The consequences to petroleum production were devastating. Capital investment to develop new production and to maintain existing production was slashed throughout the world. Even the OPEC countries curtailed development projects to divert diminishing petroleum revenues to maintain their national budgetary commitments to their citizens. The effects of lost capital are twofold. First, all oil wells deplete over time. While new technology has made the discovery of oil more effective, it has also allowed oil reserves to be depleted more quickly. Some recent studies suggest that the current oil depletion rate in the Gulf of Mexico is now averaging 26 percent per year. This is dramatically higher than historic rates of 3 or 4 or 5 percent per year. Without adequate investment to maintain existing production, critical resources were lost - many of which will never be recovered. Second, the loss of an investment year in the petroleum production business creates a critical time lag. The new production that was needed first to replace depleted resources and second to meet expanding demand was not there. IPAA warned in early 1999 that this loss of capital could produce serious production capacity limitations as early as 2000.

1999-2000: OPEC Rebounds, But the Damage Is Done

In March 1999, OPEC countries agreed to substantial reductions in exports; Mexico, Norway and other producer countries joined in. Prices began to rebound, but so did demand. The US economy remained robust and Asian economies recovered. By year's end, prices had returned to 1997 levels, but by then the consequences of a year's lost investment began to tell. In the US, where 65,000 jobs had been lost, only 7,000 had been recovered; where the oil rig count had fallen by 331, it had increased by only 67. Internationally, the results were similar. Strapped for revenues to meet national budgets, new production was not being developed and existing production was not maintained.

Continued demand growth and reducing inventories of petroleum were leading NYMEX commodity prices still higher. In March 2000, OPEC acted again - this time to increase production. It was not an easy task. When OPEC agreed to cut production, Saudi Arabia agreed to the biggest reduction - in part to offset the increased share that Iraq had acquired. Yet, when increases were at issue, no other OPEC country wanted to give market share to the Saudis, but many countries had now lost their previous production capacity - the consequence of lost investment.

While Americans demanded that OPEC "open the spigots" and let the oil flow, the reality was that the capacity was not there except for Saudi Arabia, Kuwait, and the United Arab Emirates. In its effort to raise production in September 2000, the fundamental issue had not changed. Even after a year of high petroleum prices, new capacity is lagging because of the low prices in 1998-99. While OPEC countries, particularly Saudi Arabia talked about increasing production again if petroleum prices did not fall, Kuwait announced that it could not meet its current quota. In reality the world's excess oil production capacity was whatever production the Saudis could muster. Even then, questions remained regarding worldwide tanker capacity, the quality of the remaining oil that can be produced, and the accuracy of estimates of remaining spare capacity such as those of the International Energy Agency.

Since the end of 2000, OPEC has chosen to reduce its production targets. Publicly, these actions are based on its assessment of whether world oil demand will diminish either because of slower economic activity or because of historic seasonal demand fluctuations as spring approaches. However, it is also possible that the intense production efforts of 2000 may have stressed the facilities in these countries as it has in the United States and they require the flexibility to rehabilitate their operations. While the United States has criticized OPEC's actions, the situation reflects the tenuous nature of world oil supply following the 1998-99 oil price crisis.

And then there's Iraq. Since early 1999, IPAA has warned that UN policies were placing Iraq in a position where it could ultimately control the world price of oil and demand the end to UN sanctions. On September 19, 2000, the Wall Street Journal article, "Iraq Pumps Critical Oil, and Knows It" crystalized this risk.

Every six months, the UN revisits Iraqi sanctions and each time there is a tension over what Iraq will do. For all the talk of using the Strategic Petroleum Reserve to mitigate price concerns about heating oil or gasoline, perhaps the real issue will be whether the world can physically meet its petroleum needs if Saddam "closes the spigot." Then, the SPR will be needed for its true purpose - meeting a supply crisis. Clearly, the decision on releasing SPR oil in late 2000 was based on the politics of the Northeastern and Midwestern states. Its purpose was to manipulate the commodity markets that had little response to the OPEC increases. It would be far more beneficial to assure that adequate low income assistance is provided to purchase heating oil or to address better ways to shift supplies of gasoline than to risk placing our economic future in Saddam's hands in an attempt to change the commodity price of oil on the NYMEX.

A Nation Dependent on Fossil Fuels

National energy policy must reflect an accurate understanding of the nature and politics of world oil supply and demand. The US is the second largest petroleum producer in the world; yet, domestic production has dropped by over 10 percent - to 5.8 million barrels/day - since the 1998-99 low price crisis. To meet future natural gas demand and provide the nation with its true strategic petroleum reserve of oil - domestic production - national policies must recognize the importance of a healthy domestic exploration and production industry.

During the past three decades the United States has become more dependent on energy and more dependent on foreign energy. While there have been numerous efforts to define a national energy policy, none have been successful. Today, the world is operating with its tightest supply of petroleum and the United States is facing tight natural gas supplies. Now is the time to clearly address national energy policy and build the program that is needed to meet future demand.

Like it or not, the nation will be dependent on fossil fuels for the foreseeable future. In particular, petroleum and natural gas currently account for approximately 65 percent of the nation's energy supply - and will continue to be the significant energy source. Natural gas demand, for example, is expected to increase by more than 30 percent over the next decade.

Independent Producers - The Linchpin to Future Domestic Petroleum and Natural Gas

It is important to recognize that the domestic oil and natural gas industry has changed significantly over the last fifteen years. The oil price crisis of the mid-1980's and policy choices made then triggered an irreversible shift in the nature of the domestic industry. Independent producers of both oil and natural gas have grown in their importance, and that trend will continue. Independent producers produce 40 percent of the oil - 60 percent in the lower 48 states onshore - and produce 65 percent of the natural gas. They are becoming more active in the offshore, including the deep water areas that have previously been the province of the large integrated companies. At the same time those large companies are now mainly focusing their efforts overseas, in addition to Alaska and the offshore, because they are aiming their investments to seek new and very large fields. Domestic energy policy must recognize this reality.

Recognizing The Role of The Market

Future energy policy should rely on market forces to the greatest degree possible. For natural gas the market is strong and active. Natural gas supply is essentially North American and overwhelmingly from two countries that rely on private ownership and the free market - the United States and Canada. Currently, exploration and development of natural gas in both countries is being aggressively pursued when the opportunities are there, and can be accessed. In the United States drilling rig counts for natural gas are running at rates that are as high as they have ever been since natural gas drilling was distinguished from petroleum. The principal constraints are finding the capital to invest, getting access to the resource base, finding competent personnel, and obtaining rigs. If the market is allowed to work, it will continue to draw effort to produce this critical resource for domestic consumption.

Oil, however, is a different situation. In making decisions regarding developing domestic petroleum resources, the nature of the world petroleum market must be recognized. Although the United States remains the second or third largest producer of petroleum, it is operating from a mature resource base that makes the cost of production higher than in competitor nations. More importantly, most other significant petroleum producing countries rely on their petroleum sales for their national incomes. For them, petroleum production is not driven by market decisions. Instead, their policies and their production is determined by government decisions. Most are members of OPEC, the Organization of Petroleum Exporting Countries. Several are countries hostile to the United States like Iraq, Libya, and Iran. Even those that are generally supportive of the United States, like Saudi Arabia and Kuwait, are susceptible to unrest from both internal and external forces.

Thus, the market price for petroleum will be largely framed by production decisions driven not by the market, but by the politics of these countries - both by internal issues and global objectives. United States domestic policy decisions must reflect this reality - looking to this factor in taking actions that can affect domestic production and producers. But, more importantly, it must recognize that a healthy domestic oil production industry is also essential for a healthy domestic natural gas industry, because they are inherently intertwined.

For example, the failure of the United States to recognize the need to respond to the low oil prices of 1998-99 resulted in adverse consequences for both oil and natural gas production. The nation has lost about 10 percent of its domestic oil production - most of which has been made up by imports from Iraq. And, in addition, the tight natural gas supplies this year are partially attributable to the drop in natural gas drilling in 1998-99 when oil prices were low and capital budgets for exploration and production of both oil and natural gas were slashed by producers because drilling under those conditions made no economic sense.

It is equally important to recognize that while all of these factors influence the ultimate prices of oil and natural gas, it is the commodity markets that have the final say. The role of these markets has emerged from a minor factor in the mid-1980s, when oil and natural gas trading began, to the dominant force today. While many people want to point toward OPEC or big oil, the ultimate price maker is the trading floor of the commodity markets. This has added a new volatility to oil and natural gas prices. Its impact is still poorly understood but must be considered.

However, it is clear that the market reacts to whatever information it can obtain. During the low oil prices of 1998-99 and even during the high prices of 2000, the impreciseness of this information likely created incorrect perceptions of the fundamental situation in the market. The widely held belief that there were large volumes of crude oil available that helped suppress prices in the 1998-99 time period proved incorrect. But, it also worsened the state of the industry such that productive capacity was lost. One action that has been developed to respond to this problem is the creation of an Oil Data Transparency initiative by the Department of Energy to create better information worldwide on supply and demand.

Providing Access to Essential Capital

The nation must avoid making bad policy choices like it has in the past. For example, because oil and natural gas exploration and production are capital intensive and high-risk operations that must compete for capital against more lucrative investment choices, much of its capital comes from its cash flow. The federal tax code is a key factor in defining how much capital will be retained. In the late 1970's and early 1980's when oil prices were high and drilling activity was soaring, the industry was hit by the Windfall Profits Tax that pulled a net $44 billion from the industry at a time when it could have been invested in new exploration and production. In addition, in 1986, when the industry was recovering from the low oil prices of that year, the Alternative Minimum Tax (AMT) was created. The AMT sapped capital from the industry when it was desperately needed. From 1986 to 1997 (before the latest price crisis) domestic oil production dropped by 2 million barrels per day - roughly 25 percent of 1986 capacity. Thus, those tax policies stifled the industry at a time when U.S. energy demand was increasing significantly.

Instead of such counterproductive tax actions, the Administration and Congress need to enact provisions designed to (1) encourage new production, (2) maintain existing production, and (3) put a "safety net" under the most vulnerable domestic production - marginal wells. Congress has considered a mix of tax reforms that have widespread support. They include provisions to allow expensing of geological and geophysical costs and of delay rental payments that encourage new production, extending the net operating loss timeframe and revising percentage depletion that assist both new and existing production, and a countercyclical marginal well tax credit when prices fall to low levels. All of these are programs that independent producers need because their revenues are limited to their production

Beyond these immediately needed policy changes, new tax policies must be developed to meet future demand. In 1999 the National Petroleum Council released its Natural Gas study projecting future demand growth for natural gas and identifying the challenges facing the development of adequate supply. For example, the study concludes that the wells drilled in the United States must effectively double in the next fifteen years to meet the demand increase. Capital expenditures for domestic exploration and production must increase by approximately $10 billion/year - roughly a third more than today. While these estimates are cast in the context of natural gas, the task to maintain or even enhance domestic crude oil production could be similarly stated. Generating this additional capital will be a compelling task for the industry. As the National Petroleum Council study states:

While much of the required capital will come from reinvested cash flow, capital from outside the industry is essential to continued growth. To achieve this level of capital investment, industry must be able to compete with other investment opportunities. This poses a challenge to all sectors of the industry, many of which have historically delivered returns lower than the average reported for Standard and Poors 500 companies.

For the industry to meet future capital demands - and meet the challenges of supplying the nation's energy - it will need to increase both its reinvestment of cash flow and the use of outside capital. The role of the tax code will be significant in determining whether additional capital will be available to invest in new exploration and production in order to meet the $10 billion annual target.

There are a number of different approaches that should be considered. The AMT remains a constriction. While the AMT was modified to exclude percentage depletion from the calculation of the alternative minimum taxable income (AMTI), independent producers remain subject to the AMT with regard to intangible drilling costs (IDCs). Specifically, if "excess intangible drilling costs" exceed 65 percent of net income from all oil and gas production, these costs are "potential preference items". AMTI cannot be reduced by more than 40 percent of the AMTI that would otherwise be determined if the producer was subject to the IDC preference. This 40 percent rule forces many independent producers - particularly smaller ones - to curtail drilling once the expenditures become subject to the AMT. Now is a time when drilling needs to increase significantly. It makes no sense for the federal tax code to be a barrier to this effort.

Some of the future focus also needs to be directed to getting more out of existing resources. For example, while the Enhanced Oil Recovery tax credit exists, it is based on technologies that are twenty or more years old. This provision should be restructured and updated.

Equally significant, policies need to address encouraging more new development. Proposals to encourage domestic exploration and production should be created. A number of concepts are already in play and need to be more fully evaluated.

For example, the Section 29 tax credit for unconventional fuels proved to be a strong inducement to developing those resources. It applies to wells drilled prior to 1993 and uphole completions thereafter. Just last July, the Federal Energy Regulatory Commission acted to reinstate its certification process to address many wells that would otherwise qualify for the Section 29 tax credit. But, the existing credit expires in 2003 and provides no incentive for current development since the qualifying wells had to have been drilled before 1993. S. 389 extends the existing credit and creates a second drilling window that also applies to heavy oil.

Fundamentally, the question facing the nation is how to marshal the capital to develop its domestic resources. To date the $10 billion annual spending increase target has not been met. At issue is how to obtain capital for domestic development. One source is the capital markets and some of this amount will come from there, but it has significant drawbacks. First, the capital markets have yet to show a strong interest in the oil and gas exploration and production industry despite the recent high prices of both commodities. Second, where the capital markets are likely to focus their attention will be on large companies. So, while some large independents may derive some of their capital from these markets, it will only be a portion and smaller independents will need to look elsewhere. Third, there is no guarantee that such capital will go into domestic production because even with regard to investment in exploration and production activities, capital must compete against other projects including international ones.

The next source of capital will be from the revenues generated by higher production and higher prices. First, the magnitude of this capital may be overstated because just as prices for oil and natural gas have increased, prices for drilling rigs and other costs are also increasing which will squeeze the capital that is available. Second, this capital will also be directed to the most promising projects, so there is no guarantee that it will be invested domestically. Third, this revenue will be significantly reduced by taxes.

The challenge, then, is to create a mechanism to direct the capital to domestic production. One such approach would be to create a "plowback" incentive that would apply to expenditures for domestic oil and natural gas exploration and production. This type of proposal would encourage capital formation and development of domestic wells provided it was immediately beneficial. Therefore, it would have to be creditable against both regular and AMT taxes and any excess available for carryback and carryforward. It would address the compelling need to improve natural gas supply as well as reduce the growing dependency on foreign oil. It must, in fact, apply to both oil and natural gas because they are inherently intertwined - often found together. Moreover, because of their inherent link, a healthy domestic natural gas exploration and production industry cannot exist without a healthy comparable oil industry.

Providing Access to The Natural Resource Base

National energy policy must also recognize the importance accessing the natural resource base. While this issue has been addressed extensively for natural gas in other hearings, its importance should not be underestimated. Crude oil production is also significant on government controlled lands and has to confront the same permitting problems and access constraints. The Arctic National Wildlife Refuge (ANWR) has been the focal of access discussions and its reserves are largely oil. The Department of Energy recently released a comprehensive report, Environmental Benefits of Advanced Oil and Gas Exploration and Production Technology, demonstrating that the technology for development of resources in sensitive environments is available. And, it is being employed, when exploration is allowed.

Without policy changes, the nation may not be able to meet its needs. Currently, much of the offshore is off limits to development because of moratoria that are based on technologies that have been replaced decades ago. The rationale for these moratoria is outdated and inaccurate; there must be a reassessment of these decisions in the context of today's technology and tomorrow's needs.

Even in those offshore areas of the Gulf of Mexico that are open for development, the federal policies that determine royalties will also significantly define the extent to which development will occur. For example, over the past half-decade, Gulf of Mexico development has soared, partly because of the Deep Water Royalty Relief Act that specified how royalties would be determined for a set time period. This allowed producers to plan their investments better. However, the Deep Water Royalty Relief Act was largely used by large integrated companies and its specific provisions expired in 2000. Now, as independent producers are also seeking deep water opportunities, the planning window is narrow and the policies are less certain. On the Outer Continental Shelf, marginal properties remain that could be developed if the royalty policies were right. All of these issues need to be addressed with the full understanding that independent producers will be increasingly willing to develop these areas as large integrated companies look toward the Ultra-deep Water and overseas for the large fields that they need to find.

Onshore, an inventory of resources is underway. It is an important first step. But, it is equally important to understand that access to these resources is limited by more than just moratoria. The constraints differ. Monument and wilderness designations prohibit access to some areas. Regulations like the Forest Service roadless policy and prohibitions in the Lewis and Clark National Forest are equally absolute.

At the same time the permitting process to explore and develop resources often works to effectively prohibit access. These constraints range from federal agencies delaying permits while revising environmental impact statements to habitat management plans overlaying one another thereby prohibiting activity to unreasonable permit requirements that prevent production. There is no single solution to these constraints. What is required is a commitment to assure that government actions are developed with a full recognition of the consequences to natural gas and other energy supplies. IPAA believes that all federal decisions - new regulations, regulatory guidance, Environmental Impact Statements, federal land management plans - should identify, at the outset, the implications of the action on energy supply and these implications should be clear to the decision maker. Such an approach does not alter the mandates of the underlying law that is compelling the federal action, but it would likely result in developing options that would minimize the adverse energy consequences.

The Other Challenges to Domestic Crude Oil Production

There are longer term issues that must be fully understood as they affect domestic crude oil production. Some of these have been suppressed as the industry has had to respond first to the low oil prices and then to rebuild itself as prices increased and supply tightened. For example, domestic refining capacity has shifted during the past decade or so. Many of the smaller refineries scattered throughout the middle part of the country have shut down due to increased capital requirements - in part compelled by the requirements of the Clean Air Act. These refineries were purchasers of domestic crude and as they close down, this affects where domestic crude can be sent and its economics. Similarly, pipelines that once took crude oil to refineries are being reconfigured to take product from these refineries. This both eliminates a domestic crude oil market and may affect the regional market of another refinery that is purchasing local crude. The consequence may be to create a preference for foreign crude over domestic. Similarly, crude oil pipelines connecting to Canada can adversely affect domestic production in northern states and those supplying midwest refineries.

The interrelationships between energy sources can also have adverse effects. For example, California heavy crude oil production is confronted with its own problems resulting from high natural gas prices. Because this production requires special treatment to heat it, natural gas is used to generate steam for injection. However, with natural gas prices at current high levels operating costs are so high that production is being shut in and may be lost. High electricity costs can have the same effect. Electricity is one of key operating costs for crude oil production. Particularly for marginal wells, high electricity costs can take away the profitability of a well and force it to shut down.

Conclusion

The challenges facing domestic crude oil are diverse and complicated. Because crude oil is a world market, supply is not determined by pure market forces - it can be defined by political decisions. Moreover, the commodity markets then add greater uncertainty. These dynamics taken together with the high marginal costs associated with domestic crude oil production create an uncertain investment atmosphere.

Overall, attracting capital to fund domestic production under these circumstances will be a continuing challenge. This industry will be competing against other industries offering higher returns for lower risks or even against lower cost foreign energy investment options. The slower the flow of capital, the longer it will take to rebuild and expand the domestic industry. Providing access to the resource base will be critical and requires making some new policy choices with regard to federal land use. Rebuilding the domestic infrastructure is essential but difficult in the near term. Longer term a stable policy structure is critical.

Domestic crude oil production remains an important national security issue. Maintaining or enhancing domestic production is an important national objective. The failure to have clear policies has resulted in two significant adverse events - the 1986 low price crisis that ultimately led to the loss of 2 million barrels per day of domestic production and the 1998-99 low price crisis where the consequences are still being determined.

It is time for this country to take its energy supply issues seriously and develop a sound future policy. Certainly, there is room in such a policy for sound energy conservation measures and protection of the environment. But, energy production - particularly petroleum and natural gas - is an essential component that must be included and addressed at once. Independent producers will be a key factor, and the industry stands ready to accomplish this component, if policy reflects that reality.