Statement of
Patricia Fry Godley
Assistant Secretary for Fossil Energy
U.S. Department of Energy
Before the
Committee on Commerce
Subcommittee on Energy and Power
U.S. House of Representatives

September 8, 1995

Mr. Chairman and Members of the Committee:

I appreciate the opportunity to discuss the proposal to privatize the Naval Petroleum and Oil Shale Reserves. The Reserves are a valuable asset, but they are an asset that no longer serves a Federal purpose. Since 1976, the program has been devoted solely to the large scale production and sale of oil and natural gas. In other words, the Government is a competitor in operations best left to the private sector. Properly structured, with appropriate safeguards to ensure that the taxpayer receives the full value of the Reserves, privatization can place these assets in the private sector and provide significant income to reduce the deficit.

Background

The Reserves were established in the early 1900s to ensure a secure source of crude oil for the Navy as it converted its coal-powered fleet to oil. For decades the Reserves remained generallyundeveloped, with the exception of a brief period of production during World War II, and were maintained for national defense contingencies.

The oil embargo of 1973 precipitated the decision by Congress to produce the Reserves at their "maximum efficient rate" to help offset the Nation's reliance on imported petroleum. The Naval Petroleum Reserves Production Act of 1976 mandated that the oil reserves be produced and their production sold competitively on the open market, with all receipts from those sales to be provided to the U.S. Treasury.

In 1977, Congress transferred management of the Reserves from the Department of the Navy to the Department of Energy.

The Department of Energy operates the Naval Petroleum Reserve No. 1 in California and No. 3 in Wyoming and the Naval Oil Shale Reserve No. 3 in Colorado, through its contractors. All productive acreage owned by the Government in Naval Petroleum Reserve No. 2 in California is produced under lease to private companies. Naval Oil Shale Reserves No. 1 in Colorado and No. 2 in Utah are undeveloped.

The petroleum reserves have sold crude oil to the private sector, the Department of Defense, and the Strategic Petroleum Reserve. Currently, all oil is being sold to the private sector. All natural gas and natural gas liquids not required for field operations also are sold to the private sector.

Since 1976, the Reserves have produced in excess of one billion barrels of oil, two trillion cubic feet of natural gas, and 3.2 billion gallons of natural gas liquids. On the fiscal side, the Reserves have generated over $16 billion for the Treasury, against costs of approximately $3 billion, over a 500 percent return on investment to the U.S. taxpayer.

Need for Management Change

Today, the national defense purpose for the Naval Petroleum and Oil Shale Reserves no longer exists. The Department of Defense (DOD) does not require the Reserves for defense purposes.

Earlier this year, DOD's Deputy Under Secretary (Logistics) in a letter to the Committee on National Security stated that DOD's "interest in the Naval Petroleum Reserves has diminished over the years as the Reserves have become depleted and otherwise less relevant as a Defense asset." From a readiness standpoint, a military emergency would require expanded DOD procurement and immediate distribution of refined products such as aviation kerosene -- not crude oil.

Consequently, we operate the Reserves today solely as a commercial business -- producing and selling oil and gas in the marketplace.

Yet, as successful as the Reserves have been in generating revenue, the Department of Energy, as a Government agency, does not -- and cannot -- operate the fields to achieve their maximum value. The Federal Government, by design, is not in the business of making money. Government programs are driven by the public interest -- not by a profit motive. Today, the public interest dictates that the Government restrict its expenditures to the highest priority of programs that are responsive to the broadest public interest. This has limited the Department of Energy's ability to make capital investments in the Naval Petroleum Reserves that would have been routine for the private sector.

Net revenues declined over 46 percent between 1989 and 1993, as a result of declining production, low oil prices, and increasing production and operating costs. In fact, oil production has declined more than 47 percent over the last six years, and significant capital expenditures will be needed to maintain production at rates that will maximize ultimate recovery and overall profitability of the fields.

The professional staff of the Naval Petroleum and Oil Shale Reserves has made significant progress in streamlining operations and increasing profitability. But a Government agency is inherently limited in its capability to achieve the efficiencies of a commercial business:

• A private sector company can reinvest its annual revenues to improve operations and enhance profitability. In contrast, revenues from the Naval Petroleum Reserves are deposited into the U.S. Treasury, and we rely on the appropriations process for funding. Before being able to make capital improvements, the Reserves must compete for funding with other programs throughout the Government, and in many cases, profitable investment decisions are prohibited by the need to maintain fiscal constraint.

• A private sector company can respond quickly to take advantage of market opportunities and trends. By contrast, the lengthy federal budget cycle precludes such rapid decisionmaking. For example, the spending priorities we are establishing today -- in FY 1995 -- won't be proposed until the President's budget submission in January of next year -- FY 1996 -- and, if approved, won't be implemented until FY 1997. No commercial business could prosper, particularly in the dynamic, competitive oil market, with such an inflexible and drawn out budgeting process.

• A private sector company can also make long-term plans for the development of properties. Because of the unpredictability of the year-to-year budget, a sound capital investment program that extends beyond one year may not be funded at needed levels in successive years. This inability to plan puts us at a significant commercial disadvantage compared to a private sector company.

• As a Federal agency, we are subject to statutory procurement and other bureaucratic requirements that are not applicable to a private sector company. While these requirements might appropriately apply to some governmental functions, they do not allow cost-effective operation of a purely commercial, non-Federal activity like running oil fields.

In short, we have an oil and gas operation, which includes the Nation's 10th largest oil field, but we cannot run it like a business.

Concerns have been raised that the decision to offer the Reserves for sale has been unduly influenced by Chevron, the minority owner of the Elk Hills field. In reality, three successive Administrations, including the current one, have proposed divesting of the Reserves because it is in the public interest to remove the Federal Government as a competitor to the private sector in commercial activities. Virtually every recommendation for streamlining and downsizing the Federal Government offered during the last 15 years has called for the removal of Government from non-Federal functions as a key first step.

Moreover, to protect the public's interest in the divestiture of the Reserves, our approach would be to create a fully competitive bidding environment. Our objective is to provide all prospective purchasers with complete access to field production histories, independent reserve estimates and other data. In both the House and Senate legislation, Congress has adopted many of the recommended safeguards to ensure the fairest possible competition.

As I will describe later in this testimony, the principal area where we believe this competitive environment can be enhanced is a change in the timing of the sale. By providing the Department with the flexibility to follow the guidance of an expert professional divestiture advisor and, if necessary, extend the sales process into FY 1997, Congress can ensure that adequate time is available for compiling and making available the full set of Reserve data and that all prospective purchasers have a full opportunity to analyze the data prior to preparing their bids. This flexibility would also ensure the Government adequate time to determine the full value of the Reserve.

The Administration's Approach

Earlier this summer, the Administration submitted legislation to divest of the Reserves in Fiscal Year 1997. Our plan called for an approach patterned very closely after processes routinely followed by the business community when large assets are offered for sale.

The central element of our plan was the retention of a qualified investment advisor with a solid track record in handling the disposition of major oil and gas properties. This advisor would develop a proposed divestiture approach and schedule (with a required target date of no later than the end of FY 1997) that would achieve the highest possible value for the assets and would be consistent with practices normally followed by -- and familiar to -- the oil and gas industry. For example, after analyzing market conditions, appraisals of the properties, and the likelihood of attracting prospective purchasers, the investment advisor might recommend sale of the Elk Hills reserve (the largest of the Reserves) in parcels rather than as a unit. The Federal Government does not possess the inherent expertise that would ensure the most attractive marketing strategy, therefore an investment advisor would be key to achieving the maximum asset value.

Also key to our plan was an early independent assessment of the remaining oil and gas in the ground by a recognized petroleum engineer. While the Department of Energy and its unit plan operating partner, Chevron, have routinely estimated the hydrocarbon reserves remaining in the Elk Hills reservoirs, the independent nature of estimates from a recognized petroleum engineering firmprovided in an industry standard reserve report is an important factor for prospective bidders.

The Department also envisioned the reserves report as the first step in carrying out a full independent assessment of the fields' value. It would serve as the starting point for property assessors to add the value of existing equipment, facilities, and real estate in determining the minimum acceptable value of the assets. The reserves report would also be the basis for the Government's determination of the net present value of continuing Federal operation of the properties.

Because of the fundamental importance of the independent reserves report, under the Administration's plan and schedule, it was to be prepared in advance of the other property assessments. In this way, the Department could ensure that its findings would be thoroughly incorporated into other calculations of the full value of the assets.

Determination of a Minimum Acceptable Price

While the Administration has strongly endorsed the divestiture of the Naval Petroleum Reserves, it has set the important caveat that the sale must return the full value of the fields or they will not be sold.

The Administration's plan would include a determination of the minimum value that must be achieved in the disposition of the Reserves. If offers for the purchase of the properties did not realize the minimum value established in the plan, the properties would not be sold and would continue to be managed by the Government in the form of a wholly-owned, for-profit government corporation.

There has been considerable confusion concerning the Administration's estimates of the Reserves' market value. Given that Congressional directives have expressly prohibited the Department from conducting outside studies of the sales value, figures offered by the Administration are, by necessity, only "ballpark" estimates. The estimate included in the Administration's most recent budget proposal was $2.6 billion -- a figure that falls within a range of reasonable values.

The actual value of the Reserves will depend on several variables and assumptions, including:

• An estimated production schedule for oil, natural gas and natural gas liquids over the life of the fields.

  Differences in estimates of production rates and remaining economically recoverable reserves will have a significant impact on the perception of the value of the Reserves by both the Government and prospective buyers.

• A forecast pricing schedule for each of these products.

  In constructing a cash flow analysis, the Government and prospective buyers will use pricing forecasts for oil, natural gas and natural gas liquids for each year of projected production.

• A schedule of operations and capital costs necessary to achieve the production schedule.

  General and administrative costs of a private sector company are likely to be substantially lower than those of the Government. A private sector company could eliminate managing and operating contractor fees, the overlapping program direction and oversight costs incurred both in Washington and in the field under our current operations, and other non-value-added Government burdens. Depending on economies of scale and existing operations, a potential buyer's operating costs may also be significantly lower. However, a private company would be required to pay Federal, State and local taxes that we do not pay.

• The discount rate used to calculate the net present value of the properties.

  The discount rate is a factor used to reflect risk and the rate of return required by a bidder to invest in a particular project. It is a key determinant of the net present value of the discounted future cash flow, which in turn determines the price a potential buyer is willing to pay. Discount rates are subjectively determined by purchasers based on their perceptions of the risks and rewards of the project to their individual companies.

The $2.6 billion that we have estimated as a sales value for the Reserves, while reasonable, does not necessarily represent the highest or the lowest value that would be assigned to the properties by prospective purchasers. Our proposal would obtain the advice of market and financial experts. This advice, along with the net present value of the cash flow under government operation, would be used by the Secretary to set the minimum price at which the Reserves should be divested.

Again, if no prospective purchaser offers that minimum value, the Administration would not proceed with privatization.

Congressional Legislation

In sharp contrast to the past decade, it appears today that the Administration and Congress are of like mind in the need to remove the Federal Government from non-Federal functions and to achieve the maximum possible return from the divestiture of the Naval Petroleum Reserves.

H.R. 1530, passed by the House of Representatives, on June 15, 1995, broke the impasse that has stalled past divestiture proposals. S.1026, currently being considered by the Senate, differs in some ways with the House bill but continues progress toward ultimate divestiture.

While the Administration has concerns about both bills, which are summarized below, we want to emphasize our support for a divestiture approach that returns the full value of the assets to the taxpayer, and we applaud the significant amount of movement in this direction by both Houses of Congress.

The Issue of Timing. Our main concern with both H.R.1530 and S.1026 is that neither may provide sufficient time to execute a sale that will maximize the value of the Elk Hill Naval Petroleum Reserve, one of the nation's 10 largest oil fields. As described above, it is important that adequate time be permitted for the Department to obtain independent estimates of the field's reserves and for prospective purchasers to fully assess these estimates in preparing their bids. This will ensure the most equitable competition among bidders and will likely result in the highest bids.

Our recommended approach would be to allow these reserve estimates to be obtained in FY 1996 under the direction of an experienced investment advisor and to be largely completed before other property assessments and valuations are carried out. A sale could then occur within FY 1997.

Both the House and Senate bills call for the sale to be completed in FY 1996 (assuming enactment of the authorizing legislation by October 1, 1995), potentially compressing the Administration's proposed schedule by as much as one year. Both bills also would have five assessors carry out their work concurrently with the development of the reserves estimate. The assessors would not have the benefit of a completed reserve report in conducting their calculations of the fields' full value. Finally, the compressed timeframe in the Congressional legislation for prospective purchasers to review the data could cause bidders to discount their offers. Prospective bidders would likely wish not only to review the reserves report but conduct independent evaluations, likely necessitating field tours and the review of more detailed production histories.

The amendment adopted by the Senate on August 3, 1995, is a step forward in allaying this concern. It would permit the Secretary of Energy, in conjunction with the Director of the Office of Management and Budget, to notify Congress if the divestiture approach being followed would not yield the maximum value of the Reserves. The Administration could recommend another course of action if it would enhance prospects of a better value from the sale. However, the amendment is unclear on whether the Secretary can recommend a more effective divestiture approach early in the process or only after she has determined that the ongoing sales process has progressed to the point where it will clearly fail to attract the highest possible bids.

Therefore, we would encourage that, during the legislative process, flexibility be given to the Secretary to dispose of these properties in the most effective manner possible. While we are in total agreement with the Congress over the ultimate objective, we would caution against the possibility of compromising the return to the taxpayers by mandating that a few months be saved in the divestiture process.

Consideration of Options for Reserves other than NPR-1 (Elk Hills). Both the House and Senate versions of the legislation call for the Secretary of Energy to conduct a study of options for the future of the Naval Oil Shale Reserves and the Buena Vista Hills (NPR-2) and Teapot Dome (NPR-3) fields. The House version permits the Secretary to study a full range of future options, including the development of the properties by the Government. The Senate version does not include retention by the Government as an option. We favor the House version and recommend that the Secretary be given the flexibility to study the option of Government development if for no other reason but to establish a benchmark for setting the value of these properties. This is consistent with the approach provided for the divestiture of NPR-1 (Elk Hills).

Once the study of future options is complete, we believe it is important to have the legislative authority to continue moving forward to implement the study's conclusion. The Senate language authorizes the Department to implement the study's recommendation after a 31-day "lie before." We would encourage that this language be incorporated into the final bill.

Other Concerns. We have other concerns with both the House and Senate legislation which, although important, have less of an impact than the issues cited above. We would be pleased to discuss these matters in more detail with the Committee, however, for purposes of this testimony, the following is a brief summary of three of these concerns:

• Authorization of appropriations for continued operations - The House bill authorizes $101 million for FY 1996 to carry out operations and maintenance of the fields. The Administration has submitted an amended budget request of $151 million and continues to believe that this is the minimum required to continue operation of the fields as required by both bills.

• Equity finalization - Both bills require the Department and Chevron to reach a final determination of equity (for disputed zones) within five months. The Department suggested the five-month timeframe (in lieu of the originally proposed three months) if the sales process was constrained to FY 1996. If flexibility is given to extend the divestiture into FY 1997, we would recommend that time allowed for equity fixing be adjusted by two additional months. This time extension reflects the highly technical nature of this work, the great deal of data collection and analyses that would be required, and the difficult negotiations that will likely be necessary.

• Payment of investment advisor if sale is not completed - The Senate has added the important -- and necessary -- provision permitting the investment advisor to be paid from the NPR-1 sales proceeds. This is consistent with standard industry practice and provides an incentive for the investment firm to develop a sales strategy likely to return the highest value. Language needs to be developed, however, that would address how the investment advisor would be paid if the Government decides not to complete the sale.

Conclusion

Today, with the public calling for a smaller Government that focuses on those matters of greatest public benefit, the Administration and Congress are making progress toward the ultimate divestiture of commercial oil and gas properties that are clearly not Federal functions. It is important that this progress continue.

It is also important, however, that the divestiture strategy be designed and carried out in a way that maximizes the return to the taxpayer. The Administration has been explicit in its policy of not selling these properties if their full value is not realized. The Congress has also recognized the need to establish a price that reflects the full value of the assets as a required threshold before a sale can be completed.

Clearly, there has been much progress in the last few months in breaking past stalemates and moving forward toward a bipartisan goal. The Administration remains committed to this goal and we will continue to work with the Congress in developing a sound management and divestiture plan that safeguards the interests of the taxpayer.

That completes my prepared statement. I will be pleased to answer any questions.