# T . C . Memo . 1993-616 > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A5455bd0457c23d97 ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text T . C . Memo . 1993-616 UNITED STATES TAX COURT EXXON CORPORATION AND AFFILIATED COMPANIES, ET AL., Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 18618-89, 24855-89, 18432-90. Held: Filed December 22, 1993. A Saudi crude oil resale pricing restriction in effect during a period in which Saudi crude was priced below other comparable crudes prohibited the sale of Saudi crude oil for an amount in excess of the Saudi official selling price, and petitioners complied with the restriction; consequently, respondent is precluded from allocating profits purportedly attributable to such excess from petitioners' refining subsidiaries to petitioners' offtakers pursuant to either sec. 61, I.R.C., or sec. 482, I.R.C. Commissioner v. First Security Bank, 405 U.S. 394 (1972); Procter & Gamble Co. v. Commissioner, 95 T.C. 323 (1990), affd. 961 F.2d 1255 (6th Cir. 1992), followed. 1 On Jan. 7, 1991, Exxon Corp. and Affiliated Companies (docket No. 18432-90), and Texaco, Inc., and Subsidiaries (docket No. 24855-89) were consolidated herewith for purposes of trial, briefing, and opinion of the Aramco Advantage issue, which is defined infra p. 3. BERVED DE0221bb3 Robert L. Moore, II, Jay L. Carlson, John B. Magee, Gerald Goldman, Thomas D. Johnston, Joseph O. Luby, Bradford J. Anwyll, and Craig D. Miller, for petitioners in docket Nos. 18618-89 and 18432-90. Buford P. Berry, Emily Ann Parker, Dennis J. Grindinger, George V. Larsen, Joseph M. Incorvaia, David R. Wheat, and Bradley D. Spevak, for petitioners in docket No. 24855-89. Raymond L. Collins, Ana G. Cummings, Bernard B. Nelson, Avery B. Cousins, III, John F. Eiman, Allan E. Lang, Alan Summers, William B. Lowrance, David A. Alavarez, James H. W. Insley, Roger Osburn, Emron M. Pratt, David J. Mungo, David P. Monson, Carol Bingham McClure, David E. Whitcomb, Mark Barnes, and Joyce E. Britt, for respondent. MEMORANDUM FINDINGS OF FACT AND OPINION WHITAKER, Judae: Respondent, in a statutory notice of deficiency dated June 29, 1989, determined a deficiency in the 1979 Federal income taxes of Exxon Corp. and Affiliated Companies (docket No. 18618-89) in the amount of $268,721,294. In another notice of deficiency dated July 16, 1990, issued to Exxon Corp. and Affiliated Companies (docket No. 18432-90) for the years 1980, 1981 and 1982, respondent determined deficiencies in Federal income taxes in the following amounts: - 3 Year Deficiency 1980 1981 1982 $2,898,174,073 2,037,809,876 1,599,495,218 In a notice of deficiency dated July 21, 1989, issued to Texaco, Inc., and Subsidiaries (docket No. 24855-89) for the years 1979, 1980, 1981, and 1982, respondent determined deficiencies in Federal income taxes in the following amounts: Year Deficiency 1979 1980 1981 1982 $230,193,303 925,040,885 420,056,007 579,861 Only the deficiencies for 1979 through 1981 are at issue herein. This Court's Order, dated January 7, 1991, indicated that the issues presently before the Court involved the purchase by petitioners' offtakers' of crude oil from Saudi Arabia at a below-market purchase price, commonly referred to as the "Aramco Advantage". Specifically, we ordered that the issues involved herein were limited to the following questions: (1) Whether the transfer price of Saudi Arabian crude oil paid by petitioners' offtakers was below the prices charged for non-Saudi crude oil of similar grade or quality; (2) if the answer to question (1) is in the affirmative, whether the transfer price charged by the offtakers to the other subsidiaries of each petitioner or to unrelated third parties was below the price * As defined in our evidentiary opinion, Exxon Corp. v. Commissioner, T.C. Memo. 1992-92, an offtaker is the person or company that physically loads oil obtained under a concession, contract, or other arrangement. charged for non-Saudi crude oil of similar grade or quality; (3) if the answers to questions (1) and (2) are in the affirmative, whether the reduced price was caused by the restriction(s) imposed by Saudi Arabia which petitioners, their offtakers, and other subsidiaries were required to observe in order to have continued access to Saudi Arabian oil; (4) whether the consuming country governments monitored the offtakers' sales of Saudi crude oil into their countries to assure that such sales were not in excess of the prices established by Saudi Arabia, increased only by costs incurred in transporting the crude oil; (5) whether the Saudi Arabian pricing restriction(s) required petitioners and their offtakers to reflect the pricing restriction(s) in the transfer price of sales of Saudi crude oil from petitioners' offtakers to unrelated entities which purchased the Saudi crude oil for refining; (6) whether in fact the crude oil pricing restriction(s) imposed by Saudi Arabia was/were observed by petitioners and their offtakers; (7) if a crude oil pricing restriction(s) existed and petitioners and their offtakers observed the restriction(s), whether or not the pricing restriction(s) precludes or preclude a section 482M or section 61 adjustment to petitioners' income. . The parties have stipulated that the answer to the first question is in the affirmative. The ultimate question to be addressed in question (7) arises under the rule of law presented in Commissioner v. First Security Bank, 405 U.S. 394 (1972), and its progeny. Essentially the issues are: (1) Whether the Saudi Unless otherwise noted, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. - 6 Texaco, Inc. (Texaco), had its principal place of business in Texas when the petition in its case was filed. Texaco is the common parent corporation of an affiliated group of corporations that includes all of the petitioners in docket No. 24855-89 (which collectively will be referred to as the Texaco petitioners). The Texaco petitioners at all relevant times were engaged in the production, refining, transportation, and marketing of crude oil and refined products in the United States and foreign countries. Formation of Aramco and the Offtakers After centuries of upheaval, in September 1932, King Abd alAziz ibn Abd al-Rahman Al Saud (King Abd al-Aziz) proclaimed the formation of a new state, the Kingdom of Saudi Arabia. From its very inception, the law of Islam was the paramount law of the Saudi State, and the role of the King was paramount in temporal matters, although he too was subject to the higher authority of Islamic law. In May 1933, the SAG signed a concession agreement (the Concession Agreement) with Standard Oil of California (Socal, now Chevron Corp. (Chevron)). Subsequently, the concession was assigned to the California-Arabian Standard Oil Co. (CASOC), which in 1944 changed its name to Aramco. Under the terms of the Concession Agreement (as subsequently modified), Socal was permitted to extract petroleum from Saudi Arabia, subject to the payment of taxes and royalties to.the SAG. By the end of November 1948, and continuing through the years at issue, all of the capital stock of Aramco was held directly or indirectly by four U.S. corporations: Exxon, Texaco, Chevron, and Mobil Oil Corp. (Mobil) or their predecessor corporations. Through January 1979 the Mediterranean Standard Oil Co., Inc. (MEDSTAN), a wholly owned subsidiary of Exxon incorporated in the United States, acquired crude oil from Saudi Arabia via Aramco.' Thereafter, the Exxon International Trading Co., Inc. (EITCO), another wholly owned subsidiary of Exxon incorporated in the United States, performed this function. In January 1981 Exxon International Saudi Arabia, Inc. (EISAI), another wholly owned subsidiary of Exxon incorporated in the United States, began to purchase Saudi crude oil from the Saudi Arabian national oil company. These purchases occurred pursuant to an oil incentive contract executed in December 1980 under which Exxon became entitled to buy additional Saudi crude oil as a result of its investment in a chemical facility in Saudi Arabia. MEDSTAN, EITCO, and EISAI are referred to hereafter as the Exxon offtakers. Saudi crude oil was Exxon's largest crude oil source throughout the period 1977 through 1981. It constituted * Petitioners contend that they purchased the Saudi Arabian crude oil from Aramco. Respondent contends that Aramco served as a conduit for the Saudi Arabian crude oil and that petitioners purchased the crude oil from the Saudi Arabian Government with Aramco acting as an agent. For purposes of this opinion, use of the phrase "via Aramco" is intended to be neutral as to this issue, which we need not decide at the present time. _ 8 approximately 50 percent of Exxon's international crude supply.' During the period 1979 through 1981 (the period at issue'), the Exxon offtakers acquired 2,273 million barrels of Saudi crude oil, of which 2,207 million barrels (or over 97 percent) were acquired via Aramco by MEDSTAN in January 1979 and by EITCO from February 1979 through December 1981. The dispositions of Saudi crude by the Exxon offtakers during the years 1979 through 1981 are summarized as follows: Exxon Offtakers Dispositions Barrels Percentage of Total Dispositions Sales to Exxon refining/ marketing affiliates 1,816,000,000 79.9% Sales to unrelated parties 261,000,000 11.5 "War Relief" sales to unrelated parties 61,000,000 2.7 Crude oil exchanges with unrelated parties 132,000,000 5.8 3,000,000 .1 Crude oil losses and inventory changes s Internationally traded crude oil is crude oil that is exported from the country where it was produced. The 50 percent Exxon figure referred to in the text would be somewhat lower if Exxon's indigenous production were included in the calculation. As discussed infra, the period during which the official selling price of Saudi crude was lower than that of other comparable crudes began in January 1979 and ended on Oct. 29, 1981. However, the notices of deficiency deal with the tax years 1979 through 1982, and much of the evidence deals with a time frame that includes all of 1981. For purposes of our holding here, we do not consider this discrepancy to be critical, and we treat the period at issue in this opinion as including all of 1979, 1980, and 1981. - - 9 - Total Saudi crude oil dispositions (1979-81) 2,273,000,000 100.0% Exxon had refining affiliates located in Denmark, the Federal Republic of Germany, Australia, Belgium, Italy, Ivory Coast, Kenya, Malaysia, the Netherlands, Greece, the United Kingdom, Japan, Singapore, Argentina, France, Ireland, Thailand, Canada, Norway, and the United States, which purchased Saudi crude from at least one of the Exxon offtakers during the years 1979-81. In pricing crude oil to its affiliates, the Exxon offtakers from the mid-1970s used interaffiliate billing prices (IABP's) that were based upon the official selling prices (OSP's) of the producing governments, regardless of the source or actual cost of the crude. The philosophy behind this IABP practice was that uniformity was necessary for two reasons: (1) It would be readily defensible to the consuming countries in their monitoring of Exxon affiliate crude import prices; and (2) it would be defensible to the Exxon offtakers' affiliates, since the financial performance of the refining affiliates depended to a significant degree upon the cost of the crude they refined and marketed. The Exxon offtakers continued this IABP practice throughout the years at issue, and, with one exception to be discussed later, all invoices in connection with the Exxon offtakers' transfers of Saudi crude to Exxon affiliates indicated that Saudi crude was sold at Saudi OSP. In their sales to - 10 unrelated parties, the Exxon offtakers also consistently invoiced Saudi crude at Saudi OSP during the years 1979-81. At least some of the Exxon offtakers' crude oil sales contracts with unrelated purchasers had "price reopener clauses", whereby the Exxon offtaker would have been able under the terms of those contracts to renegotiate the price of the crude sold. Prior to October 1, 1978, Saudi crude oil received by Texaco via Aramco was acquired and disposed of by two wholly owned Delaware subsidiaries, Texaco Operations (Europe) Ltd. (TOE) and Texaco Export, Inc. (Texport). Texport obtained crude oil via Aramco and sold crude oil directly to either (1) certain Texaco affiliates or (2) TOE generally for resale to Texaco's European affiliates. Additionally, Texport and TOE each processed certain volumes of Saudi crude oil for their accounts during the 1973-78 period. Texport was merged into TOE on October 1, 1978, and its corporate name was changed to Texaco International Trader, Inc. (Textrad). During the years at issue, Textrad was a wholly owned Delaware subsidiary of Texaco. Textrad (and its predecessors in interest) operated as the international crude trading company for Texaco. Most of the crude oil traded internationally by Texaco during the period 1979-81 was traded by Textrad. Caltex Petroleum Corp. (CPC) is a corporation owned 50 percent by Texaco, Inc., and 50 percent by Chevron. CPC and its controlled foreign corporations will hereafter be referred to as Caltex. Saudi crude constituted approximately 78 percent of Texaco's - 11 - international crude supply.' During the period January 1, 1979, through June 30, 1981, Textrad purchased a total of 1,872,198,217 barrels of Saudi crude via Aramco. The dispositions* of Saudi crude during the years 1979 through 1981 by Textrad are summarized as follows: Textrad Dispositions Barrels Percentage of Total Dispositions Sales to Texaco Refining/ Marketing Affiliates 780,000,000 34.2% Sales to Unrelated Parties 367,000,000 16.1 "War Relief" Sales to Unrelated Parties 77,000,000 3.4 Sales to Caltex 494,000,000 21.7 Crude Oil Exchanges with Unrelated Parties 345,000,000 15.2 Processing Agreements 213,000,000 9.4 Total Saudi Crude Oil Dispositions (1979-81) 2,276,000,000 100.0% Transfers to Affiliated Entities Pursuant to During the period at issue, in addition to several refineries in the United States, Texaco owned refining subsidiaries in the United Kingdom, Belgium, the Federal Republic See suora note 5. * These amounts represent dispositions of Saudi crude acquired by Textrad from all sources, including sources other than Aramco. - 12 of Germany, the Netherlands, six Latin American countries, and four Canadian provinces. Texaco also had equity interests in refineries located in the Federal Republic of Germany, Ireland, Italy, Sweden, Switzerland, and five Latin American countries, and Caltex had equity interests in refineries located in Australia, Bahrain, Japan, Kenya, South Korea, Lebanon, New Zealand, Pakistan, the Philippines, Singapore, and South Africa. Organization and Operation of the Saudi Arabian Government After the death of King Abd al-Aziz in November 1953, his son Saud became King and another son, Faisal, became Crown Prince. In 1962, King Saud established the state-owned General Organization for Petroleum and Minerals (Petromin) to take over petroleum distribution operations within Saudi Arabia from Aramco. In November 1964, Crown Prince Faisal became King. Prince Khalid, another son of King Abd al-Aziz, became Crown Prince. Since the reign of King Faisal, the King's formal titles, in addition to that of King, have included President of the Council of Ministers (or Prime Minister) and Commander in Chief of the Saudi Arabian armed forces. In March 1975 King Faisal was assassinated, and Crown Prince Khalid became King. Prince Fahd and Prince Abd Allah, both sons of King Abd al-Aziz, were named Crown Prince and second deputy prime minister, respectively. After King Khalid's death in June 1982, Crown Prince Fahd became King and Prince Abd Allah became Crown Prince. - 13 - The King, members of the Council of Ministers, and all citizens of Saudi Arabia are subject to Islamic law. Islamic law is based upon the Koran, which is the Holy Book of all Moslems, and the Sunna, which is the recorded account of the Prophet Muhammad's views of life and society. The King is the most prominent figure in the legal hierarchy of, and possesses the ultimate legal authority in, Saudi Arabia. He has the ultimate duty of ensuring that Islamic law is observed. The senior princes were the main drivers of policy in the years leading up to and during the years at issue. Crown Prince Fahd had been mandated by King Khalid with executive authority for affairs of state prior to the years at issue. During the period at issue, Crown Prince Fahd was perceived to be ultimately responsible for matters pertaining to national policy and was a key policymaker on Saudi oil matters. In 1953, the King established a Saudi Council of Ministers composed of the King, the Crown Prince, a Second Vice President, the heads of the various ministries, and several ministers of state. The Council of Ministers later was constituted under the Council of Ministers' Regulations and was invested with regulatory, executive, and administrative authority. Notwithstanding a certain amount of government organization, the ultimate authority of the Saudi State still rested with the King. All powers enjoyed by government officers stemmed from a delegation, either formally or informally, of those powers from the King. The Ministry of Petroleum and Mineral Resources (Petroleum Ministry) was established in 1960 and was the executive agency that converted the oil policies established by the King and Crown Prince into specific actions and ensured implementation of those policies. The Petroleum Ministry was the sole Saudi Government agency responsible for supervising the oilrelated affairs of Aramco and its four shareholders and often communicated its official government positions and directives to them by letter. Ministerial directives came into effect upon issuance by the Petroleum Ministry pursuant to the authority granted by the King as Sovereign or President of the Council of Ministers and were considered to be binding unless overridden by a Royal decree, order, or a resolution by the Council of Ministers. In March 1962, King Saud had appointed Sheikh Ahmed Zaki Yamani (Minister Yamani) to be the Minister of the Petroleum Ministry. Minister Yamani served as Petroleum Minister until October 1986. Although Crown Prince Fahd occasionally participated in press interviews or dealt with foreign dignitaries on Saudi oil policy matters, throughout Minister Yamani's tenure as Petroleum Minister, he was most commonly seen as the spokesperson for the SAG with respect to oil-related issues. Only rarely did the King or Crown Prince make a personal statement on oil policy. Minister Yamani was the SAG official responsible for consulting with the King or Crown Prince on oil- - 15 related matters, and there was a widely held understanding that such consultations occurred and that Minister Yamani regularly received instructions on Petroleum Ministry matters. He was perceived to be--and held himself out as--the authoritative spokesperson for Saudi Arabia on oil policy matters. At important meetings such as the Conference on International Economic Cooperation held in 1976-77, Minister Yamani was the Saudi representative. He participated in negotiations with petitioners' representatives over the years as the Saudi representative and was perceived by them as having the full authority to engage in these negotiations. He also participated in discussions with representatives of other countries on behalf of the SAG. Many government and industry officials believed that Minister Yamani spoke for the SAG on policy matters and would not implement a policy unless it was approved by the SAG leadership. The Saudi legal system had a judicial body called the Board of Grievances during the period at issue, which had jurisdiction over disputes between private parties and the SAG. It is unclear whether from a legal standpoint Minister Yamani's ministerial actions were capable of review by this Board. However, from a practical standpoint, in the absence of a clear violation of an existing contract or law, an adjudication of his actions in such a forum or otherwise probably would have been futile. Formation of OPEC Prior to 1960, multinational oil companies essentially controlled the production and pricing of crude oil from Middle Eastern and other oil exporting countries. In 1959 and again in 1960 the major international oil companies unilaterally reduced the posted prices for crude oils, which were the prices on which the oil companies' royalty and tax obligations to foreign governments were based. In reaction to the oil companies' 1959 and 1960 posted price reductions, Saudi Arabia, Iran, Iraq, Kuwait, and Venezuela met in Iraq from September 10-14, 1960, and formed the Organization of Petroleum Exporting Countries (OPEC). The SAG had the largest supply of crude of all the OPEC countries and was a prominent player in OPEC. Eight other oil exporting countries subsequently joined OPEC: Qatar in 1961, Indonesia and Libya in 1962, Abu Dhabi in 1967, Algeria in 1969, Nigeria in 1971, Ecuador in 1973, and Gabon in 1973 as an associate member and in 1975 as a full member. When Abu Dhabi joined other countries in forming the United Arab Emirates in 1971, the United Arab Emirates replaced Abu Dhabi as a member of OPEC. By 1977, OPEC consisted of 13 countries, which as a group produced between 50 and 55 percent of the world's crude oil, held approximately 68 percent of the world's crude oil reserves, and exported more than 80 percent of all crude oil exports. Saudi Arabia alone,had approximately 24 percent of the world's proven oil reserves, and from 1975 to 1981 it produced about 17 percent of the world's crude oil and was the world's largest exporter of crude oil. The Takeover of Pricing Decisions and Oil-Producing Operations by Producing Countries In June 1968, OPEC adopted a "Declaratory Statement of Petroleum Policy in Member Countries", and as sovereign powers they invoked the doctrine of "changing circumstances", which asserted a country's legal right to alter concession agreements to include a government ownership share if there were substantial changes in the circumstances that prevailed when the concession agreements were entered into. During the 1970s the OPEC member countries and other Middle East and North African countries began to modify concessionary terms to capture for themselves a greater share of oil-producing profits and to secure a greater role in the ownership and management of the oil companies' producing operations. From 1967 to 1971, Algeria nationalized the operations of all non-French foreign oil companies and assumed a 51-percent interest in the operations of the French oil companies. With regard to the pricing of crude oil, in December 1970, the OPEC countries met in Caracas, Venezuela, and resolved that negotiations would begin with the international oil companies regarding crude oil prices and other matters. Representatives of OPEC's Persian Gulf member countries and the international oil companies met in Tehran, Iran, in February 1971 and executed an agreement with respect to posted prices that was designed to - 18 - govern prices for a 5-year period. The international oil companies subsequently reached agreements with Libya, Iraq, and Nigeria regarding posted prices. Negotiations 6 weeks later led to another agreement between the Libyan Government and 15 oil companies, which also was intended to last 5 years. Comparable agreements with Iraq and Nigeria followed in the ensuing weeks. On September 22, 1971, OPEC called for increasing the effective "participation" of the producing countries in the producing operations of the oil companies located within their respective countries. Shortly thereafter, participation talks commenced between the oil-producing countries and the oil companies. route. Certain OPEC countries took a less conciliatory In early June 1972, Irag nationalized the oil companies' (including Exxon's) interests in the Iraq Petroleum Co. In July 1973, the Iranian Government, through the state-owned National Iranian Oil Co., formally took over all operating responsibility within the concession areas covered by a 1954 agreement between Iran and a consortium of international oil companies, including Exxon and Texaco. In the fall of 1973, Libya demanded a 51- percent participation interest in the Libyan operations of a number of the major oil companies operating in Libya. Libyan subsidiaries of Exxon and Mobil acceded to the Libyan Government's demands in 1974. Shell, Socal, Texaco, and Atlantic Richfield refused to accept Libya's demand for a 51-percent participation interest and had their operations completely - 19 nationalized. In late 1973, Irag nationalized the Exxon, Mobil, and Partex interests and the Dutch portion of the Royal Dutch/Shell interest in the Basrah Petroleum Co. By the end of 1975, Iraq had nationalized the remaining companies' interests in the Basrah Petroleum Co. In 1974, Kuwait acquired a 60 percent participation interest in the Kuwait Oil Co., a partnership of British Petroleum and Gulf Oil. By 1976, Kuwait had increased its participation interest to 100 percent. In 1973, Qatar acquired a 25-percent participation interest in the operations of the country's two producing companies, in one of which Exxon had an interest. In 1974, Qatar increased its participation interest in the two companies' operations to 60 percent. By 1977, Qatar had increased its participation interest in the two companies to 100 percent. In August 1975, Venezuela passed a law nationalizing the operations of foreign-owned oil companies (including a subsidiary of Exxon). Through increased participation (both actual and anticipated), nationalization, or expropriation, producer country ownership of OPEC oil increased from about 2 percent of production in 1970 to almost 60 percent of production by the end of 1974, and to approximately 80 percent by the end of 1980. In 1973, the national oil companies of OPEC member countries directly had sold about 5 percent of their countries' exports. By the end of 1980, this figure had increased to between 50 and 55 percent of the OPEC countries' oil exports. - 20 The Saudi relationship with Aramco developed on a parallel, but somewhat more moderate course, whereby the Saudis pursued a policy of "participation" rather than outright nationalization. In a speech at the American University in Lebanon in 1968, Minister Yamani discussed the Saudi goal of accomplishing change in a stable context. He indicated that, although Aramco originally resisted the notion of Saudi participation, Minister Yamani had ways to pressure Aramco into going along with Saudi participation. The original Concession Agreement between the SAG and Aramco continued until the early 1970s when the other producing countries began nationalizing their oil interests. Early in 1972, participation negotiations between the Aramco companies and Minister Yamani on behalf of the SAG commenced. It subsequently was publicized that, in the course of these 1972 negotiations, the King had instructed Minister Yamani to warn the Aramco company negotiators that implementation of participation was "imperative" and that the Aramco companies should not require the SAG to "take measures" to put participation into effect. Although there was significant resistance to participation by the companies, by early October 1972 a draft agreement, called the "General Agreement on Participation" (General Agreement), was reached and later signed by the SAG and two other Gulf States, whereby the SAG purchased a 25-percent initial government participation interest in Aramco's production operations, which was gradually to increase to 51 percent in 1982. The Aramco - 21 companies were to be compensated for unrecovered investments on the basis of book value adjusted for.inflation. The implementing agreements called for in the General Agreement were never executed. The gradual phasing in of the Saudi share was intended to give Petromin time to gain experience in marketing, and Petromin gradually engaged in more and more direct marketing activities after the General Agreement was signed. During the 1970s and 1980s, Petromin's role in the intern'ational marketing of crude oil continued to increase. It was the intention of the Aramco companies to hold onto as much equity ownership as possible, but after the rapidly changing events in the Middle East in the early 1970s, including the Arab oil embargo and dramatic crude price increases, as well as nationalizations by the more radical OPEC members, the Aramco companies were notified in 1974 that the SAG participation was to be speeded up. years. Extensive negotiations occurred over the next few Dr. James Schlesinger (Dr. Schlesinger), who was the U.S. Energy Secretary until August 1979, perceived the SAG takeover of Aramco to be a "lopsided" negotiation whereby the companies did not wish to be taken over but they had no choice because the~y were "negotiating" with a sovereign power. In late 1976 or early 1977, the SAG and the Aramco companies agreed upon the so-called New Arrangements. Under the New Arrangements, the SAG assumed 100 percent ownership of Aramco, and the (now former) shareholders provided services to the SAG's oil business in - 22 - exchange for stated fees. Many of the financial aspects of the New Arrangements were implemented in a draft crude oil sales agreement (COSA), but the New Arrangements and the draft COSA were never signed. The Arab Oil Embargo and the First Oil Crisis The following series of events constituted what has come to be called the "first oil crisis". On October 7, 1973, the Arab- Israeli war broke out in the Middle East. On October 8, 1973, representatives of the oil companies and the oil ministers of OPEC's Persian Gulf member countries met in Vienna, Austria, to discuss revising established prices, which already had been revised upwards twice by the Geneva Agreements of January 1972 and June 1973 to reflect changes in currency exchange rates and inflation. On October 9, 1973, oil industry representatives proposed a 15-percent increase in posted prices and offered to negotiate an inflation index provision. No agreement was reached, and discussions were broken off shortly thereafter. On October 16, 1973, OPEC unilaterally announced an immediate 70-percent increase in posted prices. This raised the posted price from $3.01 per barrel to $5.12 per barrel for Saudi Arabian Light marker crude.' On October 17, 1973, the Organization of Arab Petroleum Exporting Countries (which had * When OPEC met to discuss pricing, since Saudi Arabian Light was the crude with the largest volume moving in the international market, that crude was used as the "marker" or "benchmark" crude, or the crude to which others were compared for the purpose of determining price. - 23 been created in January 1968 and whose members included the Arab member states of OPEC) agreed to impose monthly decreases in crude oil production of 5 percent. In the following 2 weeks, the individual Arab states, including Saudi Arabia, implemented this agreement by reducing production between 5 and 10 percent. OPEC members also announced an embargo on exports to the United States and the Netherlands. At a meeting in December 1973, the OPEC member countries agreed to increase prices again, resulting in a fourfold increase in crude oil prices since the beginning of October 1973. The OPEC price increases during the last quarter of 1973 substantially increased the oil import costs of the consuming countries. By early 1974, the OPEC countries had taken control over crude oil pricing and production decisions from the multinational oil companies operating in their countries, and OPEC had established a unified pricing system for its members' crude oil. The posted price for Saudi Arabian Light marker crude was increased to $11.65 per barrel in January 1974, and then later decreased to $11.25 per barrel in November 1974. At the September 1975 OPEC meeting in Vienna, Austria, the OPEC members again agreed to increase prices by 10 percent, effective October 1, 1975. - 24 - Two-Tier Pricing and the 1977 Saudi Restriction When an OPEC meeting opened in December 1976 in Doha, Qatar (Doha meeting), Saudi Arabian Light marker crude was at $11.51. At the meeting, 11 members of OPEC voted to raise the price by $1.19, or approximately 10 percent, effective January 1, 1977, to be followed by an additional 5-percent increase on July 1, 1977. These countries also planned to add additional fees, or premia, to certain grades of crude. The SAG and the United Arab Emirates, in an effort to moderate crude prices, refused to go along with the other 11 OPEC members, which resulted in a twotier pricing structure. The SAG decided that it would raise the prices of Arabian Light and Arabian Berri by only 5 percent (to $12.09 and $12.48, respectively), that it would raise the prices of Arabian Medium by 3.6 percent (to $11.69), and that it would raise the price of Arabian Heavy by 3 percent (to $11.37), all to remain in effect for the entire year. The SAG also increased production available to Aramco at this time in an effort to force the other OPEC countries to moderate their prices. A Saudi official was quoted in the Middle East Economic Survey, a widely read weekly news source, on December 26, 1976, as saying: We shall ensure that the companies concerned keep their prices to all customers at the official government levels. If these companies increase their prices for Saudi crudes above the government levels, we will consider this a hostile act against Saudi Arabia, and they will be held to be working against the interests of the Kingdom. - 25 This official Saudi statement was known to U.S. officials. Shortly thereafter, Minister Yamani was quoted in the January 10, 1977, issue of the Middle East Economic Survey as having participated in an interview in Germany on January 3, 1977, a portion of which is as follows: Q: We would like to return to the split in oil prices. How can this system really work? A: We will make sure that the oil companies do not take one cent from the cheap Saudi crude and put it in their own pockets. We want the lowest price for the benefit of the consumers. On this we will stand firm. Q: How do you intend to do that? A: First, we have ways and means to do it. The oil companies need Saudi Arabia. And they know they will be punished if they do not behave as we expect. Secondly, the consumers are not stupid. They will be aware that they can make use of this situation. In any case, supply and demand will decide what happens. Not in January, not in February, but at any time in the future. In conjunction with these efforts toward price moderation, the SAG instituted pricing and reporting requirements to ensure that its lower price was adhered to when the Saudi crude was sold by the Aramco shareholders. Minister Yamani sent identical letters in English to petitioners dated January 10, 1977, which stated: This is to inform you that the following conditions will apply to the additional volumes of crude oil which become available for export as a result of the Government's decision to permit Aramco to increase production. You should take appropriate steps to assure compliance with these conditions: 1. The prices charged to the consuming countries for Saudi Arabian Crude Oil will not be higher than the FOB Ras-Tanura prices as - 26 conveyed to Aramco plus transportation cost to the particular countries concerned. 2. Such condition will apply also to the buyers of Saudi Crude Oil through your company. 3. An audit certificate from a certified public accountant should be made available to us to prove compliance with the conditions (1 & 2) above. Furthermore, it should be understood that the same conditions apply to all the Crude Oil lifted by your company from Saudi Arabia which is expected to flow into its historical international markets, to buyers-users and without the utilization of brokers. Hence, an audit certificate(s) in accordance with the abovementioned conditions is also required. With best regards. (sf Ahmed Zaki Yamani Minister of Petroleum and Mineral Resources The provisions of these letters will hereafter be referred to as the source of the 1977 restriction. The Saudi Petroleum Ministry statement in connection with the 1977 restriction was published in the Middle East Economic Survey on January 10, 1977. The statement read in part: The Government of Saudi Arabia, in its desire to pass on the low prices which it set for its oil to the final consumer, solicits the cooperation of the governments of the consumer countries in checking through strict auditing measures the prices at which Saudi crude oil is sold in their countries and ensuring that no party other than the final consumer benefits from the low prices. Exxon interpreted paragraph 3 of the 1977 restriction to require that audit certifications encompassing all sales of Saudi - 27 oil had to be supplied to the Saudis, including those to affiliates and to unrelated third parties. The audit certificates supplied by Exxon under the requirements of the 1977 restriction covered all sales of Saudi oil by Exxon to affiliates and unrelated entities. However, Exxon's independent auditor, Price Waterhouse & Co., apparently having received only partial information from purchasers of Saudi oil, had not submitted certificates for all sales. The SAG characteristically came forward and drew attention to matters that were not in conformity with Saudi policies. As a consequence, the SAG initially requested from Exxon more complete information and more detailed reports. Texaco guidelines indicated that sales of all Saudi oil were covered by the 1977 restriction. However, Texaco initially appears to have supplied audit information only with respect to the "additional volumes" referred to in the letter containing the 1977 restriction. Minister Yamani asked for information regarding all sales of Saudi oil as soon as possible. Subsequently, Texaco apparently did not supply all of the information that the SAG had indicated that it expected "in compliance with H.E. The Minister's instructions", for the SAG in January 1978 supplied Texaco with lists of crude oil shipments for which no audit certifications had been received and a request for expedited response. Texaco complied with the SAG requirement for additional information, with the possible exception of 18 - 28 shipments for which it could not locate the appropriate information. Texaco viewed the 1977 restriction and the audit requirements in connection therewith as mandatory and took them very seriously. Submissions of the certifications by petitioners to the SAG continued for the duration of the 1977 two-tier pricing period, which ended in July 1977 when, following a June 1977 OPEC meeting, Saudi Arabia and the United Arab Emirates imposed a 5- percent price increase. No agreement to increase crude oil prices was reached at the December 1977 OPEC meeting in Caracas, Venezuela. The Iran Crisis; Rising Prices In October 1978, oil workers in Iran went on strike. Although oil field workers in Iran returned to work in November following military intervention, strikes resumed in early December in response to the urging of Ayatollah Khomeini, the Iranian opposition leader then in exile in Paris. Iranian crude oil production averaged approximately 3.8 million barrels per day over the last quarter of 1978, as compared to an average of approximately 5.7 million barrels per day over the first 9 months of 1978. Iranian exports of crude oil ceased completely by the end of December 1978 and did not resume again until March 1979, and then at a reduced level. The bulk of lost Iranian production was Iranian Light, which was one of the lighter types of crude. - 29 In response to the Iranian takeover of the U.S. Embassy in Tehran on November 4, 1979, President Carter announced a trade embargo of Iran, including the importation of Iranian crude oil. In response to the Iranian shortfall, the SAG increased its crude production from 7.75 million barrels a day (the average for the first 9 months of 1978) to 10.4 million barrels a day by December 1978. Despite the increase in Saudi production, there was a perception of a shortage in 1979-80. The SAG briefly reduced crude oil production in early 1979. The Iranian shutdown in. 1979, and the uncertainties of supply, were significant causes of the perception of a shortage at this time. The Iranian losses were felt directly, but they also were indirectly felt by Exxon, which had a long term contract with the British Petroleum Co. (BP) whereby BP sold between 325,000 and 350,000 barrels per day of Iranian crude to Exxon. When the Iranian supplies were cut off to BP, this significant source of supply to Exxon was suspended as well. As a result of the Iranian situation overall, Exxon lost more than 10 percent of its crude oil supply. A large amount of panic trading and stockpiling of inventories occurred at this time. Texaco lost approximately 230,000-250,000 barrels a day because of the Iranian shutdown. Texaco's dependence upon Saudi oil went from approximately 75 percent of its liftings" " A "lifting" is the physical act of loading a quantity of oil obtained under a concession, contract, or other arrangement. - 30 prior to the Iranian shutdown to as high as approximately 78 or 79 percent of its liftings after the shutdown. Mul.titier Pricinq and the 1979 Restriction The next series of events has come to be known as the "second oil crisis", a period in which world crude prices almost tripled, and OPEC members individually established higher and higher prices for their oil. OPEC members met in Abu Dhabi on December 16-17, 1978, and announced that they were raising prices by an average of 10 percent for the year 1979 (the Abu Dhabi announcement). The 10-percent average price hike was to be accomplished through four quarterly price increases beginning with a 5-percent increase in the first quarter and ending with a 13.79-percent increase in the last quarter. Under the announced increase, the base price of Saudi Arabian Light marker crude was expected to rise from $13.34 per barrel on January 1, 1979, to $13.85 on April 1, 1979, to $14.55 a barrel on October 1, 1979, which would have been an increase of slightly more than 9 percent." While this announcement applied to all OPEC members, a broad array of prices resulted, because individual member countries were free to impose additional premia or surcharges as they wished. After the Abu Dhabi announcement, the SAG announced that it would reduce production again and return to its 8.5 million barrels a day production ceiling. " At a subsequent OPEC conference in March 1979, however, the October base price of Saudi Arabian Light marker crude was instituted early on Apr. 1, 1979. - 31 Minister Yamani called a meeting with Aramco representatives in Riyadh on January 15 and 16, 1979. Because they were experiencing shortages, representatives of petitioners urged the SAG at this meeting to increase production from the 8.5 million barrels a day production ceiling to make up to some extent for the Iranian shutdown. At the same time the U.S. Government also was urging the SAG to increase production. There was some discussion concerning pricing at this meeting, during which Minister Yamani apparently was unmoved by petitioners' arguments against his determination to use fourth quarter 1979 prices on the increased production. Shortly after the meeting with Aramco representatives, Minister Yamani issued a directive indicating that the SAG would increase production but on the increased production the fourth quarter 1979 prices would apply. The directive also required that the SAG efforts toward price moderation be carried through to subsequent crude purchasers. The directive was issued by means of a letter in Arabic dated January 23, 1979, to Aramco's Chairman of the Board, which was translated (the record does not indicate by whom) as follows: Kingdom of Saudi Arabia Ministry of Petroleum and Mineral Resources Office of the Minister 25 Safar 1399 (23 January 1979) No. 103/Z Chairman of the Board - 32 Arabian American Oil Company Dhahran Dear Sir: Further to our letter No. 197/Z, dated 24 Safar 1399 [22 January 1979], you are instructed to implement the following: 1 - The Kingdom's production of crude oil for the first quarter of the year 1979 shall be at the rate of nine million five hundred thousand barrels per day. You should see to it that the monthly production does not exceed this rate in any of the said three months. Further, the ratios imposed by the State on the kind of oil to be produced (65 percent [of lighter crudes] and 35 percent [of heavier crudes]) should be observed. 2 - For purposes of this letter only, the oil which the companies are entitled to transport shall be fixed at a daily rate of seven million barrels at the prices communicated to you by this Ministry's letter No. 8/SS, dated 1 Safar 1399 [30 December 1978]. 3 - For anything in excess of the first seven million barrels of the daily production rate, the prices of the fourth quarter of the year 1979 shall apply. These are as follows: Kind of Oil Gravity Price in Dollars Arabian Light Oil Arabian Medium Oil Arabian Heavy Oil 34 31 27 14.5460 14.0520 13.6434 Berri Oil 39 15.3321 4 - The oil transporting companies should see that the oil reaches the areas which have been harmed as a result of the stoppage of Iranian oil, to the exclusion of areas which are banned from having access to Saudi oil. 5 - The companies are to pledge that they will not sell to a third party at prices in excess of what we have specified herein. With kind regards. Minister of Petroleum and Mineral Resources (Sgd) Ahmed Zaki Yamani (Tpd) AHMED ZAKI YAMANI - 33 - This letter generally will hereafter be referred to as Letter 103/Z. Item 5 of Letter 103/Z constitutes the source of the restriction at issue in this case as it applied to petitioners' offtakers and will hereafter be referred to as the 1979 restriction. Resale pricing restrictions similar to the 1979 restriction occurred in other crude oil sales relationships during the period at issue, but in most cases they were contained in contracts between producing countries and private companies. Similar resale restrictions sometimes also occurred in contracts between two private entities. There was a perception on the part of several government officials of the consuming countries during the period at issue that the 1979 restriction was imposed by the SAG to ensure that Saudi crude reached the oil consuming countries at the lower Saudi price as part of the SAG's crude oil price moderation policy. In February 1979, various producing countries began imposing surcharges (or premia) of $1.20 per barrel or more over the prices agreed to in the Abu Dhabi announcement. The SAG, in its efforts toward moderation, did not impose such surcharges and thus maintained prices below those of the other OPEC members with their differing levels of surcharges. In March 1979, the OPEC countries met in Geneva and accelerated the scheduled fourth quarter 1979 price increase to be effective for the second quarter and sanctioned additional surcharges. The SAG once again - 34 - refused to impose such surcharges, indicating that it would follow each barrel of crude to the refinery gate, ensuring that its official price was adhered to. Minister Yamani often used his public interviews, which were disseminated through the press, as a means by which he communicated a Saudi position. The following interchange was quoted in the Middle East Economic Survey on April 2, 1979, representing a press interview with Minister Yamani after the Geneva OPEC conference: There is the question that since the offtakers in Saudi Arabia will be lifting oil at a lower price than in other countries owing to the absence of a surcharge in Saudi Arabia, they might be in a better competitive position than other companies. Are you thinking of any measures to deal with this situation? A: Yes the measure we will apply is to follow the barrel of Saudi crude until it lands at a certain refinery and we know that it is sold at our price through an auditor's certificate. Q: Is this already in force? A: We enforced this in 1977 when we had the two-tier pricing system, and we have asked for it again this time. But I cannot do anything after that if Exxon, Mobil or any of the four sell their refined products in the market at the market price which enables them to realize a higher rate of profit than is usually realized by other refiners. That is in their pocket; I cannot interfere. Q: In other words you can deal with the crude but not with the products? A: Right. Q: Have you put this measure back into application this time or are you about to? - 35 A: Well we have told them to sell it at our price, but the measures will be in application. In the second quarter of 1979, Saudi production reverted to its 8.5 million barrels a day level as Iranian production began to rise slightly. The Deputy Minister of Petroleum and Mineral Resources sent a subsequent letter in Arabic dated April 1, 1979, to Aramco's Chairman of the Board, which was translated as follows: Reference is made to [Letter 103/z] * * * and the provision in item 5 thereof to the effect that the companies shall pledge not to sell to any third party at prices in excess of those fixed by the Government. Please notify the companies transporting Saudi oil of the necessity of submitting certificates from auditors confirming the adherence of the companies to the instructions of the State as of the beginning of this year. We also request that every company furnish us with a list of the contracts concluded between it and the developing countries and the quantities of Saudi oil committed for the year 1979. This letter constitutes the source of the audit requirement imposed by the SAG in connection with the 1979 restriction. In June 1979, Minister Yamani sent to Aramco's Chairman of the Board the following letter: I wish to inform you that we have received a complaint from the Republic of South Korea to the effect that Caltex, which has a contract with it for the supply of crude oil, has reduced the contracted quantities. Therefore, please urge Caltex to insure that the Republic of South Korea is supplied with all the contracted quantities and see that sales to it are made, just like other sales, at the prices set for you by the state. Also in June 1979, the OPEC members met and announced another round of significant price increases. A press conference - 36 - with Minister Yamani after the OPEC meeting was published in the Middle East.Economic Survey on July 2, 1979, in which the following question and answer appeared: Q: How can you be sure that oil from Saudi Arabia is not sold at more than official prices? A: [Minister Yamani] The only thing we can do - as we are doing - is to ask for an audited account to show that the Saudi barrel is supplied to a refinery or sold to a third party at our price. But the oil companies are definitely making much higher profits in the downstream by refining Saudi crude and selling the products at higher prices. This we cannot control. It is the consumers' responsibility. In early July, after repeated requests from the U.S. Government to do so, the SAG again increased production to 9.5 million barrels a day. the end of 1979. This level of production continued beyond In December 1979, the SAG, in an attempt to unify OPEC prices, unilaterally raised its crude prices, but at a meeting of the OPEC members in Caracas, Venezuela, on December 17-19, 1979, OPEC members again failed to reach an agreement on a unified price structure, and the more aggressive OPEC members simply raised their prices further, resulting in continued multitier pricing. In early 1980, the SAG maintained its 9.5 million barrels a day production level for the first quarter. Petitioners' Responses to Letter 103/Z There was a widely held understanding that the Crown Prince and Minister Yamani consulted on a regular basis and that Minister Yamani would not have issued the 1979 restriction without royal approval. To those of petitioners' employees who - 37 - were involved at the time, the substance of the 1979 restriction was a replay of the 1977 restriction. Nevertheless, there apparently were differing interpretations among the Aramco shareholders concerning the scope of both the 1979 restriction and the audit requirement in connection therewith. This was at least in part because the translation of Item 5 of Letter 103/Z refers to a pricing requirement in sales to "a third party". The transliteration of the original language in Letter 103/Z that was indicated to be a "third party" in the translation is the Arabic phrase "taraf thalith", which, although commonly understood to mean "third party" more precisely means "any other natural or juridical person that exists". Thus the phrase "taraf thalith" actually used in the Arabic version of Letter 103/Z connotes a meaning that is very different from the meaning of the term "third party" to the Englishspeaking corporate world. The term "third party" suggested to some of petitioners' employees the narrower notion of an unrelated or unaffiliated purchaser, and there was some initial confusion as to the scope of the 1979 restriction on the part of Exxon officials from the use of this "third party" language in the translation of Letter 103/Z. After he received Letter 103/Z, Exxon chief executive officer and chairman, Clifton Garvin, Jr., realized that the "third party" language in the translation was confusing, because his understanding of the typical interpretation of the term "third party" was that it referred to - 38 an unaffiliated party, and only approximately 15 percent of Exxon's sales were to unaffiliated entities; thus he felt that limiting the application of the term to only unaffiliated entities would not have made sense. Therefore, he telephoned Minister Yamani and asked for clarification of the directive. After that conversation, Mr. Garvin believed that the restriction applied to all oil that Exxon purchased from the SAG, whether it was sold to unaffiliated entities or affiliates, used in exchanges, or otherwise. Several other pieces of correspondence from the SAG to Aramco subsequent to the letters containing the 1979 restriction and the audit requirement do not refer to "third parties" and contain language indicating broader application of the 1979 restriction than merely to sales of Saudi crude to unaffiliated parties. As a result of these or other subsequent communications with the Saudis, Exxon and Texaco officials came to understand that the 1979 restriction applied to all sales of Saudi oil, including those to affiliates as well as those to unaffiliated entities. The stated objective in both petitioners' audit certificates was to certify compliance with the restriction in sales to "third parties", excluding affiliates from the definition of this term. Despite the apparent initial confusion among Exxon employees concerning the interpretation of the "third party" language of Letter 103/Z, Exxon's response to the audit requirement for the first quarter of 1979 was to submit figures on the number of - 39 barrels of Saudi crude oil received and sold to affiliates as well as to unaffiliated entities. The other three Aramco shareholders reported only figures in connection with sales to parties less than 50 percent owned by them (unaffiliated entities). However, Texaco executives understood the 1979 restriction to apply to all sales. for material on affiliate sales. The SAG did not ask Texaco Although they continued to perform audit activities, petitioners did not submit, and the SAG did not require them to submit, any audit certificates to the Petroleum Ministry after the first quarter of 1979. During the rest of 1979, petitioners continued to monitor compliance with the restriction, so that audit certificates could be compiled if the SAG asked for them. Later, when internal reporting was felt to be no longer required, Exxon explicitly advised its personnel that this was not intended to signal a departure from the pricing practices previously followed. There is no evidence that the audit submissions in connection with the 1979 restriction were considered by the SAG to be inadequate. Unlike the series of communications between petitioners and the SAG in connection with the 1977 audit requirement, which are described earlier in this opinion, there is no evidence indicating dissatisfaction on the part of the SAG with petitioners' submission of audit materials in 1979 or their subsequent failure to submit audit certificates. - 40 Mandatory Nature of the 1979 Restriction There is evidence that there would have been potentially serious consequences if petitioners had violated the 1979 restriction. Continued access to Saudi crude was critical to petitioners during the period at issue, because it was their largest internationally traded crude oil source, representing about 50 percent of Exxon's and 78 percent of Texaco's crude oil supply (excluding indigenous production, or crude produced by petitioners themselves). As indicated earlier, Minister Yamani in April 1979 was quoted in the Middle East Economic Survey as saying in a press conference that the SAG had "enforced [the 1977 restriction] in 1977 when we had the two-tier pricing system, and we have asked for it again this time." In May 1980, Minister Yamani participated in another press conference, and the following question and Minister Yamani's answer were quoted in the Middle East Economic Survey on May 19, 1980: Q: How will OPEC deal with the situation arising from the sale by the oil companies of their OPEC oil purchases at well above OPEC official prices, when at the same time the consumer governments continue to blame inflated oil prices on the OPEC countries? A: There is little that OPEC can do about this problem. The most it can do is what Saudi Arabia is already doing which is to ensure that the barrel of Saudi oil is sold at Saudi prices until the oil is delivered to the refineries. After that stage the oil companies are in a position to make large profits, and these do not fall within the jurisdiction of OPEC. The "refineries" referred to in Minister Yamani's answer are appropriately interpreted to include all refineries, including - 41 petitioners' affiliated refineries. The mandatory nature of the restriction also was noted in a book published in 1980 by Ian Seymour, an editor of the Middle East Economic Survey, when he stated what was "very common knowledge at the time" as follows: The Saudis can, and do, oblige the Aramco companies to sell the crude (which mostly goes to their own affiliates) at the cheaper Saudi official price; and they can police these transactions right up [to] the entrance to the refinery. But once the oil is processed and marketed as products, the profit to be gained from having access to cheaper crude supplies than one's competitors will end up in the pockets of the US majors which participate in Aramco, and there is nothing Saudi Arabia can do about it. The similarity between the 1977 and 1979 restrictions and the Saudi expectation of compliance was echoed in a letter dated August 8, 1990, submitted to the Court by petitioners during trial, from the Minister of Petroleum and Mineral Resources in 1990, stating as follows: No. 71/H 18 Muharram 1411 (8 August 1990) Mr. Jack Clarke Vice President, Exxon I hereby confirm to you that the Government of the Kingdom of Saudi Arabia issued directives to Aramco, by letter No.103/z, dated 25 Safar 1399 (23 January 1979), concerning prices in the year 1979, that required oil offtakers of Aramco shareholder companies to sell Saudi crude oil obtained from Aramco at the Government-established prices. As in the case of similar pricing directives issued in 1977, the 1979 directive applied to all Saudi crude oil sales of offtakers whether related to said parties or otherwise. The Government expected oil offtakers to continue their normal operations, including barter deals, using the prices established by the Government of the Kingdom of Saudi Arabia for Saudi crude oil. The Government required Petromin also to sell Saudi crude oil at the Government-established prices. The Government monitored the oil offtakers' L - 42 - activities in an attempt to assure compliance with pricing directives. Minister of Petroleum and Mineral Resources (Signature) Hisham Mohiuddin NazerD" The provisions of this letter will hereafter be referred to as the first Nazer letter. Minister Nazer was the Acting Minister of Petroleum when Minister Yamani was absent from Saudi Arabia during the years at issue and became the Minister of Petroleum in 1986. Minister Nazer subsequently confirmed in another letter (which will hereafter be referred to as the second Nazer letter) that the first Nazer letter was written on the basis of my knowledge of the policy of the Government of the Kingdom of Saudi Arabia in my capacity as a member of the Council of Ministers and after conducting a thorough examination of the Ministry of Petroleum & Mineral Resources documents during the relevant periods. These statements of Saudi intent in the above-quoted documents were borne out by the Saudi actions. As described above, the SAG had notified petitioners when it had felt that its requirements in connection with the 1977 restriction were not adequately followed, and the SAG drew attention immediately to matters that incorrectly attributed something to one of its officers. In addition, by a series of directives beginning in April 1979, the SAG instructed Aramco and its shareholders to " In our evidentiary opinion, we admitted the first and second Nazer letters into evidence under Rule 146, reserving judgment on the weight to be accorded to them. Exxon Corp. v. Commissioner, T.C Memo. 1992-92. We discuss this matter infra note 39. - 43 maintain their deliveries of Saudi crude to customers in less developed countries (LDC's) at 100 percent of the quantities contracted for with these countries. Although there was a United Nations definition of LDC's, the SAG defined the list of the countries subject to the Saudi LDC requirement. In April and May 1979, Aramco was asked by Minister Yamani to furnish the SAG with a list of contracts concluded between the Aramco companies and companies located in LDC's. In a letter to Aramco dated May 8, 1979, concerning the LDC requested lists, Minister Yamani indicated: "Of course, the selling prices of said quantities are to be the same as other sales made at the prices fixed for you by the State." In response, Exxon sent a letter to the SAG dated May 10, 1979, listing the LDC's to which it was supplying Saudi oil. It also explained that, because of the disruption in Iran it was experiencing a crude oil shortage and therefore was forced to reduce quantities sold to all its customers, including those in LDC's. Minister Yamani responded on June 6, 1979, by instructing Mr. Garvin that the Aramco companies were to continue to guarantee to LDC's the quantities of Saudi crude they had contractually committed to "at the prices set out by the Saudi Arabian Government", and to advise the SAG of its compliance. similar letter was sent to Texaco. A Minister Yamani also indicated that "strict" compliance with the Saudi LDC requirement was "a very important matter" and that "necessary measures" would be taken "to remedy any deviation from these instructions." - 44 - Exxon advised the SAG shortly thereafter that it would do so. Rather than violate these clear Saudi requirements, in July 1979 an Exxon manager suggested attempting to narrow the list of LDC's during 1979 in order to increase Exxon's flexibility in cutting back supplies in times of shortage. Taiwan and Spain were considered as suggested countries to be excluded. Although listed as an LDC under the United Nations definition, Spain subsequently was excluded from the list of LDC countries by Minister Yamani. There is no evidence explaining the Saudi reasons for this exclusion. Minister Yamani subsequently sent another similar letter dated December 10, 1979, to Aramco's Chairman of the Board, which indicated that all companies transporting Saudi oil were to continue supplying LDC's with their contracted allotments so that, according to the translation, "we will not be compelled to reduce the quantity of Saudi oil supplied to any company not observing this strictly by the amount of contracted oil withheld from any developing country." do so. Exxon responded once again that it would continue to The implications of noncompliance with the Saudi LDC requirements were perceived by an Exxon executive as being "uncertain" and very likely to be "adverse for Exxon". There was concern about the possible reduction in Exxon's volumes by more than its LDC volumes, and "other ways to penalize Exxon for noncompliance". - 45 - A legal adviser to the Petroleum Ministry concluded that the SAG was acting in its sovereign capacity when it set prices of crude oil during the period at issue. Petitioners were required to follow the crude pricing requirements of the SAG if they were to continue to have access to Saudi oil. Mr. Garvin felt that petitioners were always aware that they were dealing with a sovereign entity that could make decisions at will, without regard to economics or the marketplace. Alfred DeCrane, Texaco's executive vice president during the years at issue, believed that the most logical sanction the SAG would have used if Texaco had failed to comply with the restriction would have been reduction of the amount of crude available to Texaco. In several other instances the SAG took a strong stance in connection with its requirements. For example, just prior to 1979 a U.S. Senate investigative committee subpoenaed materials from Exxon concerning Saudi production capabilities. The Saudi Minister of Petroleum was notified by Exxon that Exxon intended to comply with the subpoena, and the Minister instructed Exxon not to comply because such disclosures would be in violation of Letter 1030/Z (which forms the basis for the protective order in this proceeding). Letter 1030/Z provides for the confidentiality of information pertaining to activities between Aramco and the SAG. In his testimony before the Senate committee, Mr. Garvin expressed his concern about the "security of supply of Saudi oil to the U.S." if the disclosures became public. When the - 46 - Minister's instruction was not followed by Exxon, and the disclosures were publicized, Minister Yamani assured Mr. Garvin that the disclosures "will not pass without leaving its effect on the relationship of your company with the Government of Saudi Arabia." Exxon and Chevron (the other company involved) were penalized by the SAG by receiving approximately 24,000 barrels per day less crude than they otherwise were entitled to receive. This situation lasted for between 6 and 9 months. While the number of barrels reduced was not a significant amount, petitioners thereafter were concerned that this action was a precedent, and that the Minister would use punitive measures in other similar disclosure situations or in other areas of even more concern to them, such as the pricing of Saudi oil. Pricing restrictions apparently were required by the SAG with companies other than Aramco, and two other similar incidents involving punishment of other companies occurred in 1979. In one of these incidents, the Italian national oil agency, ENI, had signed a contract with Petromin in June 1979 to purchase 100,000 barrels per day of Saudi crude at Saudi OSP for a period of 3 years. Toward the end of 1979, Italian press reports stated that a fee had been paid to a Panama company in connection with the contract, and the SAG suspended the contract in December 1979. subsequent investigation confirmed that ENI had complied with Saudi pricing requirements and paid Saudi OSP, and the contract was put back into effect in the third quarter of 1981. In A another unrelated incident, the SAG suspended crude supplies to Japan in the amount of 140,000 barrels per day for similar violations. These incidents conveyed to petitioners the principle that the SAG requirements were expected to be enforced. Similarly, there was a perception by the Japanese that the SAG could stop the flow of Saudi oil into their country if Saudi pricing requirements were not complied with. Minister Yamani also corresponded with petitioners when in another instance he apparently believed that the 1979 restriction was not being followed. In that situation, the Minister indicated that he had been advised that Texaco was planning to sell Saudi crude in the Philippines at a price in excess of the restricted price. There is no evidence indicating that the Minister's suspicions were justified. On December 30, 1980, Minister Yamani sent a letter to Texaco, indicating as follows: During my recent trip to Philippines I was surprised to learn that you have informed your affiliates that the price of Saudi oil supply will be more than what Saudi Government has established. Should this be true it will certainly be a breach of your commitment to us which will be seriously regarded. Saudi oil should always be delivered at Government established prices and the audit certificate thereof should be submitted to us. Furthermore, we reiterate our established policy that supplies to developing countries should not be decreased at any rate. Strict adherence to these guidelines will help streamline our relationship. A similar letter describing Minister Yamani's concerns about possible violations by some of the Aramco partners was sent to - 48 Exxon. Because of Texaco's high dependence upon Saudi oil, Mr. DeCrane was very concerned that the SAG would reduce crude supplies if it believed that Texaco had failed to comply with the restriction. Texaco promptly advised Minister Yamani that it was not charging, or advising its affiliates to charge, higher prices than the Saudi established prices. Exxon officials also advised Minister Yamani in March 1979 that: "All Aramco crude sold by Exxon this quarter, whether to affiliates or to third parties, has been priced no higher than the * * * [relevant Saudi prices]." On various other occasions during the period at issue Exxon advised the SAG that it was not selling Saudi crude at prices above Saudi OSP. Because of these potential consequences, petitioners took steps to ensure that they complied with the 1979 restriction, and they invoiced their Saudi crude at Saudi OSP. There were a few isolated instances in which petitioners did not do so, but these instances apparently were not a disregard of Saudi requirements and occurred inadvertently. In one incident Texaco sold 129,675 barrels of crude during the period at issue for a price in excess of Saudi OSP. This sale constituted approximately .006 percent of the 2,276 million barrels of Saudi crude disposed of by Texaco during the period at issue. Exxon mispriced one sale to a related entity involving 352,626 barrels of Saudi crude when it used the Saudi established price in effect on the date the loading was completed rather than on the date loading commenced. - 49 - This sale constituted approximately .016 percent of the 2,273 million barrels of Saudi crude disposed of during the period at issue. There is no evidence indicating Saudi knowledge of, or objection to, these sales. These incidents are so isolated and the number of barrels is so small in relation to petitioners' total sales of Saudi crude that they is,insignificant. Supply Needs; Shortages Every grade of crude oil is different in chemical composition and quality. The relative value of one crude oil versus another is affected by, among other things, its physical and chemical characteristics, locational differences, and the relative prices of the various refined products that can be made from the various crude oils. is sulfur. One common contaminant in crude oil Because sulfur is corrosive, a crude oil with a high sulfur content generally requires more extensive processing than a crude oil with a low sulfur content. In addition, during the years 1979-81, many countries (including the United States) regulated the level of refinery sulfur emissions and/or the sulfur content of or emissions from petroleum products. Another important characteristic of crude oil is its density, or specific gravity, which normally is expressed in American Petroleum Institute (API) degrees. On the API scale, the lower the density of crude oil, the higher the degree of API gravity and the greater the value. Crude oil ranges from "light" crude (approximately 34 degrees specific gravity), which is processed - 50 - into automobile gasoline, to "medium" crude (approximately 31 degrees), which is processed into home heating oil, to "heavy" crude (approximately 24-31 degrees), which is consumed by large power plants. As reliance upon the automobile increased, the lighter crudes came increasingly into demand in the late 1970s. Shortages were anticipated shortly after the first oil crisis. As early as 1974-75, Exxon had advised its unrelated customers to diversify their crude oil sources and not to rely on Exxon for long-term supply. the situation. But subsequent events exacerbated On February 13, 1978, the SAG issued a directive requiring a reduction in the amount of Arabian Light crude that the shareholders could lift from 75 to 65 percent of their total liftings from the SAG. The reason for such a directive probably was that a high percentage of the SAG reserves was in the heavier grades, and thus the SAG sought to increase its sales of the heavier crudes. The crude oil shortages that had occurred after the first oil crisis became even more acute during the years 1979-81. Middle East and North African daily crude oil production during the years 1978-81 was as follows: DAILY CRUDE OIL PRODUCTION (in thousands of barrels) Country 1978 1979 1980 1981 Saudi Arabia Iraq 8,296 2,629 2,096 1,990 5,197 1,447 9,530 3,450 2,060 2,490 3,110 1,464 9,926 2,646 1,788 1,675 1,467 1,350 9,818 1,184 Libya Kuwait Iran Abu Dhabi 1,180 1,118 1,114 951 - 51 - Algeria Egypt Qatar Dubai Oman Syria Tunisia Bahrain Totals 1,225 482 1,116 506 942 585 900 587 100 53 100 50 100 49 118 44 24,847 25,191 21,796 18,260 485 362 315 170 500 360 295 160 471 349 283 165 405 358 317 166 As discussed earlier, as Iranian and other Middle East production decreased, there was considerable uncertainty whether supplies might be further disrupted, and petitioners experienced shortages of crude, even in some cases for their own requirements. As a consequence they tried to cut back deliveries to unrelated customers. By early March 1979 Exxon determined that it would not renew its term crude oil supply contracts with unrelated customers, which were scheduled to expire at various times beginning on March 31, 1979. Exxon's sales of Saudi crude to affiliates increased from approximately 69 percent of total Saudi sales in 1978 to 77 percent during the first three quarters of 1979. The volume of subsequent sales of Exxon's Saudi crude to unrelated customers dropped significantly thereafter from 16.5 percent of total sales of Saudi oil in the first quarter of 1979 to 1.1 percent of such sales in the first quarter of 1981. Texaco's system during the 1970s had become "unbalanced" as a result of the trend toward higher sulfur, heavier crude supplies, and changes in demand for lower sulfur products. of Texaco's crude supply was high-sulfur Saudi crude. Most The situation was exacerbated by the losses of Iranian Light crude in - 52 late 1978. By 1979, the Texaco system began to correct this imbalance by selling high-sulfur crude and purchasing low-sulfur crude, either outright or through exchanges. At the same time that it was attempting to reduce the system's sulfur content, there was a Texaco management "consideration" to phase out unrelated customer crude supply agreements in 1979. However, during the years 1979-81 Texaco sold Saudi crude to unrelated customers in a generally consistent pattern as before the issuance of the 1979 restriction, in amounts of approximately 15 to 20 percent of its Saudi Arabian liftings. There was a decline of unrelated customer sales under contracts that had been entered into by Texaco prior to 1979, primarily as a result of the end of the terms of these contracts. There also apparently were seven specific instances of substitutions by Texaco of non-Saudi crude for Saudi crude in sales to certain Japanese companies (which collectively were Caltex's largest crude customer). However, Caltex's supply of Saudi crude to those companies remained basically constant during the period at issue, at approximately 200,000 barrels per day. In the face of shortages, the four Aramco shareholders sent a letter to Minister Yamani in May 1980 urging the SAG to increase production. They stated in that letter that they had "relied upon the terms of the present Arrangements as the basis for our relationships with the [Saudi] Government", and that Saudi production volumes were far below their expectations under - 53 those Arrangements. Because of these shortages, they indicated, they were not able to meet the needs of their refining facilities and product outlets throughout the world, and they were forced to purchase crude on the spot market to meet their requirements, which was contrary to the SAG stated objectives and policies. In September 1980, Iraqi forces invaded Iran. The outbreak of the Iran/Iraq war resulted in the loss of crude oil production from Iran and Iraq of approximately 3.9 million barrels per day on average over the fourth quarter of 1980. During the latter part of 1980, Minister Yamani advised petitioners that the SAG had decided to increase production from 9.5 to approximately 10 million barrels per day in order to "close the gap" brought about by the Iran/Iraq crude production losses. Petitioners were further advised that the SAG would designate the specific customers, prices, and volumes for petitioners' sales of Saudi crude. The countries that were to be sold crude under these conditions included France, Brazil, Japan, Italy, Greece, Spain, Morocco, and Turkey. These sales came to be known as "designated sales", or "war relief crude sales". Pursuant to this requirement, Textrad and the Exxon offtakers sold approximately 77 million and 61 million barrels, respectively, of "war relief" Saudi crude to unaffiliated entities during 1980 and 1981 combined. Petitioners were not to suffer any economic loss nor derive any economic gain from these sales. The parties were to provide the SAG with certain information demonstrating - 54 compliance. Texaco told its auditor to prepare and submitted to the SAG audit certificates regarding designated sales. There is no evidence concerning Exxon's submission of audit materials on designated sales. The prices of Saudi Arabian Light during the period 1979 through 1981 were as follows: Date Announced Date Effective Price Per Barrel December 30, 1978 January 23, 1979 April 1, 1979 July 4, 1979 December 12, 1979 January 26, 1980 May 13, 1980 September 21, 1980 December 14, 1980 November 1, 1981 January 1, 1979 January 23, 1979 April 1, 1979 June 1, 1979 November 1, 1979 $13.34 14.55" 14.55 18.00 24.00 October 1, 1981 34.00 January 1, 1980 April 1, 1980 August 1, 1980 November 1, 1980 26.00 28.00 30.00 32.00 As discussed earlier, as dramatic as this rise in Saudi prices was, these prices of Saudi Light were exceeded by the prices of comparable crudes from the other OPEC members during the years at issue until October 29, 1981. Other Saudi crudes (including Berri, Medium, and Heavy) also were priced below other Middle Eastern crudes of similar density during the period at issue. At a December 1980 OPEC meeting in Bali, Indonesia, the OPEC ministers again agreed to raise crude oil prices. OPEC price unification was finally obtained at an OPEC meeting in Geneva, Switzerland, on October 29, 1981, when Saudi Arabia agreed to " Letter 103/Z indicates that this price applied only to additional production received by Aramco in excess of the first 7 million barrels of daily production received by Aramco out of total crude oil production. - 55 raise the price for Saudi Arabian Light crude from $32 to $34 per barrel. This constituted the end of the period during which Saudi crude was sold at prices below other comparable crudes and thus the end of the so-called "Advantage" period. By 1982, Saudi crude was more expensive than other similar crudes, and this period came to be called the "Disadvantage" period. In contrast to the 1978-79 period when there were world- wide crude shortages, during 1982-83 demand for crude generally was reduced because crude supplies were readily available. During 1981, when there began to be a reduction in demand, Exxon reduced its purchases of Saudi oil from approximately 2 million to 1 million barrels a day. Exxon's Saudi liftings in 1983 were approximately 600,000 barrels a day. Textrad dispositions of Saudi crude decreased from almost 2 million barrels a day in 1981 to under 1 million in 1982. U.S. Government Actions and Statements During the period 1975 through 1981, officials of the U.S. Government undertook numerous diplomatic efforts to affect or moderate OPEC crude oil price increases, urging the SAG as well as other OPEC Governments to moderate crude oil prices and to increase crude oil production. Officials of the U.S. Government met with representatives of the SAG on several occasions during the period at issue and conveyed their appreciation for Saudi efforts towards moderation in price as well as its continued maintenance of high production levels. Prominent U.S. officials - 56 believed that the SAG's price moderation policies were designed to obtain the defense and foreign policy support of the United States and to meet the need for stability in the world economy. In August 1973, the U.S. Government had issued refined petroleum product price controls on motor gasoline and propane. These price controls were in effect until January 27, 1981. The U.S. Government also issued a regulation concerning crude transfer pricing standards that refiners were to use to establish the cost of imported crude purchased in transactions between affiliated entities. That regulation was in effect from October 25, 1974, through January 27, 1981. After the 1979 restriction was issued, official U.S. policy was strongly in favor of enforcing the restriction and seeing that the Saudi policy toward moderation was carried out. Minister Yamani had a reputation with U.S. officials of being influential in developing and implementing Saudi oil policy. He also had a reputation as a careful and cautious individual who would not attempt to implement a policy unless it was authorized by the SAG. In his personal dealings with Crown Prince Fahd prior to the years at issue, Richard Cooper, the Under Secretary of State for Economic Affairs under President Carter, was led to believe by Crown Prince Fahd that Minister Yamani's position presented at the Doha conference in late 1976 (establishing the 1977 restriction) represented the official SAG position. U.S. officials believed that the 1979 restriction was mandatory, that - 57 - it was essentially a replay of the 1977 restriction, and that in exchanges Saudi crude was required to be sold at Saudi OSP. There was a perception among U.S. officials that, because the SAG's ability to market oil directly through Petromin was increasing during this period, the SAG could feasibly cut off supplies to the Aramco shareholders if they did not comply with the restriction. A violation of the restriction would have been reported by U.S. officials to the U.S. Department of Energy. Consuming Country Oil Market Information Systems As producing country governments preempted more and more of the functions of the private oil companies, some of the consuming country governments became more involved in the oil industry's refining, marketing, and distribution activities, initiating a variety of controls on usage, imports, and prices. After the 1973 Arab oil embargo, a mechanism was established whereby accurate data on the actual prices being charged for crude oil and petroleum products were collected, in order to provide better information on the situation in the international petroleum market. The foreign ministers of the major consuming countries met in Washington, D.C., during February 1974 at what came to be called the Washington Energy Conference. This Conference led to an Agreement on an International Energy Program (IEP), which set forth such objectives as promoting secure oil supplies on reasonable and equitable terms, creating an international oil market information system, creating an emergency oil-sharing - 58 plan, restraining demand for oil, achieving long-term cooperation on energy matters, and developing constructive relationships with oil-producing countries. The IEP, among other things, authorized the formation of the International Energy Agency (IEA). By the end of 1974, the IEA was formed as a 16-nation autonomous body within the Organization for Economic Cooperation and Development. Its members were Austria, Belgium, Canada, Denmark, the Federal Republic of Germany, Ireland, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. 1975. New Zealand joined the IEA in Norway subsequently participated in the IEA pursuant to a 1975 agreement. Greece joined the IEA in 1976, Australia in May 1979, and Portugal in July 1981. During the 1974-81 period, the Governing Board of the IEA, which is composed of delegates from each participating country, oversaw the activities of four standing groups, one of which was entrusted with the responsibility of overseeing the development of a crude oil market information system. The IEA crude oil market information system was designed to promote fairness in the overall distribution of crude oil by providing participating countries with greater information on the conditions in the international oil market, to moderate prices (particularly spot market prices, which were of concern to U.S. officials), and to reduce suspicion among the member countries by means of the "transparency" of the system. The participating countries agreed - 59 - to provide oil market information requested by the Secretariat of the IEA. The U.S. Department of Energy, together with the Department of State, supported the creation of the IEA crude oil information system. In January 1977, the European Community (EC) established its own crude oil price information system. The following countries were members of the EC throughout the years 1975-1981: Belgium, Denmark, the Federal Republic of Germany, France, Ireland, Italy, Luxembourg, the Netherlands, and the United Kingdom. Greece joined the EC in January 1981. In June 1979, the heads of state of the seven largest industrialized countries met in Tokyo for an economic summit meeting (Tokyo Summit). On the first day of the Tokyo Summit, OPEC announced significant crude price increases, which were officially deplored by the Tokyo Summit participants. The Saudi price moderation policy was discussed at the Tokyo Summit and praised by the various heads of state. It was the understanding of Dr. Schlesinger, who attended the Tokyo Summit with President Carter, that the 1979 restriction fulfilled the common U.S. and SAG objectives to have the lower-priced Saudi crude reach the consuming countries at the lower price. Officials of the Governments of the United Kingdom, Italy, the Federal Republic of Germany, the Netherlands, and France understood the Saudi objective to be the same. It was Dr. Schlesinger's understanding that the leaders of the countries participating in the Tokyo Summit believed that the 1979 restriction was applicable in all - 60 of their countries and applied to all sales of Saudi crude, including sales to petitioners' affiliates in those countries. He believed that the United States and SAG objectives would not have been met if the restriction had not applied to affiliate sales. He also believed that this was the view of Minister Yamani. One of the actions taken by the participating countries at the Tokyo Summit was to agree to set up a register of international crude transactions to bring the workings of oil markets more into the open. During the period 1979 through 1981 agencies of the Governments of Canada, the Federal Republic of Germany, France, Greece, Ireland, Italy, Japan, the Netherlands, Norway, Sweden, the United Kingdom, and the United States had knowledge of or were aware of the prices at which Saudi crude oils were imported into their respective countries either through their own government's crude oil information system, or through information obtained from the IEA or the EC. The transparency created by the information-sharing was important in ascertaining compliance with the restriction. This transparency ensured that all consuming member countries were being treated the same. Some countries, such as France and the Netherlands, controlled petroleum product prices and directly monitored the - 61 prices of imported crude oil." The same was true in Japan." During the period at issue, Italy's system established that Saudi crude was to be imported at Saudi OSP." The German Government France had domestic product price controls on certain refined products, which were fixed by reference to the official selling prices of a "basket" of crude oils, in which every crude entered in direct proportion to its share in the supply of French refineries. While it did not have crude price controls, France took a very active part in monitoring the prices of imported crude oil. France did not separately control exchanges. A portion of the 1979 income attributed to the Exxon offtakers was from a French Exxon affiliate. The Netherlands had product price controls and closely monitored crude prices. It did not separately monitor exchange transactions because these transactions historically had been occurring regularly for logistical and supply purposes, and there was no indication that they were occurring for other reasons during the period at issue. A portion of the income attributed to the Exxon offtakers was from a Dutch Exxon affiliate. " It was common knowledge among the Japanese people that the SAG had established lower crude selling prices than other OPEC countries. Japan had a product control system, the Ceiling Price System, in effect during the years at issue, which would not have permitted Japanese affiliates of Aramco shareholders to charge product prices that reflected import costs of Saudi crude above Saudi OSP. The Japanese Government monitored the quantities and prices of all imports of petroleum into Japan. Saudi crude constituted almost one-third of Japan's total oil imports in the years 1979-81, and, because of the importance of Saudi crude to Japan, higher prices would not have been permitted under the Ceiling Price System. " A close watch was kept by Italy on imports of Saudi crude because that crude amounted to approximately one-third of Italy's aggregate imports. Italian officials knew that Saudi crude was selling for less than other crudes and that petitioners had been instructed by the Saudis to sell it at OSP. Italy required oil importers to submit monthly reports on each crude shipment, its quantity, origin, price, and terms of payment. This monitoring was intended to keep crude import prices as low as possible. In 1980 a system was adopted in Italy whereby all crude was to be based on official selling prices and conformity with this requirement was routinely verified. This system of monitoring in (continued...) - 62 encouraged the Saudis to pursue their moderate policies and was fully aware of Saudi pricing policies during the years at issue." The United Kingdom also monitored the flow of crude into the country." In the course of this monitoring, officials from all of these governments were aware of the 1979 restriction and did not find any violations. A violation of the restriction would have been known to these officials, and they would have required compliance with it, either through informal pressure in the press and political arena (thereby informing the SAG of such "(...continued) Italy was in addition to the monitoring procedures already in effect by the IEA and the EC. Italy did not monitor separate price information of exchange transactions but simply verified the conformity of all import prices with official prices. A portion of the income attributed to the Exxon offtakers was from an Italian Exxon affiliate. Although the German Government did not have official product or crude price controls, it had a Government price information system by which it monitored the prices of crude imported into the Federal Republic of Germany. The Federal Republic of Germany would have intervened had it become aware that petitioners' offtakers were transmitting Saudi crude into the Federal Republic of Germany at prices in excess of Saudi OSP. The Texaco notice of deficiency allocated income from a German Texaco affiliate to Textrad. " The United Kingdom had no formal controls over crude oil or product prices during the years at issue. It had a basic policy of allowing market forces and prices to work. However, it also sought to discourage or restrain price increases that could not be sustained in the long run and were not justified by the underlying supply and demand trend. There was a perception that the high OPEC prices were artificial and thus not in compliance with free market forces. Therefore, it supported the Saudi price moderation policies. The oil market information system and the crude oil register provided it with an ongoing picture for assessing whether petitioners were selling Saudi crude at the Saudi OSP. - 63 - violation), or by more formal legal means, such as the withholding of permits and licenses, formal investigations, the initiation of legislative measures, or the assertion of certain emergency powers. Officials of these countries and of the United States were under the impression that the restriction applied to all sales of Saudi oil into their countries. Petitioners had refining affiliates located in each of these countries. At various times during the period 1979-81, the IEA and the EC expressed public concern or interest with respect to: (1) Crude oil prices and the rapid escalation of such prices; (2) the refined product prices of their respective member countries; and (3) assuring an adequate supply of crude oils to all participating countries and an equitable distribution of that crude oil supply. Exchanges Reciprocal purchase/sale agreements, or exchanges," were mechanisms by which oil companies exchanged oil with one another to accomplish one (or more) of three purposes: To save transportation costs (a location exchange), to save storage costs (a timing exchange), and to solve refinery operating problems or improve crude quality (a quality exchange). Sometimes exchanges " In a reciprocal purchase/sale agreement there are two "matching" transactions, a sale and a purchase, each subject to a separate legal document, whereas in an exchange there is a single transaction, subject to a single legal document. The two terms are used interchangeably in the industry. For purposes of this opinion, we use the term "exchange" to refer to both exchanges and reciprocal purchase/sale agreements. - 64 were used to obtain specific crudes necessary to meet contractual commitments. The intracorporate economic decision whether to engage in an exchange transaction is based upon whether the internal values of the crude oils involved result in benefits to both parties to the transaction. The internal value is the value to each particular company of the refined products that could be produced from the crude in question.'° One crude oil may be worth more to one company than another simply because it has refinery capability that the other does not. Accordingly, the market price for each crude oil in an exchange is irrelevant to the economics of the exchange. What matters is the value to the company on each side of the exchange of the finished products that could be produced from that crude by that company. Companies tend to divide the difference in value through negotiation of a "differential" that is within the range of the difference between the refined values of the two crudes for each of the parties. The refined value to each exchanging party of the crude received necessarily is higher than the refined value of the crude given up, or the exchange would not be entered into because it would not be beneficial to that party. 2° For example, in one transaction involving a disagreement between Texaco and one of its exchanging partners over who had to bear the responsibility for retroactive price increases, the exchanging partner had indicated that the exchange differential had been calculated based upon "the difference in value of each crude, in respect of the yields of refined products." - 65 Because the differential between the internal values of the two crudes was the focal point of the exchange transaction (not the differential between the OSP's or market prices of the crudes being exchanged), it was not uncommon for petitioners' ledgers to reflect that petitioners obtained non-Saudi oil in an exchange at a price that was less than that crude's OSP, which respondent has characterized as a "discount". This "discount" occurred because the internal value differential in an exchange during the period when the 1979 restriction was in effect was different from the OSP differential between the crude oils involved; consequently, because the Saudi oil was required to be invoiced at Saudi OSP, the non-Saudi oil received in an exchange was purchased by petitioners at a price lower than its OSP. Nor was it uncommon for petitioners' records to reflect special credit notes or memoranda or adjustments in credit terms,'' freight terms, and the like received by petitioners in exchange transactions, since For example, in one transaction, the trading partner insisted for its own reasons that its crude had to be invoiced at its own OSP, and a "credit note" was used to balance out the transaction based on the parties' understanding of the profit to be earned from refining each crude. In another situation, a telex from Exxon to an exchange partner during the period of the 1979 restriction provides that the 30 days additional credit Exxon would receive in the negotiation would only partially offset the effect of the low price of the Saudi crude while Algerian was at the maximum official price. The telex goes on to state that: "In evaluating the exchange this point was a significant consideration and thus we would prefer to maintain 60 days credit on the Algerian". This would appear to make it clear that favorable credit terms commonly went into negotiation of the differential. Other documents show similar adjustments of credit periods in order to bring the values of the crudes being exchanged into balance. - 66 these forms of consideration reflected the differentials in refined values between the crude given up and the crude received in an exchange transaction. The relative values of each crude to each exchanging party were also affected by other factors, including the volume ratios," the percentage of Arabian Light in the total Saudi exchange pool at any one time, payment term variations, transportation costs, and package exchanges." Exxon guidelines had been devised for exchanges during the period of the 1977 restriction. These guidelines had provided that there were three basic objectives for engaging in exchanges: To correct grade imbalances, to reposition crudes geographically, and to resolve timing problems. With the 1977 two-tier pricing system, Exxon guidelines indicated that Exxon should continue in its historical types and volumes of exchanges, continuing to " In exchanges, the number of barrels of Saudi crude that Textrad disposed of often was different from the number of barrels received, with the difference referred to as the "exchange ratio" or the "volume ratio". This ratio is defined as the number of barrels disposed of in an exchange transaction as compared with the number of barrels received in the exchange. The evidence indicates that, over the period 1973-1982, on average, 1.36 barrels of Saudi crude were given up by Textrad for 1 barrel of non-Saudi crude. For the years at issue, on average 1.44 barrels of Saudi crude were given up for 1 barrel of nonSaudi crude. Package exchanges were employed when Saudi oil was sold with no offsetting exchange barrels received under that contract. In some situations these barrels were sold outright by Textrad and recorded as part of an existing exchange contract, rather than as an outright purchase. There were a variety of legitimate reasons for using this method of recording the sale. The evidence does not indicate whether petitioners took part in such transactions. - 67 value them in terms of internal values, with reference to the Saudi crude.price. There was seen "no reason to view continuation of these same practices as a contravention of Saudi Arabian directives." The 1977 Exxon guidelines were supplied to Exxon affiliates. Exxon's exchange practices under the 1977 guidelines were discussed with the Saudis. At a meeting between Exxon officials and a Petromin representative on July 20, 1977, the Petromin representative wanted to know why the SAG had been receiving audit certificates in four different formats and covering different aspects of the 1977 restriction and why the independent auditors had not consulted with each other. He also indicated that he wanted to "take away with him" certain materials from Exxon, including a copy of their interpretations of the 1977 restriction provided to affiliates, and that he had made the same request of Texaco. A similar meeting between Petromin and Texaco officials apparently occurred on the same day, and one of the questions raised by the Petromin representative was "how exchanges had been handled". The parties have directed the Court to no evidence that the SAG objected to Exxon's or Texaco's 1977 exchange policies. During 1979-81, Exxon updated its exchange guidelines to govern its transactions involving Saudi crude oil during that period in a manner very consistent with the earlier guidelines. In setting out the guidelines for exchanges during the period of - 68 the 1979 restriction, the corporate instructions were that "The directives are essentially the same as those received from the Saudi Arab Government during the two tier pricing environment of 1977." Mr. Garvin again instructed the Exxon offtakers not to make any arrangements that had not been made before the 1979 restriction. Exxon's 1979 exchange guidelines provided that all Saudi oil given up in an exchange was to be priced at the Saudi OSP; that exchange volumes were to remain at historical volumes; that exchanges usually were to be for quality, volume, timing or location reasons; and that exchanges were preferably not to be made with companies that were primarily traders (who would be more likely to violate the restriction by reselling the Saudi oil at higher prices on the spot market). Exxon's exchange guidelines also stated that corporate economics should be improved by Exxon exchanges, and there was an Exxon policy issued in September 1979 to obtain non-Saudi crude in an exchange at a discount. Exxon also continued the policy of permitting exchanges where necessary to meet particular commitments. Exxon officials discussed with the SAG why exchanges were necessary and that the Exxon offtakers would continue to engage in exchanges during the period of the 1979 restriction. The Exxon guidelines were followed during the years at issue. In almost every Exxon exchange transaction, there was a business reason, a specific operational purpose, for the exchange. There was, in other words, a reason for every exchange - 69 unrelated to a potential to capture the profit from the low cost of the Saudi. crude. In one apparently exceptional case, Exxon engaged in an exchange for the express purpose of obtaining the non-Saudi crude for resale to an unrelated party to meet a contractual commitment. The number of barrels of Saudi crude exchanged out in the course of this transaction constituted less than 1 percent of Exxon's total Saudi dispositions during the period at issue. Exxon's offtakers transferred 132 million barrels of Saudi crude to unrelated customers as part of exchanges. In each of these transactions, Exxon invoiced the Saudi crude at prices no higher than the prevailing official selling prices set by the SAG (plus transportation and other applicable costs associated with the movement of crude). If non- Saudi oil received by Exxon in an exchange was reflected in Exxon's ledgers as being sold to a unrelated party at a profit, that profit was reported for U.S. income tax purposes. Exxon told its purchasers about the restriction and monitored sales of its Saudi oil to see if any Saudi oil that it sold or exchanged was being resold in the spot market at higher prices. Exxon was satisfied that its exchange practices did not violate the 1979 restriction because it followed its historical internal guidelines, which required that all Saudi oil be invoiced at OSP, and because it kept its exchange levels at - 70 historical volumes.'' For example, in September 1980, EIC did not participate in an exchange of Saudi Light for Tapis crude owned by a company called Petronas because of a concern that the arrangement could yield a price in excess of Saudi OSP. The idea of a noninvoicing exchange was opposed by Esso Middle East because Saudi crude was involved and because this mechanism had not been "the historical means of doing business with the crudes involved." During 1977, Exxon's liftings of Arabian Light were almost 74 percent of total Saudi liftings. As discussed earlier, in February 1978, the SAG reduced to 65 percent of Saudi liftings the amount of Arabian Light available to Exxon. Thus, after this time Exxon needed to obtain lighter grades of oil to satisfy the requirements of its affiliates, and it accomplished this in part through an increase in exchanges of the heavier grades of Saudi oil for lighter grades of non-Saudi oil. Exxon also had lost significant sources of low sulfur ("sweeter") crudes by the beginning of 1979. The Iranian Revolution in late 1978 further complicated Exxon's supply situation by cutting off a significant production source at a time when demand was increasing. Despite this need for increasing amounts of lighter and sweeter grade crudes, the amount of Saudi crude given up by Exxon One Exxon executive expressed concern to another in September 1979 that exchanges in which Saudi crude was given up were "risky" because they might damage Exxon's Saudi relationship, but apparently this person's concerns were not pursued. in exchange transactions did not increase during the years at issue compared to the preceding 2 years. Over the 5-year period 1977-81 Exxon transferred Saudi crude oil to unrelated customers as part of crude oil exchanges in the following amounts expressed in millions of barrels: Exxon's Saudi Crude Oil Exchange Transactions Saudi Crude Given Up Saudi Crude Received Net Saudi Crude Given Up Year MB MB MB 1977 1978 1979 1980 1981 46.9 77.5 56.3 41.3 34.8 12.4 7.8 7.6 7.3 13.4 34.5 69.7 48.7 34.0 21.4 The net amount of Saudi crude given up by Exxon in exchanges expressed as a percentage of total Saudi crude dispositions during these same years is as follows: Year Percentage 1977 1978 1979 1980 1981 4.2 9.2 6.1 4.5 3.0 Crude oil exchanges also were a longstanding business practice of Texaco. Textrad was responsible for balancing crude oil and product supply and demand for the Texaco system by engaging in international trading activities. It was Textrad's responsibility to review the requirements of the various subsidiaries and affiliates, to arrange for transportation and acquisition of crude oils to meet the system's requirements, to - 72 buy products when needed to supplement the refining activities, and to sell products when products were surplus to Texaco requirements. Approximately three-quarters of Textrad's crude sales and exchanges over the period 1973 to 1982 involved Saudi crude. As discussed earlier, during the 1970s the Texaco system had become "unbalanced" as a result of the Saudi trend toward high sulfur "heavier" sources in supply," changes in the demand for refined products, the losses of Iranian exports, and changes in product specifications, particularly sulfur content. In 1977 Textrad estimated that its shortage of low sulfur crude was about 400,000 barrels per day. Textrad needed Arabian Light purchased from the SAG for its system requirements. Accordingly, the largest portion of Textrad's exchanges was quality exchanges. Textrad's exchange practices during the years immediately preceding the years at issue involved efforts to exchange some of the heavier grades of Saudi crude for the light, lower sulfur crudes needed in the Texaco system. By early 1979, Textrad tried to lighten the overall quality of its crude supplies through outright purchases of low-sulfur crude, outright sales of high-sulfur crude, and exchanges of heavier (usually Saudi) crude for lighter crude. Textrad increased the percentage of Arab Medium and Heavy to total Saudi crude disposed of by exchanges from an average of " Lighter crude generally tends to be "sweet", or to contain lower amounts of sulfur, although there are many exceptions to this tendency. - 73 20 percent over the period 1973 to 1978 to an average of 39 percent over the period at issue. Textrad's general exchange policy instruction was to adhere to the 1979 restriction by engaging in exchanges only in the ordinary course of business. Textrad's exchanges during the years at issue were handled in much the same manner as they had been handled during the 1977 restriction period, with careful periodic review to ensure that the number of exchanges remained consistent with historical levels and were generally for operational system needs. Textrad followed a procedure whereby the numbers of exchanges were reviewed and examined to be sure that they were for specific needs for particular refineries in the Texaco system. Occasionally, both before and during the period at issue, non-Saudi crude received in exchanges also was resold to unrelated purchasers. Texaco officials discussed Textrad's exchange policies with the SAG, and advised the Saudis that Textrad intended to continue to engage in exchanges in the ordinary course of business. There is no evidence indicating Saudi dissatisfaction with Textrad's exchange practices. Pursuant to exchanges, Textrad disposed of 139,780,564, 105,034,926, and 100,382,961 barrels of Saudi crude oil, in the aggregate," to unaffiliated entities in 1979, 1980, and 1981, respectively. In each invoiced exchange transaction during the These amounts represent dispositions by exchanges of Saudi crude oil acquired by Textrad from all sources, including Saudi crude oil acquired other than via Aramco. years 1979-81 in which Textrad disposed of Saudi crude oil, the invoiced price of the Saudi crude oil specified in the contract was the official selling price set by the SAG. The non-Saudi crude oil received by Textrad in exchange transactions was invoiced at a price specified in the contract. As with Exxon, in negotiating the price of the crude received for purposes of an exchange, Textrad determined the value of each crude in the exchange based on the value of the products that could be refined from those crudes. Textrad's exchanges involving Saudi crude were essentially consistent during the period 1979-81 with historical levels. They constituted approximately 15 to 17 percent of Textrad's total sales of Saudi crude over the period 1973 to 1982, and 17 percent over the period at issue. The same consistency is present with regard to non-Saudi crude received by Textrad in exchanges and disposed of in outright sales to third parties instead of to affiliates for operational purposes. From 1973 to 1982, Textrad transferred to unrelated entities 7 percent of the non-Saudi crude acquired in exchange for Saudi crude. Over the years 1979-81, Textrad resold to unrelated entities 8 percent of such crude. This constituted less than 1 percent of the amount of Saudi crude disposed of by Textrad during the same period. In those situations where Textrad disposed of oil received in an exchange, it sold the oil at its market price. Although the 1979 restriction itself did not expressly address exchanges, Texaco - 75 - officials were satisfied, after discussions with the Saudis, that Textrad's exchange practices did not violate the restriction. As discussed, in Textrad exchanges the differentials between the exchanged crudes were computed so as to represent the differences between internal refined values. In addition, in one transaction a differential originally negotiated was adjusted to reflect a particular change in circumstances. In that transaction an exchange differential of $3.75, originally negotiated by Texaco with Koch Industries (Koch), later was adjusted to $3.57. However, it appears that Koch purchased from Textrad an additional 320,000 barrels of Arab Heavy crude after the original exchange transaction was negotiated. The differential adjustment may have been to account for a change in the price of the Arabian Heavy crude during the period between the original negotiation of the contract and the purchase of the additional barrels. There is some indication that Koch may have resold the Saudi oil received from Textrad at a profit, but a Koch official also was aware that petitioners were required to sell the Saudi oil at OSP. Internal Texaco documents indicate that various methods were recognized by Textrad as being useful to adjust the differences in official prices in order properly to reflect the refined values in Textrad exchange transactions. These documents contain the following language: As we have discussed, a significant pricing disparity currently exists when comparing Saudi Arabian crude official prices to official prices of crudes marketed by other - 76 producing countries. In our exchange arrangement negotiations, we have minimized this disparity through a combination of approaches such as reducing exchange ratios, reducing the percentage of Arabian Light in the total Arabian exchange pool, payment term adjustments and negotiating discounts from the official price of low sulfur crudes acquired thereby directly reducing Texaco acquisition costs. This "disparity" language was repeated in subsequent Texaco documents. In a transaction with Gulf summarized in a typical document containing the above language, the terms of the exchange were described by a Texaco official as follows: An advantage to Texaco under this arrangement will be achieved through a combination of the following factors: (1) An Overall exchange ratio of 1 BBL Arabian crude to 1 BBL of low sulfur crude. The Arabian crude volume will consist of 65% Arabian Light. (2) A discount of $0.35 per barrel from the official Cabinda and Zaire selling prices of $17.50 and 17.40 per barrel, respectively. (3) Gulf will deliver the Cabinda and Zaire crudes to Texaco refining locations, and absorb the freight costs associated therewith (about $1.00 per barrel less the discount in (2) above). (4) Payment terms for all of the low sulfur crudes will be 60 days compared to 30 days on the Arabian crudes. This transaction and the language quoted above were consistent with the normal methods of invoicing exchange transactions, with exchange ratios, discounts on non-Saudi oil received, freight costs, and payment terms used to take into account the differences in the relative internal values of the crudes exchanged. In addition, there were certain transactions in which some of Textrad's exchange contracts had "overlift penalties." Overlifts were quantities of crude lifted that were in excess of the amount agreed upon in the exchange contract. Overlift penalties were contained in approximately 6 percent of Textrad's exchange contracts during the years 1979-81. These penalties provided that, if excess Saudi oil were inadvertently lifted by the purchaser of the Saudi oil in an exchange, the excess crude would be priced at a level that contained a penalty over and above Saudi OSP. The penalties were included in contracts during the period at issue because it was not possible for loading equipment to lift exactly the precise amount of oil intended in the exchange contract. They were not necessary when there was no multitier pricing system in effect, since the unified OPEC price would then be used to price the barrels overlifted. Without these penalties, the exchanging partner obviously would have had an incentive repeatedly to overlift and be charged the lower Saudi OSP on a larger percentage of the exchange transaction, which would have changed the economics of the exchange. These overlift penalties did not constitute prices in excess of Saudi OSP but were necessary deterrents occasionally used by Textrad to discourage overlifts. There is no evidence of SAG dissatisfaction with the overlift penalties used by Textrad in these contracts. - 78 - Processing Agreements In furtherance of its role of balancing system requirements, Textrad as far back as the 1960s entered into processing agreements with Texaco affiliates. These processing agreements allowed Texaco to concentrate international product trading in Textrad, which is consistent with Textrad's charter. In almost all cases, the processing agreements were entered into to serve the needs of the refining affiliates. During the period January 1, 1977, through December 31, 1982, Textrad entered into processing agreements with five affiliated refining e [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A5455bd0457c23d97. Public record. Not legal advice.