An election once made under these options will control the taxpayer's returns for all subsequent years.

It will be noted that this loss may be charged off under either (a) or (b), and unless there is a very close analysis of accounts, especially "labor and supplies," it is possible to charge the entire amount off under (a) and at the same time charge off a lump sum per each dry well under (b). Whether oil is discovered or not, it is not a complete loss since under the regulations this is a proper deduction for tax purposes, and taxes therefore reduced. As a matter of fact, it would work to the corporation's advantage to spend a large part of its anticipated taxable income in development and exploration. If the anticipated profits are such that the income tax is to be $2,000,000, the operator can and in many cases did spend profits in an extensive drilling program to the extent that no taxable profit accrued. In this way, the Government would actually finance much of this exploration work, and at the same time give a discovery valuation to further reduce taxes. The small operator can not avail himself of this technicality by reason of lack of capital.

PROVEN OIL LAND

Discovery on proven (highly probable) oil lands is also permis

sible.

The regulations define a proven area as the 160 acres surrounding the discovery well as the center.

In the discussion of proved oil land by Beal, page 82, Bulletin 177, Bureau of Mines, he states that:

Proved oil land includes those areas in which drilling involveś practically no risk. Just what constitutes proved oil land depends, it is true, upon local conditions. All of some quarter sections on which only one well has been drilled may be called proved oil lands, even though it may not be surrounded by wells. Other tracts on the contrary, before they could be considered proved, would require many tests.

The following definition (modified from California State Mining Bureau) is given by Beal:

Proved oil land is that which has been shown by finished wells, supplemented by geologic data to be such that other wells drilled thereon are practically certain to be commercial producers.

Senator KING. Under that definition-and I think it is a very fair one-a proved field might have an area of 4 or 5 or 8 or 10 square miles?

Mr. FAY. Certainly.

Senator KING. Take the Santa Fe Fields in California.

Mr. FAY. Certainly.

Senator KING. You are just as certain to get oil in all of that field as you are up around Bakersfield. In many of those fields it is so certain that it is simply a question of drilling, because you know you are going to get it, and in some sections there the area is very extensive; so I was wondering why so much emphasis is placed upon

160 acres.

The CHAIRMAN. That 160 acres was the limit set up by the Bureau itself, was it?

Mr. FAY. Set up by the Bureau's committee that was appointed to draft the regulations.

Senator KING. That seems to me to be most absurd, and I would like some explanation before we get through of why they selected that subdivision.

Mr. MANSON. Go ahead, Mr. Fay.

Mr. FAY. The above definition (by Beal) would seem to be as nearly correct as it is possible to give. The income tax regulations 45, 62, and 65 define a proven area as a 160-acre square surrounding a producing well, the well being at the center of the square with the boundary lines of the square running North, East, South, and West, or in accordance with the public land surveys. The Regulations also recognize other areas as proven, as follows:

Regulations 45 and 62, article 220, (a) 2:

* * And even though a well is brought in on a tract or lease not included in a proven area as heretofore defined, nevertheless it may not entitle the owner of the tract or lease in which such well is located to revaluation for depletion purposes, if such tract or lease lies within a compact area which is immediately surrounded by proven land, and the geologic structural conditions on or under the land so inclosed may reasonably warrant the belief that the oil or gas of the proven area extends thereunder, unless the tract or lease had been acquired before it became so proven. Under such circumstances the entire area is to be regarded as proven land.

The "unless" inserted there nullifies the provisions above. Senator KING. The Supreme Court has held repeatedly that you may indulge in geologic inferences, not only with respect to lodemining territory but coal lands, and that geologic inference may comprise within its operations an area of coal lands of hundreds of square miles. I do not mean to say that it is so and that broad interpretation should be applied to oil lands, but I am interested to ascertain the reasons for selecting such a narrow field as 160 acres for the operation of that rule.

The CHAIRMAN. Does the witness know when those regulations were drawn up?

Mr. FAY. I have stated that. I will give it to you in a minute. The CHAIRMAN. Well, that is not important. Do you know who drew them up?

Mr. FAY. I can not give you the names of the individuals. They were drawn up, I believe, in the solicitor's office. Do you know, Mr. Hartson?

Mr. HARTSON. I can not answer definitely, Mr. Fay, but I rather think that is correct. I think that was done in 1920. It seems to me it was done in either 1919 or 1920.

Mr. GREGG. It was done in October of 1920.

Mr. HARTSON. It was done in October of 1920?

Mr. GREGG. Yes.

Mr. HARTSON. Maybe Mr. Gregg can throw some light on that. He was in the bureau at that time, and, of course, I was not.

Mr. GREGG. The people who worked on it principally were Mr. George Davis, who was in the solicitor's office; Mr. Wayne Johnson, who, as I remember it, was then solicitor. They worked in conjunction with the representatives of the natural resources division of the bureau, in direct connection with the assistant commissioner and the commissioner. Mr. Callan, as I remember it, was assistant commissioner then, and Mr. Roper was commissioner. They worked in direct touch with it.

Mr. FAY. May I ask this question: Were there not some hearings on the proposed regulations at which representatives of the petroleum industry and the mining industry were present, prior to that?. Mr. GREGG. As I remember it, there were.

Mr. FAY. I am certain that there were.

Senator KING. Yes; I remember going down myself to attend some of those hearings.

Mr. GREGG. Mr. Chairman, do you contemplate the witness finishing up this discussion at this point?

Mr. HARTSON. Yes; I think he ought to finish, rather than to hear at this time any explanation by the bureau as to the adopting of the

160-acre area.

The CHAIRMAN. Yes; you may proceed, Mr. Fay.

Mr. MANSON. You had finished that quotation, Mr. Fay.

Mr. FAY. Yes.

The regulations recognize that a proven area may exist outside of the 160-acre square, but still permit a discovery valuation to be set up thereon if the lease was acquired prior to the time these conditions became known, although the expense of drilling may be withheld until it becomes necessary to drill offset wells for self-protection.

DISCOVERY NOT CONFINED TO ONE SAND

Discovery valuation is not confined to one sand. The acquisition of oil lands by lease, purchase, or gift guarantees the explorations and exploitation of any or all the tract to any depth attainable by any physical equipment. In many places there are two or more distinct and disconnected oil sands, each capable of producing oil in commercial quantities. It is possible to set up as many discovery values on the same 160 acres as there are producing oil sands. A discovery value is set up on the first big well, which is the first or shallow sand. The same well is sunk another 500 or 1,000 feet, and a second oil sand encountered. The regulations permit (by not prohibiting) a second discovery valuation. This may be repeated three or four times, thus giving the operator an opportunity to set up large values on each sand for depletion purposes, although the second and succeeding sands are within a proven area-160 acres surrounding the discovery well. The oil will be brought to the surface through the same drill hole and it will be an easy matter to credit the oil to the sand that has established the largest depletion unit, the discovery value being based on market price of oil at date of discovery or within 30 days thereafter.

Senator KING. Do you know of any allowances for discovery for penetrating the sands below the first sand?

Mr. FAY. I do not recall a specific case, but I know that there are cases. I can not recall any specific case, but I know it has been done. Mr. MANSON. We will present a case of an 18-acre lease upon which two discovery values have been allowed.

Senator KING. I know, of course, there are many of those cases where the second and third sands have been penetrated, and perhaps each succeeding sand has given greater returns than the first sand. The CHAIRMAN. Go ahead with your statement, Mr. Fay. Mr. MANSON. Begin on page 5, Mr. Fay.

Mr. FAY. Thus $1.50 oil would give possibly a depletion unit of $0.97 for sand No. 1, while $3 oil would give a depletion unit of $1.76 for sand No. 2. The logical effect would be to charge all the production from sand No. 1 to sand No. 2 for purposes of tax reduction.

VALUATION FOR DEPLETION

Valuation for depletion: Depletion is the loss sustained through the progressive removal of natural resources, as mineral deposits. It is not to be applied to offset profits, except to the extent that it is used to extinguish the capital sum representing the cost or market value of natural resources, as the 1916 law states, "not to exceed the market value in the mine."

Profits per unit of product can be estimated with a fair degree of accuracy in any industry by one familiar with the history, production costs, and past records. The basis of value for any property is its "income-producing ability" over a period of years. This being known or estimated, the buyer determines the rate of profit and return of capital with which he will be satisfied, and upon this decision determines what price he will pay for the mine or well.

For taxation purposes it is necessary to determine cost or value of ore, oil, or timber in place on an equitable basis, independent of what use is made of the commodity through manufacturing processes and independent of any personal element, good will, trade connections, etc. These are all reflected in any method using discounted profits as a basis. The question then is, What is ore or oil worth in the ground? They have a potential if not actual or market value. The value of a barrel of crude oil may be increased many times if this value is determined by reflecting the profits from its varied byproducts, viz, kerosene, gasoline, paraffin, candles, dyes, medicated compounds, perfumes, etc.

The value of a ton of iron ore should not be predicated on the retail or wholesale price of needles and the profits arising therefrom. Nor should it be based on the price of steel rails. Rails may sell at $30 to $40 a ton, while 1 ton of needles or watch springs may be worth $10,000 to $50,000. Any increase in the value of ore or oil after they leave the ground is due to the various manufacturing processes through which they pass, advertising, selling agencies, etc. The profits arising from these latter processes are independent of the material in the ground.

The blast-furnace man not having ore of his own can go into the open market and by ore at $4 to $6 per ton, perhaps even cheaper than he can mine it from his own mine. The manufactured product from the purchased ore yields as much profit as though the ore came from his own mine. He would not expect to charge off depletion on the purchased ore. This charge would come under the head of cost of material and would be limited to cost or market price of ore. In the case of ore from his mine the cost of ore would be charged to mining costs, transportation, and original cost of ore deposit. However, if the present worth of the actual profits on the manufactured article are used as a basis for depletion of ore reserves, it may amount to many times the cost of the ore. Iron-ore royalties are about $1 per ton, thus fixing a basis for value in the mine. The discounted earnings may give $2 or even $5 per ton.

ANALYTICAL APPRAISALS

Analytical appraisal of oil lands: In the valuation of oil lands by the analytical appraisal method there are so many variables that a correct vluation is indeed difficult to obtain. Among the items to be considered are:

1. Quantity of oil in the ground (recoverable reserves): This is subject to varying conditions, as thickness of sand; porosity of sand; gas pressure; grade of oil, as light or heavy; chemical salts in the oil and water, etc., and due consideration should be given to the following:

(A) Number of wells: Many wells exhaust a property at an early date, but at a high development cost. Few wells usually prolong life, give slower returns with less development cost. The drilling program is, therefore, important.

(B) Discount for dry holes: This varies with locality and geologic conditions from 10 to 100 per cent. See Oil and Gas Manual (revised edition), pages 207-214, for actual percentages in various counties, based on United States Geological Survey data. This factor should be applied in connection with the estimation of re

serves.

(C) Discount for offset wells on adjoining property: Often a very important factor by reason of drainage from property if drilling program does not keep pace with that on the adjacent properties. Applies more particularly to the small operator who can not finance a drilling program rather than the large operator who is able to protect his property by drilling offset wells.

(D) Reduction in flow:

(a) Reduction in flow of individual wells by reason of decreasing gas pressure and the clogging of interstices in oil sand adjacent to the drill hole with precipitated salts, tar, paraffin, sulphur, etc. By reason of this, an oil well is "shot" by exploding nitroglycerin in the oil sand. This shatters rock and temporarily increases the flow.

(b) The initial flow of succeeding wells is often not as great as that of the first well on account of reduced gas pressure in the pool due to the escape of gas through the first hole.

(c) Replacement of oil by salt water: In some fields this hazard may apply to 50 per cent of the producing wells.

2. Price of oil: Varies with supply and demand, grade of oil, location of wells as regards market, and market manipulation by large groups. The expected future price of oil should be given consideration in arriving at the market value of an oil property.

3. Cost of development: Varies with depth, location as regards transportation of supplies, character of rock through which drilling must be done, pipe-line construction, and number of wells. In arriving at the fair market value, allowance should be made for the cost of the maximum number of wells necessary to recover total

reserves.

4. Cost of lifting or pumping: Varies with gas pressure, depth, and locality. Lessee to bear expense of pumping and storing lessor's share, i. e., royalty oil.

5. Economic life: The economic life of a well varies in different fields and depends upon gas pressure, porosity of sands, chemical