This is in response to your letter of November 19, 1985, in which you submitted additional questions following the recent hearing on coal leasing before the Natural Resources Development and Production Subcommittee. Our responses to the questions are enclosed.

Thank you for the opportunity to respond to the Subcommittee.

Sincerely,

Enclosures

Assistant Secretary
Minerals Management

Land and

QUESTIONS SUBMITTED BY SENATOR WARNER

1.

THE DEPARTMENT'S SEPTEMBER ANALYSIS OF OPTIONS INDICATES THAT IF THERE
IS A HOLDING FEE AND IT IS CREDITABLE AGAINST FUTURE ROYALTIES ON
PRODUCTION, THE CONGRESS SHOULD CONSIDER LIMITING THE CREDIT SO THAT
IT ONLY APPLIES ABOVE A CERTAIN LEVEL. THE ANALYSIS INDICATES THAT
SUCH A LIMITATION WOULD MINIMIZE ANY MAJOR DISRUPTION IN THE FLOW OF
REVENUES TO THE STATES.

(a) WOULD YOU EXPLAIN HOW THIS WORKS?

(a)

As discussed in the November 8, 1985, testimony as well as in the
September 1985 report, if holding fee payments are allowed to be
credited against future royalties it is possible that actual
production royalty payments could drop to zero in the early years of
production from a lease. If production royalties in the first year or
two are less than the cumulative holding fees paid prior to
commencement of production, the entire production royalty due could be
offset by the accumulated credits. This would lead to zero cash
payments in the early years of production from a lease. We believe
this possibility to be of concern to State and local governments which
may rely on a stable flow of royalty revenues to assist in programs to
mitigate any adverse economic and environmental impacts that may
accompany coal development, or to serve as a significant portion of
the State's general revenues. Accordingly, to provide a more stable
lease payment revenue stream, it would be desirable to structure the
holding fee as a minimum royalty payment with a crediting provision.
Under this structure, a lessee could offset, with previously paid
holding fees, only the amount of royalties due that exceed the minimum
payment. An example of this minimum payment or limited crediting
notion is contained in S. 570 which would permit crediting of
previously paid fees only in excess of annual production royalties due
above 1 percent of reserves. This is to be contrasted with S. 372
which is similar to S. 570 except that under S. 372 the fees are fully
credited in any year.

The Department recommends that the minimum royalties, or holding fees, be based on .3 percent of recoverable reserves. For crediting purposes, therefore, the previously paid holding fees or minimum royalty payments would be creditable against production royalties due on that component of production that exceeds .3 percent of recoverable reserves produced in that year. The effect of this limiting measure is that, beginning in year 11 the lessee would always make a payment based on at least .3 percent of the recoverable reserves. The State's share of such payments would therefore always be greater than zero, independent of the amount of the accumulated credits.

1.(b)

WHAT, IF ANY, WOULD BE THE IMPACT ON CORPORATE DECISIONMAKING OF SUCH
A LIMITATION?

(b) Corporate decisionmaking will vary from company to company but given the September 1985 staff analysis, the impact appears to be minor. This is illustrated in Exhibit V-2 on p. 82 of the analysis. In that graph both S. 570 and S. 372 (introduced by Senators Wallop and Johnston respectively) are shown by a single line. This is because a graph of the effects of these two proposals, one including the limiting feature and the other not, can be represented by a single line, which indicates no significant difference in the impact on profitability to the firm and consequently no impact on corporate decisionmaking. That is, on a discounted cash flow basis, the basis upon which staff believes industry would evaluate such a limitation, there is no significant differences in the income flow.

1. (c)

(c)

WHAT RANGE OF MINIMUM PAYMENTS WOULD THE CONGRESS CONSIDER BASED ON
YOUR ANALYSIS, AND WHAT WOULD BE THE EFFECT ON BOTH THE FLOW OF
REVENUES AND ON CORPORATE DECISIONMAKING?

The dollar amount of the minimum payment which Congress should
consider, based on our analysis would be different for different
regions, owing to the value of the coal produced in various regions.
Specifically, the Department recommends that the minimum payment be
based upon .3 percent of the recoverable reserves, and that crediting
against future royalties due on production be limited to crediting for
that portion only that would be due in excess of the minimum. With
respect to the flow of revenues, this would mean that in all years the
government would never receive cash payments less than the minimum
based on .3 percent of recoverable reserves. As previously indicated,
the staff analysis suggests that the limiting feature itself is
expected to have no discernable impact on corporate decisionmaking.
The .3 percent basis would allow approximately a six year (from year
10 to 16) window of flexibility for getting a lease into production as
compared with the current statutory inflexibility relative to the 10
year deadline, assuming a 1 percent real price annual escalation in
the market price of coal. This 1 percent assumption should be
considered high relative to what has been experienced in the market in
recent years. Under the more realistic assumption of constant real
prices (1.e., the price of coal increases no faster than the general
level of inflation) no real flexibility would be accorded by the
minimum royalty notion. This is because, with no expected real price
increase to offset the cost of money suffered by the firm from paying
the holding fee, each annual payment of the holding fee can be
expected to irrevocably reduce profits by the cost of capital
associated with each year's holding fee, even assuming that the lease
is eventually developed and the previously paid fees are creditable.