES SOUTHWESTERN LEGAL FOUNDATIONS'S INSTITUTE ON PETROLEUM EXPLORATION AND ECONOMICS ADOLPHUS HOTEL MARCH 10, 1982

WEDNESDAY

I appreciate very much being invited to speak here this afternoon. I could make a very short speech today and it would be very accurate, and that is that the Optimum Reserve Base of the petroleum company, very simply, is one that the company can replace annually. The annual depletion of reserve can be replaced annually and that is the Optimum Reserve Base. The American Petroleum Industry is subject to change and we are now in the 80's and you can see that we are changing fast. I think that we are going to have revolutionary levels of change in the 80's and it will be looked on even more so than in the 70's.

In oil and gas companies, both large and small, all managements are managements of depletable assets. The continued replacement of production is essential to the maintenance and growth of the share holder's investment. Therefore, the Optimum Base for any size company can be replaced annually. The early 80's could go down as a period of awareness in the oil industry, an awareness for both stockholders and management. Why? For one reason, many companies are not replacing their assets, liquidation has been going on for years, mislead by increased prices through the 70's and foreign exploration successes earlier in the 70's. Under the present structure of the industry, the reserve base is too large for many company's exploration and production base. They frankly have been too successful in the past. I'm talking about domestic, not foreign. Their reserve bases are too large. Cash flows are too large for quality prospects that are available to them. Cash flows are also too large for the number of personnel that might be available to these companies. Now, this could be changing because you see, we are having some real shakeouts in this industry right now and is probably much deeper than alot of people are willing to admit. For some companies, there is no hope for replacing the reserve base as they annually deplete it. Sellouts and takeovers, I think, will become commonplace in the 80's. We have already had a number of them. Texas Pacific, Delhi, Houston Oil & Minerals, Trans-Ocean and the two large ones, Conoco and Marathon. Sellouts will occur for several reasons. One is the age of management and the succession of management. Lack of drillable prospects. Cost of money. Two small to compete. Takeovers will occur because it is the cheapest way to replace reserves. We already can see that reserve replacement right now is probably between fifteen to twenty dollars per barrel. You can make a purchase of considerably less than that. Even on friendly deals you can buy reserves today for twelve to fourteen dollars per barrel. So, it is an easy way to go on buying, but you have problems with it. On acquisitions, you are also buying declining curves. If you are not replacing your reserves and you decide to replace the reserves by acquisition, you mmediately have bought the reserve replacement and you also bought the declining curve that goes along with those reserves you just purchased. Hostile offers are obviously a problem and there has been tremendous problems for Mobil. It is interesting and I wonder when it occurred to Mobil that the reserve base was safer than for it to be replaced. You can see now that they are frustrated in trying to get those reserves back into reserve bases. Domestic reserves from Mobil are probably replaced 25% or 30% of the reserves annually. There may be a solution to some of these cases, and some considered to be a drastic solution. But it involved the restructure of the industry based on the Royalty Trust concept. Now it is a solution that benefits everyone including shareholders, management and the government, and that pretty well covers everybody that is involved.

In 1979, Mesa pioneered the concept of creating the Royalty Trust as a means of insuring more realistic value for the company's assets. That was the primary reason for the deal. Mesa doesn't fit the criteria for a company considering Royalty Trust and let me give you the reason. Mesa was probably the most unlikely suspect for the deal and that was because there was no concentration of ownership in the hands of management. You will read otherwise, that it was not the case, but I was not a large stockholder as a founder in the company. In fact, I think I owned something like less than 2% of the stock or had approximately that on option. When you see a founder with 20, 30 or 40% of the company, this concept is very exciting to them. So that was not the primary reason for the spin-off. Second, Mesa had replaced their reserves annually 18 straight years as a public owned company. So those two points were not considered in why we had the spin-off. Our thought was, "why sell at below asset value if you are replacing reserves?" And we were selling well below asset value in early 1979 when we started to consider the idea. For instance, in February, 1979, the Mesa stock was $34 per share, breakup value was two or three times that much. In June, 1979, we announced the Trust and the stock price moved up to $44 per share. Now we were also having some increases in oil prices through there: to give us some help. In November, 1979, we spun-off the Trust and the combined value of the Trust and Company at that point was $65 per share. In December of 81', the combined value of the Trust and Company after two splits of Company was $115 per share. At the same time, this concept will reduce the reserve base and save alot of replacement problems. If you reduce the reserve base, it is obviously much easier to impact the base with a discovery. Basically the Trust brings each stockholder a direct ownership interest in producing property. We spun-off approximately half of our reserves, 8 million barrels of oil and 800 billion cubic feet of gas to the Trust. By providing shareholders the more direct income stream from these properties, not burdened by income tax from the corporate level, the stock market is more likely to recognize the value of-the assets. Let's look at that point of the restructured company and see what you have as far as the optimum level of reserves. By spinning-off the Trust, the company reduces the reserve base which can be more meaningfully impacted by new discoveries. Therefore, more companies would be able to replace production on a continuing basis and avoid depletion of stockholder's assets. Consequently, they would increase their PE multiple. I don't think there is any doubt about that and that to me is a very, very sensitive area, especially for the majors. I can not believe the the majors would not consider the Royalty Trust when their PE multiples are something like 3 and 4. You have got wonderful natural resources there that are annually being depleted. The multiple on those companies is 3 to 4 times early. It would be a tremendous advantage for stockholders to change the PE multiple on income. Remember on the creation of the Trust, the company maintains 100% of the working interest and this is a very, very sensitive area when you are talking to managements about reducing size to get to the optimum level of reserve base. When you start talking about spinning-off, let me tell you, that is not what they have heard all through their history with a major oil company or any oil company or any business. What they have heard is to get smaller is the smart thing to do. When you start talking about getting smaller, the first thing they say is just like our directors when we called them and told them we had an idea that we wanted to run by them. When we went through the whole thing, one of our directors said, "Well, that means that you will probably cut your reserves in half and cut your personnel in half". That is just not so because you keep 100% working interest subject to a net profits interest. It gives me a real opportunity to redesign, to fit all factors in the equasion. You have control of the reserves with 100% of the working interest. You have no reduction of people and the question that continually comes up is that you have an IRS ruling that is hanging right now. So they aren't going to consider anything like that until we get cleared. We did get that cleared last week with the IRS. So they have given us Grantor Trust status for the Mesa Royalty Trust. We have some other problems that we don't consider to be of any consequence, but typical with rulings from the government, there are going to be some details that need to be worked out. They have identified the Mesa Royalty Trust as a Grantor Trust. The Trusts that you currently see around are interesting. Why were they formed? We felt that we wanted to get the market value up to near asset value for the stockholders for one. The second, we also saw the point that we were going to have a tough time replacing annual reserves if we didn't reduce the reserve base. Back in early 1979 we had seventy-five million barrels reserved at that point and two trillion cubic feet of gas, so when we started to move into the play we started to reduce several places. We reduced by selling out in the North Sea which was about 30 to 40 million barrels. We sold off Canada which in 79 was about 400 or 500 billion cubic feet of gas and 10 to 15 million barrels of oil. Then the debt was down to about where it was easy to spin-off the Royalty Trust. We were reducing size in here because we could see that in the mid 80's we were going to be running budgets that were absolutely out of bounds if you follow the concept of our budgeting. That, very simply, is one that we have to replace reserves. If we don't replace reserves, we might as well get out of the business because we are liquidating the assets of the stockholders. When we go back to that period and take a look at it, we could see that we had budgets that were on projection that were going to be so huge that we couldn't finance it. We are talking about projecting out 5 or 10 years. What is the optimum size to bring this down? We wanted to get as much off of the stock as we could to raise the value. But we also wanted to leave ourselves with a company that was very exciting. So we decided to reduce the size and keep all of the undeveloped acreage and move off from another base, which we did and it has been a very successful operation.

Now, you have the Permian Basin and San Juan Basin Trusts which all come out of Southland Royalty. I talked to John Brumley the night that they announced their deal. I told John that I wanted the lawyers to get with him right away to make some changes in our standard override agreement on the Royalty Trust concept and that we were not bragging about what we expected out of his deal. He said, "Thanks for the idea and all, but no over-rides for you." Of course, I was jesting when I suggested anything like that. So I said, "Why did you do it John?" He said, very simply, "I'm so glad to get rid of those reserves to our stockholders, that I don't know what to do." I asked, "Why?" He said, "Because I am having trouble replacing the reserves annually." I knew then that John really understood the whole restructure of what had to be done in his company to keep depletion. Of course he has some large stockholders which I would imagine were making him aware of these things about that time or asking questions. The Houston Oil Trust very simply, the first one they spun-off, which I thought was very unique, was an idea expanded from the Trust idea that we had, but it was a financing tool. They sold an over-ride from the public on some undeveloped acreage and some producing properties and I think it was 60 million dollars they raised. The second Houston Oil Trust was very simply one that Tenneco didn't want to step up to the cost of Houston. Oil. They wanted the undeveloped acreage. They didn't want all the reserves. They wanted control of all of the reserves. So they just picked out an optimum spot there, spun-off 75% of it, kept 25% and had all of the undeveloped properties and had control of the reserves.

Now Sabine has announced a Royalty Trust. I had a conversation with some of the Sabine people about that and they said that there wasn't very much reaction to it in the market place. Well, in this kind of market, I can't believe that there is going to be much of a reaction to anything. I'm sure that they had analyzed it the same way. The second was that Sabine said their's would be effective January 1, 1983 and I think alot of people now are looking at the stocks and stock market and the oil and gas industry. Especially the oil and gas stocks and there may not even be anything in 1983 as far as the oil and gas industry is concerned. I think it is a little bit far out and as it is understood and gets closer to the date of the spin-off, that it will also react. I think there will be others announced shortly. I think there are alot of them on the drawing board and I think that managements are going to better understand how valuable this tool is. I'm continually amused how some writers see the Royalty Trusts. There was one in the Denver Post just last week, "Schemes for Founders to Make Large Gains." Now,it sounds like the founders had some hedge on the other stockholders. There is no way. They fail to realize every stockholder is treated the same. There is never a conflict of interest anywhere in deciding how much you are going to spin-off because everybody is going to be treated exactly the same way. I think some companies with excess cash flows are investing outside the energy industry. Cash flows, as I see it are synonymous with Royalty Trusts. We are talking about companies that have excess cash flows spinning-off into Royalty Trusts. So you are talking about spinning-off cash flows. I think that investing outside the industry is particularly dangerous politically. I think industry managements have demonstrated that they do not have the expertise to be fooling around outside the oil and gas industry. I selected two disasterous deals as my examples. Mobil and Exxon. I think they had way too much, money and they were having a hard time getting it placed and made some bad deals. Political attitudes towards the industry can change rapidly. For example. When we were in the North Sea back in the 70's, we got the British National Oil Company. Thatcher government came in 1979. We sold out in the North Sea two months ahead of the Thatcher government coming in. We did not believe Margaret Thatcher could do what she said she was going to do. She said she wouldn't tax the oil and gas industry in the North Sea again. She has taxed them now three times. She doesn't have a choice. I don't think the woman is dishonest, I just think she has her back against the wall and they had to create money. That same situation can happen to our own administration. I think we could very well be looking at Windfall Profits Tax on gas if that issue comes up in 1983. Treadeau in 1979 in Canada, before he was knocked out and Joe Clarke came in, had politics that were well known to the industry. I used to live in Canada where we had an office there from 1959 to 1979. Everybody knew what Treadeau might do if he ever got the majority to do what he wanted them to do. Clarke came in and was there nine months. That was all. We didn't have any idea that Joe Clarke was only going to last nine months. But we did get out before Joe. The timing could not have been more perfect, and we were very lucky on the timing. Treadeau came back in with the majority and look what they have, PETRO-Canada. Canada had it before but it is really moving now. It made shambles of the industry in Canada. I think that very situation can-happen here in 1984. I think if our industry is fat, if it is a sitting duck, if we have a change of administrations you are going to have a PETRO-USA. We are going to have a national oil company. They are going to move in on the play just like BNOC and PETRO-Canada did. If numerous companies form Trusts and reduce the reserve base to a level that they couldn't replace, they would create thousands of new royalty owners throughout the United States, including nonproducing states, which would provide increased broader geographical based political support for the industry. Now, there is no doubt that we would not have Windfall Profits Tax if we had not had, very simply, more nonproducing states than we had producing states. Naturally if you are going to pick up royalty owners out of other nonproducing states, you are going to pick up allies to the industry.

The Grantor Trust status that we received last week from the IRS should cause many to consider the Royalty Trust concept and I'm sure there will be many questions about it at their annual meetings this year. We already started picking them up last year. Gulf Oil and Cities Services had them last year. They are going to have questions about Royalty Trusts and what they plan to do about it. The Trades Department could also encourage Trusts by considering such spin-offs as long term capital gains to the shareholders. I think that is a little farfetched, but we are talking about changing the tax law there so it is a possibility. The Royalty Trust concept will not fit all companies. Let me be very clear about that point. They will not fit all companies. If the deals and cash flow are in balance, a Royalty Trust probably should not be considered by management. If they have cash flow, they probably should get into the energy business and I'm talking energy business, not just oil and gas business. This going back into the energy business is good viable projects and I think they are not intended for Royalty Trusts. Their reserve base is optimum as far as they are concerned. The debt structure of some companies will not allow it. They just can't handle it because they have everything tied up.

Let me summarize the concept. I see it as all parties are winners. The party shareholders, management and the government. Shareholders receive a greater and more direct return on their investment. Assets would not be depleted by the company. And remember the tax advantage of a Grantor Trust. The shareholder would not be taxed at the corporate level, so you can cut one level of tax. Management. Companies can more easily impact the reserve base by reducing their size and that should take a great deal of frustration out of managing an oil company with a huge reserve base. Government. Government can increase its revenues very simply. Let me expand on that statement just briefly. According to a preliminary study by Mesa's people, and it is very preliminary, if 100 oil and gas companies formed trusts, comprised of 1/2 of their US reserves, they would give shareholders direct ownership of approximately $130 billion in present value for distribution, plus approximately $15 billion in annual distributions. This would create an additional federal tax revenue of some $10 to $15 billion on the initial distribution and $2 to $3 billion on annual distributions.

I hope I have made my case, that America's industry is facing a series of dramatic changes and the Royalty Trust concept is the option available to managements to adjust the reserve base to the optimum level.

Thank you very much.