Appendix — Commissioner v. Texaco Inc.

me Court, U.S.

961107 JAN 1 1997.

esi OF IHE CLERS

oO.

In the Supreme Court of the Gnited States

OCTOBER TERM, 1996

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

Vv.

TEXACO, INC. AND SUBSIDIARIES

ON PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

APPENDIX TO THE

PETITION FOR A WRIT OF CERTIORARI

WALTER DELLINGER

Acting Solicitor General

LORETTA C. ARGRETT

Assistant Attorney General

LAWRENCE G. WALLACE

Deputy Solicitor General

KENT L. JONES

Assistant to the Solicitor

General

JONATHAN S. COHEN

THOMAS J. CLARK

Attorneys

Department of Justice

Washington, D.C. 20530-0001

(202) 514-2217

TABLE OF CONTENTS

Page

Appendix A (court of appeals’ opinion dated la

a Ses, MEU ‘steaisensshachasantch Rlcientnrnnepintiiiinbiantinn

Appendix B (tax court’s opinion dated Dec. 22,

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APPENDIX A

UNITED STATES COURT OF APPEALS

FIFTH CIRCUIT

No. 95-60696

TEXACO, INC. AND SUBSIDIARIES,

PETITIONER-APPELLEE,

v.

COMMISSIONER OF INTERNAL REVENUE,

RESPONDENT-APPELLANT

Appeal from the United States Tax Court

[Filed: Oct. 17, 1996]

Before: DAVIS, JONES and EMILIO M. GARZA,

Circuit Judges.

W. EUGENE Davis, Circuit Judge:

The Commissioner of Internal Revenue challenges

the Tax Court’s legal conclusion that Letter 103/z, a

1979 pronouncement of Saudi Arabian oil policy by

the Saudi Arabian Oil Minister, prohibits the Com-

missioner from exercising her authority to reallocate

income under 26 U.S.C. §8§ 482 and 61 (1994). We

affirm.

(1a)

2a

I.

Texaco, Inc. is the parent corporation of a group of

entities engaged in the production, refining, trans-

portation, and marketing of crude oil and refined

products in the United States and abroad. Texaco has

a number of subsidiary/affiliate corporations under

its umbrella. One of those affiliates is Texaco Inter-

national Trader, Inc. (Textrad), which acted as

the international trading company for the worldwide

Texaco refining and marketing system during the

period in question. As the trading company, Textrad

purchased Saudi crude oil from the Saudi government

by way of the Arabian American Oil Company

(Aramco) and resold that crude to both affiliates and

unrelated customers.

The Commissioner contends that Textrad unduly

shifted profits to its foreign affiliates during taxable

years 1979-81, and she increased Textrad’s U.S. tax-

able income for those years under §§ 482’ and 61 of

the Internal Revenue Code to reflect those profits.

Texaco argues that it had no power to control the

allocation of profits on Saudi Oil during those years

1 26 U.S.C. § 482 (1994) states:

In any case of two or more organizations, trades, or busi-

nesses (whether or not incorporated, whether or not organ-

ized in the United States, and whether or not affiliated)

owned or controlled directly or indirectly by the same in-

terests, the Secretary may aistribute, apportion, or allocate

gross income, deductions, credits, »r allowances between or

among such organizations, trades, or businesses, if he deter-

mines that such distribution, apportionment, or allocation is

necessary in order to prevent evasion of taxes or clearly to

reflect the income of any such organizations, trades, or

businesses.

——— eee

F

4

i

Y

3a

because of the restrictions imposed by Letter 103/z,

which required Texaco and the other Aramco mem-

bers to re-sell Saudi Arabian crude at specified below

market prices. The Tax Court conducted a lengthy

trial and entered detailed findings of fact, which we

need not repeat here. We state only those facts neces-

sary to understand our opinion.

A.

From early 1979 through late 1981, Saudi Arabia

permitted Texaco and the other Aramco participants

to buy Saudi Arabian crude oil at below market prices.

The Saudi government also established the official

selling price (the OSP) for Saudi Arabian crude below

the market price. The Saudi government took these

actions in response to requests by the United States

and other consuming countries to moderate the price

of crude oil. To ensure its price regulation had its

intended effect, the Saudi government prohibited Tex-

aco and other participants in Aramco from re-selling

Saudi crude at prices higher then the OSP. As the

Tax Court found, these restrictions were authorized

by the King and communicated to Aramco by Minister

Yamani in Letter 103/z, dated January 23, 1979.’ Ex-

cept in instances where it was excused from doing so,

Textrad complied with Letter 103/z and resold the

Saudi crude at the OSP.

During the period in question, Textrad sold ap-

proximately 34 percent of its Saudi crude or about

780,000,000 barrels to its refining affiliates. Of these,

2 Paragraph 5 of Letter 103/z required Texaco and the

other Aramco participants “to pledge that they will not sell to

a third party at prices in excess of what we have specified

herein.”

4a

approximately 275,000,000 barrels were sold to Tex-

aco’s domestic refining company and 505,000,000

barrels to Texaco’s foreign refining affiliates.’ Tex-

trad also sold 15-20 percent of its Saudi oil at the

below market OSP to customers that were completely

unrelated to Texaco. This was consistent with the

pattern and volume of Textrad’s sales to unrelated

customers in earlier years. Moreover, the Tax Court

specifically found that any changes in Textrad’s sales

to both its affiliates and its unrelated customers

during this period were not related to the Saudi price

restrictions.

The restrictions in Letter 103/z, however, applied

only to Saudi crude, not to the sale of products refined

from Saudi crude. As a result, the companies that

bought Saudi crude from Textrad at the below market

OSP, including Texaco’s refining affiliates, earned

large profits from the sale of refined products. Un-

like its domestic affiliates, Texacc’s foreign refining

affiliates reported no taxable income in the United

States.

B.

The commissioner alleges that Textrad shifted

profits attributable to the lower cost of Saudi crude

out of Texaco’s U.S. taxable income when it sold

Saudi crude at the OSP to its foreign refining affili-

ates. The Commissioner reallocated over $1.7 billion

in income to Textrad for taxable years 1979, 1980, and

1981. Following a five-week trial, the Tax Court

issued a detailed opinion. The Tax Court held that the

3 Any profits made by Texaco’s domestic affiliates from

the sale of products refined from this oil were included in

Texaco’s United States taxable income.

5a

Commissioner was precluded from allocating income

to Texaco under §§ 482 and 61 because the price re-

strictions in Letter 103/z were the “virtual equiva-

lent of law,” which Texaco was required to obey.

The Tax Court supported this conclusion with a

number of factual findings, including the following:

1. The Saudi government, with the approval of the

King, issued Letter 103/z prohibiting the resale of

Saudi crude at amounts exceeding the OSP.

2. Texaco-was subject to that restriction and faced

severe economic repercussions, including loss of its

supply of Saudi crude and confiscation of its assets, if

it violated Letter 103/z.

3. This mandatory price restriction applied to all

sales of Saudi crude, including sales to affiliated enti-

ties.

4, Neither Texaco nor any other Aramco partici-

pant had any power to negotiate or alter the terms of

this restriction.

Based on its findings that Texaco was obligated to

comply, and did comply, with the Saudi government’s

price restrictions, the Tax Court concluded that Tex-

aco’s pricing policy to its foreigr. affiliates as well as

its unrelated customers was due *o these restrictions

and not to any attempt to distort its true income for

tax purposes. The Commissioner has appealed the

order disallowing the allocation.

6a

Il.

A.

Based on the Tax Court’s factual findings, which

are not clearly erroneous, we agree that Letter 103/z

had the effect of a legal restriction in Saudi Arabia.

The 1979 pricing requirements were authorized by

the King and issued by Minister Yamani on behalf

of the Saudi government as mandatory restrictions.

These restrictions applied to all sales of Saudi crude

by the Aramco participants and others. The restric-

tions were in effect during the period at issue and

were followed by Texaco. The Tax Court’s findings of

fact fully support its conclusion that Letter 103/z

should be given the effect of law for purposes of §§ 482

and 61.

We also agree with the Tax Court’s legal conclu-

sion that the teaching of Cuoimmissioner v. First

Security Bank, 405 U.S. 394, 92 S.Ct. 1085, 31 L.Ed.2d

318 (1972), bars the Commissioner from allocating in-

come to Textrad on its sales of Saudi crude under

§ 482. Because the sales price of the crude is gov-

erned by Letter 103/z, Texaco did not have the power

to control the sales price of the oil.

Section 482 of the Internal Revenue Code author-

izes the Secretary to apportion or allocate income

between organizations controlled by the same inter-

ests “if he determines that such distribution, appor-

tionment, or allocation is necessary in order to

prevent evasion of taxes or clearly to reflect the

income of any such organizations. ...” 26 U.S.C.

§ 482. The relevant IRS regulation explains that the

purpose of § 482 is “to place a controlled taxpayer on a

“ ee ee en ee Se ee Va eT

Ta

tax parity with an uncontrolled taxpayer” and to

ensure that controlling entities conduct their sub-

sidiaries’ transactions in such a way as to reflect the

“true taxable income” of each controlled taxpayer. 26

C.F.R. § 1.482-1A(b)(1) (1996). The regulation fur-

ther explains that “(t]he standard to be applied in

every case is that of an uncontrolled taxpayer dealing

at arm’s length with another uncontrolled taxpayer.”

Id.

In First Security, the Court held that § 482 did not

authorize the Commissioner to allocate income to a

party prohibited by law from receiving it. 405 U.S. at

404, 92 S.Ct. at 1091. In that case, two related banks

offered credit life insurance to their customers. Fed-

4 26 C.F.R. § 1.482-1A(b)(1) reads in full:

The purpose of section 482 is to place a controlled taxpayer

on a tax parity with an uncontrolled taxpayer, by

determining, according to the standard of an uncontrolled

taxpayer, the true taxable income from the property and

business of a controlled taxpayer. The interests controlling

a group of controlled taxpayers are assumed to have com-

plete power to cause each controlled taxpayer so to conduct

its affairs that its transactions and accounting records truly

reflect the taxable income from the property and business

of each of the controlled taxpayers. If, however, this has

not been done, and the taxable incomes are thereby under-

stated, the district director shall intervene, and, by making

such distributions, apportionments, or allocations as he may

deem necessary of gross income, deductions, credits, or

allowances, or of any item or element affecting taxable

income, between or among the controlled taxpayers con-

stituting the group, shall determine the true taxable in-

come of each controlled taxpayer. The standard to be

applied in every case is that of an uncontrolled taxpayer

dealing at arm’s length with another uncontrolled tax-

payer.

Sa

eral law prohibited the banks from acting as

insurance agents and receiving premiums or commis-

sions on the sale of insurance. The banks referred

their customers to an unrelated insurance company

to purchase this insurance. The insurance company

retained a small percent of the premiums for admin-

istrative services and transferred the bulk of the

premiums through a reinsurance agreement to an

insurance company affiliated with the banks, which

reported all of the reinsurance premiums it received

as income. The Commissioner reallocated 40% of the

related insurance company’s income from these rein-

surance premiums to the banks as compensation for

originating and referring the insurance business. Id.

at 396-99, 92 S.Ct. at 1087-89.

The Court concluded that due to the restrictions

of federal banking law, the holding company that

controlled the banks and the insurance affiliate did

not have the power to shift income among its sub-

sidiaries. In so holding, the Court emphasized that

the Commissioner’s authority to allocate income

under § 482 presupposes that the taxpayer has the

power to control its income: “The underlying assump-

tion always has been that in order to be taxed for

income, a taxpayer must have complete dominion over

it.” Id. at 403, 92 S.Ct. at 1091. Indeed, as the Court

noted, the Commissioner’s own regulations for im-

plementing § 482 contemplate that the controlling

interest “must have ‘complete power’ to shift income

among its subsidiaries.” Jd. at 404-05, 92 S.Ct. at

1091-92 (quoting 26 C.F.R. § 1.482-1(b)(1) (1971)).

Moreover, the regulations and First Security make

clear that this standard is not limited to cases where

the government contends the taxpayer attempted to

9a

evade taxes. Rather, the Court explicitly extends its

reasoning to circumstances where the government

contends that the organization’s “true taxable in-

come” has not been reflected.’ After explaining that

the right to control the allocation of income is

critical, the Court stated: “It is only where this

power exists, and has been exercised in such a way

that the ‘true, taxable income’ of a subsidiary has

been understated, that the Commissioner is author-

ized to reallocate under § 482.... The ‘complete

power’ referred to in the regulations hardly includes

the power to force a subsidiary to violate the law.” Id.

(emphasis added). Because the holding company in

First Security could not have allocated the income to

the banks unless it acted in violation of the law, the

Court concluded that the banks’ true income was not

understatea and the Commissioner’s allocation under

§ 482 was improper.

5 We find no indication from the facts and contentions of

the parties in First Security that the government contended

that the banks or the holding company sought to evade taxes.

Rather, First Security explains in general terms the type case

§ 482 is designed to reach without distinguishing between

claims of evasion and other claims that the true income of the

taxpayer has not been reflected: “The question we must an-

swer is whether there was a shifting or distorting of the

[taxpayers] true net income.” Jd. at 400-401, 92 S.Ct. at 1089-90

(emphasis added); see also id. at 407, 92 S.Ct. at 1098 (conclud-

ing that because the holding company “did not utilize its

control over the [banks and the affiliated insurance company]

to distort their true net incomes,” the Commissioner could not

exercise his § 482 authority) (emphasis added). This is consis-

tent with the approach and structure of the regulation, which

also does not distinguish between evasion and other conduct

that fails to reflect the true taxable income of the taxpayer.

See 26 C.F.R. § 1.482-1A(b)(1) (1996).

10a

The Sixth Circuit decision in Procter & Gamble

Co. v. Commissioner, 961 F.2d 1255 (6th Cir.1992)

also supports the Tax Court’s conclusion. In that

case, the court held that a Spanish law prohibiting a

foreign affiliate from paying royalties for the use of

patents was sufficient to preclude the Commissioner

from reallocating income to account for a reasonable

royalty. The court stated that “the purpose of § 482 is

to prevent artificial shifting of income between

related taxpayers.” Jd. at 1259 (emphasis added).

Again the deciding issue was one of control: “Because

Spanish law prohibited royalty payments, [the

controlling company] could not exercise the control

that § 482 contemplates, and allocation under § 482 is

inappropriate.” Jd. at 1259. See also L.E. Shunk La-

tex Products, Inc. v. Commissioner, 18 T.C. 940, 1952

WL 188 (1952) (holding that Commissioner could not

allocate additional income to condom manufacturer

where manufacturer sold condoms to its affiliate

at price set by Office of Price Administration, even

though affiliate made substantial profits on the trans-

actions).

It is precisely this ability to control the flow of its

income that Texaco lacked. The Tax Court found, and

we agree, that Letter 103/z had the force and effect of

law, that Textrad was obligated to comply with its

requirements, and that it did so comply. Because

Textrad lacked the power to sell Saudi crude above

the OSP, reallocation under § 482 is inappropriate.

B.

The Commissioner tries to justify the allocation by

analogizing Texaco’s conduct to an “assignment of

income” and places much reliance on the Supreme

lla

Court’s decision in United States v. Basye, 410 U.S.

441, 93 S.Ct. 1080, 35 L.Ed.2d 412 (1973). However,

nothing in Basye is contrary to the principles dis-

cussed above, and the Commissioner’s reliance on this

case is misplaced.

In Basye, the Court relied on familiar principles

“that income is taxed to the party who earns it and

that liability may not be avoided through an anticipa-

tory assignment of that income” to hold that a group

of doctors’ failure to actually receive a portion of

their compensation that was instead placed in a re-

tirement trust did not preclude the Commissioner

from allocating that income to them. Id. at 457, 93

S.Ct. at 1089. The Court found that the sole reason

the doctors could not receive the challenged portion of

their income was because their medical partnership

had agreed with a health plan foundation to service

the foundation’s members for free in exchange for

contributions to a retirement trust. Jd. at 449, 93

S.Ct. at 1085.

The Court’s holding in Basye turned on the con-

sensual nature of the agreement and is entirely

consistent with the principles of control expressed in

the regulations adopted under § 482 and in Firsi

Security. As the regulations make clear, the goal of

inquiring into the transactions of controlled tax-

payers under § 482 is “to ascertain whether the

common control is being used to reduce, avoid or

escape taxes.” 26 C.F.R. § 1.482-1A(c) (1996). The

Court in Basye agreed with the Commissioner that

the doctors’ compensation scheme was entirely

voluntary—that the medical partnership possessed

common control and used it to reduce, avoid, or escape

taxes. That the doctors exercised that control prior

12a

to their actual possession of the income was irrele-

vant.

But where, as here, the taxpayer lacks the power

to control the allocation of the profits, reallocation

under § 482 is inappropriate. As stated above, we fully

agree with the Tax Court that Letter 103/z deprived

Textrad of the power to sell Saudi crude to its foreign

refining affiliates for a price that exceeded: the OSP.

Because Texaco lacked the ability to control the allo-

cation of the income in question, it follows that it

could not have used its control to evade taxes or

artificially shift its income to its foreign affiliates so

that its true taxable income was not reflected.

C.

_ Nor would the Commissioner’s proposed allocation

be consistent with § 482’s goal of achieving tax parity

between controlled and uncontrolled taxpayers. As

the First Security Court and the regulations make

clear, the “ ‘purpose of § 482 is to place a controlled

taxpayer on a tax parity with an uncontrolled

taxpayer.” 405 U.S. at 407 (citing 26 C.F.R.

§ 1.482-1(b)(1) (1971)). Thus, “(t]he standard to be ap-

plied in every case is that of an uncontrolled taxpayer

dealing at arm’s length with another uncontrolled

taxpayer.” 26 C.F.R. § 1.482-1A(b)(1) (1996).

The record evidence fully supports the Tax Court’s

findings that Textrad sold significant amounts of

Saudi crude to unrelated customers at the same OSP

it sold to its affiliates, that the volume of Textrad’s

sales of Saudi crude to unrelated customers during

this period remained generally consistent with his-

toric levels, and that any changes in Textrad’s sales

to its affiliates and 1+. mnrelated customers during

13a

this period had no nexus with the restrictions

imposed by Letter 103/z. Therefore, the Tax Court

did not err in concluding that the Commissioner fail-

ed to demonstrate any disparity between Texaco’s

treatment of its affiliates and its unrelated customers

as a result of the Saudi price restrictions. Thus,

under the regulation’s tax parity standard, the Com-

missioner’s allocation of Texaco’s income under § 482

is improper.

In sum, the Tax Court did not err in concluding

that Textrad sold the Saudi crude to both its affiliates

and its unrelated customers at the below market OSP

to avoid violating Letter 103/z and the severe eco-

nomic reprisal that would have flowed from such

a violation. Accordingly, the Commissioner had no

authority to allocate the income under § 482.

For the reasons stated above, the Tax Court

properly concluded that the Commissioner was

without authority to reallocate Texaco’s income

under § 482.

AFFIRMED.

14a

APPENDIX B

UNITED STATES TAX COURT

Nos. 18618-89, 24855-89 AND 18432-90

EXXON CORPORATION AND AFFILIATED COMPANIES, ET

AL.,' PETITIONERS,

Vv.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

[Filed: Dec. 22, 1993]

Memorandum Findings of Fact and Opinion

WHITAKER, Judge: Respondent, in a statutory no-

tice 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 defi-

ciencies in Federal income taxes in the following

amounts:

1 On Jan. 7, 1991, Exxon Corp. and Affiliated Companies

(docket No. 18432-90), and Texaco, Inc., and Subsidiaries (doc-

ket No. 24855-89) were consolidated herewith for purposes of

trial, briefing, and opinion of the Aramco Advantage issue,

which is defined infra p. 3.

Year Deficiency

ET iciishintsvintrsiinevanceennnsnveecveneccessensensonnenents $2,898,174,073

____ EEE ae en 2,037,809,876

Pe eielicceneitcneiisininneetanreneiniocipainerenscorensnsines 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:

Y Defici

SNA sibscdiisiditnkenivonebshecbonnemesenineciovsoons $ 230,193,303

Si siebousbadaniensatbeieinesioneiovonsesnanacisneninsees 925,040,885

____ SETAE eee ON TET 420,056,007

ive iiailelersitbiapeeedéincesscseverscieetesosouneuseeceusines 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 As defined in our evidentiary opinion, Exxon Corp. v.

Commissioner, [Dec. 48,005(M), T.C. Memo. 1992-92, an off-

taker is the person or company that physically loads oil ob-

tained under a concession, contract, or other arrangement.

16a

(2) if the answer to question (1) is in the affirma-

tive, whether the transfer price charged by the

offtakers to the other subsidiaries of each petitioner

or to unrelated third parties was below the price

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 restric-

tion(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 restric-

tion(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 restric-

tion(s), whether or not the pricing restriction(s)

17a

precludes or preclude a section 482° or section 61 ad-

justment 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 [72-1 USTC 4 9292A], 405 U.S. 394

(1972), and its progeny. Essentially the issues are: (1)

Whether the Saudi Arabian Government (SAG) im-

posed a price restriction prohibiting the sale of Saudi

crude oil for an amount in excess of the Saudi official

selling price; (2) if so, whether petitioners complied

with this restriction; and (3) if so, whether the

restriction and petitioners’ compliance with it pre-

clude respondent’s proposed allocation of profits from

petitioners’ refining subsidiaries to petitioners’

offtakers pursuant to either section 61 or section 482.

Findings of Fact

Some of the facts have been stipulated and are so

found. The stipulations and attached exhibits are

incorporated herein by this reference. We also

incorporate by reference the facts contained in our

earlier opinion in these cases on evidentiary matters,

Exxon Corp. v. Commissioner [Dec. 48,005(M)], T.C.

Memo. 1992-92, although some of the facts contained

therein will be repeated here for convenience.

Petitioner Exxon Corp. (Exxon) had its principal

place of business in New York when the petitions in

its cases were filed. Exxon is the common parent

8 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.

18a

corporation of an affiliated group of corporations that

includes all of petitioners in docket Nos. 18618-89 and

18432-90 (which collectively will be referred to as the

Exxon petitioners). At all relevant times the Exxon

petitioners were engaged in the business of produc-

ing, refining, and marketing crude oil and petroleum

products in the United States and numerous other

countries around the world. Petitioner 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 al-Aziz 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 incep-

tion, 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 (#s subsequently modified), Socal was

19a

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 incor-

porated 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 here-

after as the Exxon offtakers.

4 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.

20a

Saudi crude oil was Exxon’s largest crude oil

source throughout the period 1977 through 1981. It

constituted 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:

5 Internationally traded crude oil is crude oil that is ex-

ported 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 in-

cluded in the calculation.

6 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.

21a

_ Exxon Offtakers

% Percentage of

Dispositions Barrels Total Dispositions

Sales to Exxon

refining/marketing

as i taiirccanessciens 1,816,000,000 79.9%

Sales to unrelated

DATUICS....acnccccoseccoeseesecoeee 261,000,000 11.5

“War Relief’ sales

to unrelated

PATTIEB........c.ccecccccrecssceeeees 61,000,000 2.7

Crude oil

exchanges with

unrelated

I cones ecasconscsensveresccece 132,000,000 5.8

Crude oil losses

and inventory

CTT oacensnciaccorerscossersvenve 3,000,000 P|

Total Saudi crude

oil dispositions

(19779-81).......cecrsccsesersseees 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

22a

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 de-

pended to a significant degree upon the cost of the

crude they refined and marketed. The Exxon off-

takers 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 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

Ss

23a

was merged into TOE on October 1, 1978, and its cor-

porate 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 inter-

nationally 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 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:

7 See supra note 5.

8 These amounts represent dispositions of Saudi crude

acquired by Textrad from all sources, including sources other

than Aramco.

24a

Textrad

Percentage of

Sales to Texaco

Refining/Marketing

“War Relief’ Sales

to Unrelated

Crude Oil

Exchanges with

Transfers to

Affiliated Entities

Pursuant to

Processing

Agreements................. 213,000,000

Total Saudi Crude

Oil Dispositions

6 | 2,276,000,000

34.2%

16.1

15.2

9.4

100.0%

During the period at issue, in addition to several

refineries in the United States, Texaco owned re-

fining subsidiaries in the United Kingdom, Belgium,

the Federal Republic of Germany, the Netherlands,

six Latin American countries, and four Canadian

provinces. Texaco also had equity interests in refin-

eries located in the Federal Republic of Germany,

25a

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, Paki-

stan, 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 Ara-

bia 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.

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

26a

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 man-

dated 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 min-

istries, and several ministers of state. The Council of

Ministers later was constituted under the Council of

Ministers’ Regulations and was invested with regula-

tory, executive, and administrative authority. Not-

withstanding 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 oil-related affairs of Aramco and its four share-

holders and often communicated its official govern-

ment positions and directives to them by letter.

Ministerial directives came into effect upon issuance

—

27a

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 Min-

ister of the Petroleum Ministry. Minister Yamani

served as Petroleum Minister until October 1986.

Although Crown Prince Fahd occasionally partici-

pated 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-related matters, and there

was a widely held understanding that such con-

sultations occurred and that Minister Yamani regu-

larly 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 Coopera-

tion 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 negotia-

tions. He also participated in discussions with repre-

sentatives of other countries on behalf of the SAG.

Many government and industry officials believed that

28a

~=

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 Griev-

ances during the period at issue, which had jurisdic-

tion 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 essen-

tially controlled the production and pricing of crude

oil from Middle Eastern and other oil exporting coun-

tries. In 1959 and again in 1960 the major inter-

national 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 subse-

quently 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

ee

29a

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 State-

ment of Petroleum Policy in Member Countries”, and

as sovereign powers they invoked the doctrine of

“changing circumstances”, which asserted a coun-

try’s legal right to alter concession agreements to

include a government ownership share if there were

substantial changes in the circumstances that pre-

vailed 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 aad

management of the oil companies’ producing opera-

tions. 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

30a

international oil companies regarding crude oil prices

and other matters. Representatives of OPEC’s Per-

sian 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 govern prices for a 5-year period.

The international oil companies subsequently reachd

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 coun-

tries 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.

Certain OPEC countries took a less conciliatory

route. In early June 1972, Iraq 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 inter-

est 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 Govern-

ment’s demands in 1974. Shell, Socal, Texaco, and

Atlantic Richfield refused to accept Libya’s demand

al

8la

~

for a 51-percent participation interest and had their

operations completely nationalized. In late 1973, Iraq

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 Petro-

leum 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 1978,

the national oil companies of OPEC member coun-

tries 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.

The Saudi relationship with Aramco developed on a

parallel, but somewhat more moderate course, where-

by the Saudis pursued a policy of “participation”

32a

rather than outright nationalization. In a speech at

the American University in Lebanon in 1968, Minis-

ter 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 par-

ticipation. The original Concession Agreement be-

tween 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 com-

panies 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 partici-

pation was “imperative” and that the Aramco com-

panies should not require the SAG to “take mea-

sures” to put participation into effect. Although

there was significant resistance to participation by

the companies, by early October 1972 a draft agree-

ment, called the “General Agreement on Participa-

tion” (General Agreement), was reached and later

signed by the SAG and two other —Gulf States,

whereby the SAG purchased a 25-percent initial gov-

ernment participation interest in Aramco’s produc-

tion operations, which was gradually to increase to 51

percent in 1982. The Aramco companies were to be

compensated for unrecovered investments on the

basis of book value adjusted for inflation. The imple-

menting agreements called for in the General Agree-

ment were never executed. The gradual phasing in of

the Saudi share was intended to give Petromin time

to gain experience in marketing, and Petromin

33a

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

international 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 nationaliza-

tions by the more radical OPEC members, the

Aramco companies were notified in 1974 that the SAG

participation was to be speeded up. Extensive nego-

tiations occurred over the next few years. 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” negotia-

tion whereby the companies did not wish to be taken

over but they had no choice because they 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 per-

cent ownership of Aramco, and the (now former)

shareholders provided services to the SAG’s oil

business in 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

34a

East. On October 8, 1978, 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 Agree-

ments of January 1972 and June 19738 to reflect

changes in currency exchange rates and inflation. On

October 9, i973, 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, 19738, the Organization of Arab

Petroleum Exporting Countries (which had 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 per-

cent. 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

® 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 com-

pared for the purpose of determining price.

35a

beginning of October 1973. The OPEC price in-

creases 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 deci-

sions 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 meet-

ing in Vienna, Austria, the OPEC members again

agreed to increase prices by 10 percent, effective

October 1, 1975.

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 J uly

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 two-tier

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 8 percent (to $11.37), all to

36a

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 govern-

ment 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.

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

37a

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 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.

8. 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 ex-

pected to flow into its historical international

38a

markets, to buyers-users and without the utiliza-

tion of brokers. Hence, an audit certificate(s) in

accordance with the above mentioned conditions is

also required.

With best regards.

/s/ AHMED ZAKI YAMANI

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 check-

ing 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 restric-

tion to require that audit certifications encompassing

all sales of Saudi 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

39a

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 J anuary 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 shipments for which it could

not locate the appropriate information. Texaco

viewed the 1977 restriction and the audit require-

ments 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 J uly 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.

40a

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.

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) where-

by BP sold between 325,000 and 350,000 barrels per

day of Iranian crude to Exxon. When the Iranian

4la

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 ap-

proximately 75 percent of its liftings” prior to the

Iranian shutdown to as high as approximately 78 or 79

percent of its liftings after the shutdown.

Multitier Pricing 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 individu-

ally 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.”

” A “lifting” is the physical act of loading a quantity of oil

obtained under a concession, contract, or other arrangement.

“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.

42a

While this announcement applied to all OPEC mem-

bers, a broad array of prices resulted, because individ-

ual 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.

Minister Yamani called a meeting with Aramco

representatives in Riyadh on January 15 and 16, 1979.

Because they were experiencing shortages, repre-

sentatives 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 peti-

tioners’ arguments against his determination to use

fourth quarter 1979 prices on the increased produc-

tion.

Shortly after the meeting with Aramco repre-

sentatives, 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

- 48a

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

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 [80 December

1978].

44a

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 Doll

Arabian Light Oil.............. 34 14.5460

Arabian Medium Oil........... 31 14.0520

Arabian Heavy Oil.............. 27 13.6434

TIES Diicicnciassinetonipcciiias 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

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 relation-

ships during the period at issue, but in most cases

they were contained in contracts between producing

45a

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 refused to impose such surcharges, indicating

that it would follow each barrel of crude to the re-

finery 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

46a

a press interview with Minister Yamani after the

Geneva OPEC confereiice:

Q: 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?

A: Well we have told them to sell it at our price,

but the measures will be in application.

47a

In the second quarter of 1979, Saudi production re-

verted 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 com-

panies 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 sup-

48a

plied 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 in-

creases. A press conference 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 con-

sumers’ 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. This level of

production continued beyond the end of 1979. 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

49a

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 ap-

proval. To those of petitioners’ employees who were

involved at the time, the substance of the 1979

restriction was a replay of the 1977 restriction.

Nevertheless, there apparently were differing inter-

pretations among the Aramco shareholders concern-

ing the scope ofboth 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” actuaily 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 English-speaking 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,

50a

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 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 be-

lieved 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 require-

ment 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 cer-

tificates was to certify compliance with the restric-

tion 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 require-

ment for the first quarter of 1979 was to submit

figures on the number of barrels of Saudi crude oil

5la

received and sold to affiliates as well as to unaffiliated

entities. The other three Aramco shareholders re-

ported only figures in connection with sales to partic.

less than 50 percent owned by them (unaffiliated

entities). However, Texaco executives understood

the 1979 restriction to apply to all sales. The SAG did

not ask Texaco for material on affiliate sales. Al-

though 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 per-

sonnel that this was not intended to signal a depar-

ture from the pricing practices previvusly 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.

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 inter-

52a

nationally 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 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

53a

stated what was “very common knowledge at the

time” as follows:

The Saudis can, and do, oblige the Aramco com-

panies 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 restric-

tions 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 Minis-

ter 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 share-

holder companies to sell Saudi crude oil obtained

from Aramco at the Government-established

54a

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 othwerwise.

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 off-

takers’ activities in an attempt to assure com-

pliance with pricing directives. _

Minister of Petroleum and Mineral Resources

(Signature)

Hisham Mohiuddin Nazer” i

The provisions of this letter will hereafter be re-

ferred 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

2 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. j

v. Commissioner [Dec. 48,005(M)], T.C. Memo. 2992-92. We ’

discuss this matter infra note 39.

55a

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 ade-

quately 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 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 prizes 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.

56a

Garvin that the Aramco companies were to continue

to guarantee to LDC’s the quantities of Saudi crude

they had contractualiy committed to “at the prices

set out by the Saudi Arabian Government”, and to

advise the SAG of its compliance. A similar letter

was sent to Texaco. Minister Yamani also indicated

that “strict” compliance with the Saudi LDC require-

ment was “a very important matter” and that “ne-

cessary measures” would be taken “to remedy any

deviation from these instructions.” 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 con-

sidered as suggested countries to be exclhded.

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 cou» ry.” Exxon responded once again

that it would continue to do so. The implications of

noncompliance with the Saudi LDC requirements

were perceived by an Exxon executive as being “un-

certain” and very likely to be “adverse for Exxon”.

57a

There was concern about the possible reduction in

Exxon’s volumes by more than its LDC volumes, and

“other ways to penalize Exxon for non-compliance”.

A legal adviser to the Petroleum Ministry con-

cluded 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 execu-

tive 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 th2 restric-

tion 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 investiga-

tive 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

58a

the 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 approxi-

mately 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

tre 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. A

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 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

59a

the principle that the SAG requirements were ex-

pected to be enforced. Similarly, there was a per-

ception 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 peti-

tioners 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 estab-

lished. 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 pol-

icy 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 con-

cerns about possible violations by some of the Aramco

60a

partners was sent to 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 Minis-

ter 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 af-

filiates 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, peti-

tioners 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. This sale

constituted approximately .016 percent of the 2,273

million barreis of Saudi crude disposed of during the

period at issue. There is no evidence indicating Saudi

ee

i ,

~—— — e .

6la

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. One common contaminant in crude

oil is sulfur.

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 (approxi-

mately 34 degrees specific gravity), which is pro-

cessed 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.

62a

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 sup-

ply. But subsequent events exacerbated the situa-

tion. On February 13, 1978, the SAG issued a direc-

tive 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:

63a

DAILY CRUDE OIL PRODUCTION

(in thousands of barrels)

Country 1978 1979 1980 1981

Saudi Arabia............... 8,296 9,580 9,926 9,818

IEE ACEO 2,629 3,450 2,646 1,184

SII isd dibicopiobaiois 2,096 2,060 1,788 1,180

i cncstes Moinctcessnkans 1,990 2,490 1,675 1,118

lik ieclsiticcesiss 5,197 3,110 1,467 1,114

PO i icshasiacncecsiosts 1,447 1,464 1,850 9651

Be iccccestsesintensinanites 1,225 1116 942 900

| SS 482 506 585 587

RID ccictsnsseiicilioniasasdansose 485 500 471 405

BR isiisritcsussce jain 362 360 349 358

i ciciniicsininsctchiecsohiins 315 295 288 317

NRC TI oe 170 160 165 166

is sctectebhconindidigtine 100 100 100 = 118

I i cnticiciedisnals 53 50 49 44

A sctsissnectins 24,847 25,191 21,796 18,260

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

64a

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. Most of Texaco’s crude

supply was high-sulfur Saudi crude. The situation

was exacerbated by the losses of Iranian Light crude

in 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 agree-

ments 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.

,

65a

In the face of shortages, the four Aramco share-

holders 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 ex-

pectations under 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 approxi-

mately 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 approxi-

mately 10 million barrels per day in order to “close

the gap” brought about by the [ran/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

66a

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 compliance.

Texaco told its auditor to prepare and submitted to

the SAG audit certificates regarding designated

sales. There is no evidence concerning Exxon’s sub-

mission of audit materials on designated sales.

The prices of Saudi Arabian Light during the

period 1979 through 1981 were as follows:

Price Per

Date Announced Date Effective Barrel

December 30, 1978..... January 1,1979 $13.34

January 23, 1979........ January 23,1979 14.55”

April 1, 1979.......c..0+0 April 1, 1979 14.55

July 4, 1979.......cccccccee June 1, 1979 18.00

December 12, 1979... November1,1979 24.00

January 26, 1980...... January 1, 1980 26.00

May 138, 1980............. April 1, 1980 28.00

September 21, 1980.. August 1, 1980 30.00

December 14, 1980... November 1,1980 32.00

November 1, 1981..... October 1, 1981 34.00

3 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.

SNAP i

67a

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 dur-

ing 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 unifica-

tion was finally obtained at an OPEC meeting in

Geneva, Switzerland, on October 29, 1981, when Saudi

Arabia agreed to raise the price for Saudi Arabian

Light crude from $32 to $34 per barrel. This con-

stituted 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 worldwide 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 approxi-

mately 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.

68a

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 main-

tenance of high production levels. Prominent U.S.

officials 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 stan-

dards 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 restric-

tion and seeing that the Saudi policy toward modera-

tion was carried out. Minister Yamani had a reputa-

tion with U.S. officials of being influential in develop-

ing 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

69a

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) repre-

sented the official SAG position. U.S. officials be-

lieved that the 1979 restriction was mandatory, that 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 govern-

ments became more involved in the oil industry’s

refining, marketing, and distribution activities, initi-

ating 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

70a

Washington Energy Conference. This Conference led

to an Agreement on an International Energy Pro-

gram (IEP), which set forth such objectives as pro-

moting secure oil supplies on reasonable and equita-

ble terms, creating an international oil market infor-

mation system, creating an emergency oil-sharing

plan, restraining demand for oil, achieving iong-term

cooperation on energy matters, and developing

constructive relationships with oil-producing coun-

tries. 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 Eco-

nomic Cooperation and Development. Its members

were Austria, Belgium, Canada, Denmark, the Fed-

eral Republic of Germany, Ireland, Italy, Japan, ©

Luxembourg, the Netherlands, Spain, Sweden,

Switzerland, Turkey, the United Kingdom, and the

United States. New Zealand joined the IEA in 1975.

Norway subsequently participated in the IEA pursu-

ant 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

7la

reduce suspicion among the member countries by

means of the “transparency” of the system. The par-

ticipating countries agreed 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, Luxem-

bourg, 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 eco-

nomic summit meeting (Tokyo Summit). On the first

day of the Tokyo Summit, OPEC announced signifi-

cant 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 Ger-

many, the Netherlands, and France understood the

Saudi objective to be the same. It was Dr. Schles-

inger’s understanding that the leaders of the coun-

tries participating in the Tokyo Summit believed that

the 1979 restriction was applicable in all of their

countries and applied to all sales of Saudi crude,

72a

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 coun-

tries 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 informa-

tion 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 Nether-

lands, controlled petroleum product prices and di-

rectly monitored the prices of imported crude oil.”

4 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 ex-

changes. A portion of the 1979 income attributed to the Exxon

offtakers was from a French Exxon affiliate. The Netherlands

73a

The same was true in Japan.5 During the period at

issue, Italy’s system established that Saudi crude was

to be imported at Saudi OSP.” The German Govern-

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 off-

takers 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.

6 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 con-

formity with this requirement was routinely verified. This

system of monitoring in 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 transac-

tions but simply verified the conformity of all import prices

74a

ment 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 restric-

tion 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 violation),

or by more formal legal means, such as the with-

holding of permits and licenses, formal investigations,

the initiation of legislative measures, or the assertion

with official prices. A portion of the income attributed to the

Exxon offtakers was from an Italian Exxon affiliate.

7 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.

8 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 percep-

tion 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 informa-

tion system and the crude oil register provided it with an

ongoing picture for assessing whether petitioners were selling

Saudi crude at the Saudi OSP.

75a

of certain emergency powers. Officials of these coun-

tries and of the United States were under the

impression that the restriction applied to all sales of

Saudi oil into their countries. Petitioners had refin-

ing 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 ex-

changes,” 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). Some-

times exchanges 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

9 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.

76a

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 “differen-

tial” that is within the range of the difference be-

tween 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 ex-

change would not be entered into because it would not

be beneficial to that party.

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

oi] in an exchange at a price that was less than that

crude’s OSP, which respondent has characterized as a

* 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 prod-

ucts.”

ee ee ee a aera

77a

“discount”. This “discount” occurred because the in-

ternal 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 petition-

ers at a price lower than its OSP. Nor was it uncom-

mon 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 these forms of consid-

eration 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 per-

21 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.

2 In exchanges, the number of barrels of Saudi crude that

Textrad disposed of often was different from the number of

78a

centage of Arabian Light in the total Saudi exchange

pool at any one time, payment term variations, trans-

portation 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 geographi-

cally, 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 value them in

terms of internal values, with reference to the Saudi

crude price. There was seen “no reason to view con-

tinuation of these same practices as a contravention

of Saudi Arabian directives.” The 1977 Exxon guide-

lines were supplied to Exxon affiliates.

Exxon’s exchange practices under the 1977 guide-

lines were discussed with the Saudis. At a meeting

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 non-Saudi crude.

2 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.

79a

between Exxon officials and a Petromin representa-

tive 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 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 pro-

vided 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

80a

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 im-

proved 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 con-

tinue to engage in exchanges during the period of the

1979 restriction.

The Exxor 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 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

8la

profit, that profit was reported for U.S. income tax

purposes. Exxon told its purchasers about the re-

striction 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 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 op-

posed 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 Ex-

xon 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

#4 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.

82a

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 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 Saudi Crude Net Saudi Crude

Given Up Received Given Up

Year MB MB MB

ne 46.9 12.4 34.5

bs: 77.5 7.8 69.7

TOTO ciesesse 56.3 7.6 48.7

SOUND ccnssceis 41.3 7.3 34.0

|.) Serna 34.8 13.4 21.4

83a

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

PEE titsinetesinmdaien 4.2

RINT sichisacsevsicniichislid 9.2

RU Aisiniseicdancokaicien 6.1

OT scitcinsischiibcansisabiaasen 4.5

POT enctiseccsecopatiipais 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 buy products when needed to

supplement the refining activities, and to sell prod-

ucts when products were surplus to Texaco require-

ments.

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 “unbal-

anced” 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

% Lighter crude generally tends to be “sweet”, or to

contain lower amounts of sulfur, although there are many

exceptions to this tendency.

84a

exports, and changes in product specifications, par-

ticularly 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. Tex-

trad’s exchange practices during the years immedi-

ately 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. Tex-

trad increased the percentage of Arab Medium and

Heavy to total Saudi crude disposed of by exchanges

from an average of 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 care-

ful 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 refin-

eries in the Texaco system. Occasionally, both before

and during the period at issue, non-Saudi crude

85a

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 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 speci-

fied 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 pur-

% 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.

86a

poses. 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 per-

cent 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 ex-

change, it sold the oil at its market price. Although

the 1979 restriction itself did not expressly address

exchanges, Texaco officials were satisfied, after dis-

cussions with the Saudis, that Textrad’s exchange

practices did not violate the restriction.

As discussed, in Textrad exchanges the differen-

tials between the exchanged crudes were computed so

as to represent the differences between internal

refined values. In addition, in one transaction a differ-

ential originally negotiated was adjusted to reflect a

particular change in circumstances. In that transac-

tion 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 ex-

change 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 con-

tract 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

Fe ee ee ee a ee ee ee ee a

87a

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 producing countries.

In our exchange arrangement negotiations, we

have minimized this disparity through a combina-

tion 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 subse-

quent 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.

88a

(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, dis-

counts on non-Saudi oil received, freight costs, and

payment terms used to take into account the differ-

ences 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 Tex-

trad’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 dur-

ing 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

89a

be charged the lower Saudi OSP on a larger per-

centage 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 occa-

sionally used by Textrad to discourage overlifts.

There is no evidence of SAG dissatisfaction with the

overlift penalties used by Textrad in these contracts.

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 Tex-

aco 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 entities,

which used their excess refining capacity for the

processing of crude oil, some of which included Saudi

oil. By means of these processing agreements, Tex-

trad retained title to the crude, paid a fee to the

refining entity that was consistent with fees paid by

unrelated entities, and sold the resulting products for

their market value to affiliates in almost all cases.

Textrad sold the products that had been refined under

these processing agreements to Texaco marketing

affiliates for marketing and distribution outside of the

country in which the processing refinery was located

and to unaffiliated entities. Textrad realized the full

value of the refined products resulting from these

90a

processing agreements. Any profits earned by Tex-

trad on sales of products refined from Saudi crude

pursuant to processing agreements with affiliates

during the years at issue were reported for U.S.

income tax purposes.” The following crude amounts

were delivered for Textrad’s account under process-

ing agreements over the period 1977-82, expressed in

yearly averages of thousands of barrels per day:

Textrad Processing (Yearly Averages

Year Saudi Non-Saudi

SOFT ssdiicidins 220 320

TOTS vivccsia nee 230

TNO shinies 200 265

BU aissacensittiees 220 260

EE sincasecsadeuess 160 200

FI wtcsttenseins 45 175

The following total barrels of crude were processed

for Textrad at refineries pursuant to processing

agreements over the same period:

27 Respondent alleges that Textrad realized over $598 mil-

lion in “bargain purchase profits” (profits from refining Saudi

crude in excess of the profits that would have been realized

from refining other comparable crude) from these processing

agreements during the years at issue; petitioners assert that

the offtaker profits from the sale of products produced pursu-

ant to processing agreements (including the refining profit)

were $160 million less than that figure. The parties did not

present complete information pertaining to profits (as in-

structed by the Court several times during trial); thus a precise

finding is not possible, nor is one necessary, as we explain later

in this opinion.

9la

Textrad Processing (Total Barrels)

Year Total Barrels

yt SEED 6,505,255

Ea eR 8,315,384

EE Seis ie 12,878,616

RI cle 5,662,980

Ras ae 6,657,871

TE site. 2,585,642

Over the period 1977-82, an average of approxi-

mately 233,000 barrels per day of Saudi and non-Saudi

crude were processed for Textrad. Over the period

1979-81, an average of approximately 242,000 barrels

per day of Saudi and non-Saudi crude were processed

for Textrad. These volumes constituted less than 10

percent of the total crude moved by Textrad during

each of these periods. Although there were fluctua-

tions from year to year, the overall volume of crude

processed by Textrad pursuant to processing agree-

ments during the years at issue was consistent with

Textrad’s historical practices, and Textrad’s level of

processing of Saudi crude did not increase signifi-

cantly during the period at issue.

The Exxon offtakers did not engage in any process-

ing agreements with refining and marketing affiliates

during the years at issue, but they did supply Saudi

crude to five Exxon affiliates that participated in such

agreements. For example, during the years at issue

Exxon’s offtakers sold more than 75,000 barrels of

Saudi crude per day to Esso Eastern Products and

Trading Company (EEPTC), and this crude was

processed at an affiliated refinery. EEPTC’s process-

ing agreement with the refinery affiliate contained a

negotiated processing fee, and the agreement dated

92a

back to 1971. The resulting products were sold at

market prices, earning profits for EEPTC. Four

other Exxon affiliates that received Saudi crude from

Exxon offtakers did not have refining affiliates, and

they participated in processing agreements with

other entities. Two of these processing agreements

had been entered into several years prior to the years

at issue. There is no evidence that these arrange-

ments were out of the ordinary course of business for

these affiliates. Nor is there any evidence that the

SAG objected to these processing agreements or that

they were in violation of the 1979 restriction.

Spot Market Purchases

It came to Exxon’s attention during 1979 that a

company by the name of Ultramar, one of Exxon’s

crude customers under a long-term contract, had been

selling Saudi crude (purchased at OSP from Exxon)

on the spot market at prices in excess of Saudi OSP.

Because it was experiencing severe shortages at that

time, in August of that year Exxon purchased at a

price in excess of Saudi OSP Saudi crude that it had

sold to Ultramar at Saudi OSP. This crude was then

offered for resale by Exxon to an Exxon affiliate at a

price in excess of OSP. This transaction was ap-

proved by Exxon officials on the basis that it was “in

effect buying out of our commitment to sell the crude

to Ultramar”. There may have been other isolated

instances of such purchases of Saudi crude by Exxon

affiliates from the open market at prices in excess of

OSP, and these purchases were explained as being

necessary in the face of severe shortages. There is

no evidence indicating the actual price at which this

crude was sold, or any Saudi objection to these

purchases. Exxon did not profit from this Ultramar

93a

transaction or other similar purchases or otherwise

benefit from the Shortage situation other than to

obtain crude that it needed for supply reasons.

; Sales to Canadian Affiliates

Texaco maintained books and records in the ordi-

nary course of its business regarding all dispositions

of Saudi and non-Saudi crude oil by Textrad. Prior to

and during the years 1979-81, Texaco maintained a

ledger that reflected information regarding each

disposition of crude oil by Textrad, including, among

other things, the name of the purchaser, the contract

reference, the volume and type of crude, the sale date,

the revenue from crude dispositions, the cost of crude

disposed of, and miscellaneous adjustments. Tex-

trad’s Crude Oil Sales Ledgers originally supplied to

respondent showed that in 1979 Textrad sold 5,831,255

barrels of Saudi crude to Texaco’s Canadian affiliate

at prices in excess of Saudi OSP. At trial, Texaco

Supplied the Court and respondent with revised

summaries of these ledgers, indicating that the

earlier figures were in error because they errone-

ously had treated marine revenue (freight) as an

element of crude revenue, thereby making it appear

that Textrad had charged the affiliate a higher price

than was actually charged. Respondent’s counsel

indicated at trial that, while he was willing to accept

the revised summary as an accurate summary of

Textrad’s records, he would not agree that they

contained accurate data. Respondent’s counsel was

given an opportunity to verify the accuracy of the

revised summaries, and he did not thereafter present

any evidence that they were inaccurate.

94a

Profits Earned by Petitioners From the Low Cost

of Saudi Oil

There are two types of profits that have been

discussed by the parties as relevant to the issues

before us, and these have been referred to in the

record as downstream and upstream profits. Down-

stream profits for purposes of this proceeding are

those profits which are earned by petitioners’ proc-

essing subsidiaries at least in part upon the sale of

products produced from crude oil. The parties have

stipulated that profits were realized by one or more of

petitioners’ subsidiaries and that such profits re-

flected the benefit of the below-market purchase price

of the oil from Saudi Arabia. Petitioners have indi-

cated a willingness to make the admission that these

profits earned by their subsidiaries were substantial.

Some of the profits of petitioners’ processing affili-

ates were beyond the reach of U.S. taxes. Conse-

quently, respondent in the notices of deficiency at

issue has allocated a portion of these profits to

petitioners’ offtakers, which were U.S. taxable enti-

ties.

As discussed earlier, Minister Yamani had been

quoted in the press as saying that he did not believe

that downstream profits such as those involved here

were within the scope of Saudi power as far as the

1979 restriction was concerned. Press reports indi-

cated that Minister Yamani had stated publicly in late

March 1979 that in enforcing the 1979 restriction the

SAG intended to “follow the barrel of Saudi crude

until it lands at a certain refinery.” Press reports

further indicated that Minister Yamani had stated

that the SAG had control over the price of its oil up to

the refinery, but that it could not interfere in sales of

a

95a

refined products produced from Saudi oi! even thowgh

they were sold at a price which enabled one refiner to

earn higher profits than others. The regulation of

product prices, he had Stated, was up to the con-

suming country governments themselves. In May

1980, Minister Yamani was quoted in a newspaper as

stating that the SAG decision to increase Saudi crude

prices by $2 per barrel was an attempt to take back

some of the profits being realized by the oil com-

panies, since once the oil was delivered to the

refineries, it was beyond Saudi jurisdiction. Thus,

Minister Yamani was believed to be of the opinion that

petitioners’ downstream profits or earnings were not

within the reach of Saudi control by means of the 1979

restriction or otherwise. There is no indication in

the record that Minister Yamani objected to these

statements in the press.

Upstream profits are those profits which were

earned up the chain by petitioners’ offtakers before

the Saudi crude was processed. Profits earned by the

offtakers from exchanges came about when non-Saudi

oil received in exchange for Saudi oil was sold for its

fair market value, which was higher than the pur-

chase price of the Saudi oil exchanged. We have

instructed the parties that at the present time we are

not interested in precisely quantifying the profits

earned by petitioners’ offtakers, except that they may

be used by respondent to show that they were so

extensive that the 1979 restriction was superficial.

See Exxon Corp. v. Commissioner [Dec. 48,005(M)],

T.C. Memo. 1992-92. To the extent that any profit

figures are referred to in this opinion, they are for

this purpose alone and are not intended to be precise.

The Exxon and Texaco offtakers experienced

significant profits during the years at issue as a

96a

consequence of the lower Saudi price. One aspect of

these profits came about as a result of processing

agreements, which we have already discussed.”

Another portion of petitioners’ offtakers’ profits

arose upon the sale of non-Saudi crude received in

exchanges. Exxon’s approximate profits from these

sales during the period 1977-81 are summarized in the

following table:

Year Profits

SET aictiidciontinsianal $ 5,500,000

IT -cciinsoiansiinniiionas 2,800 ‘00

EE sis decnieteglanie 14,000,000

DP -snissntinnnieiaiadl 53,000,000

PIE sicenkihiatiammnd 27,000,000

During the years immediately preceding and

following the years 1979-81, Textrad experienced

losses from sales of non-Saudi crude received in its

exchange transactions. During the period 1979-81,

Textrad experienced profits in excess of $500 million

from the sale of non-Saudi crude received in ex-

changes.” Total sales of Saudi crude to affiliates

resulted in losses to Textrad of more than $2 million

during the years 1979-81.

Although there is some indication in the record

that petitioners were concerned that the SAG might

2 See supra note 27.

*% A Texaco in-house document indicates that in 1982

Texaco estimated its after-tax earnings on Saudi crude to be in

excess of $700 million, excluding aownstream earnings. We

cannot determine the basis for these figures, and therefore are

more inclined to rely upon the number admitted to by -

petitioners, which is quite close to the figure presented by one

of respondent’s experts.

97a

not be pleased with the magnitude of petitioners’

profits during the period of the 1979 restriction, there

is no evidence that the SAG indicated to anyone that

such profits violated the restriction. Moreover, the

Saudis apparently were aware of the publicity con-

cerning these profits. The Saudi price moderation

policies during the period at issue did not keep crude

oil or product prices from rising, which led to con-

siderable consumer outrage against both OPEC and

the oil companies. Esso Middle East’s President,

Charles Hedlund, sent to Minister Yamani in March

and April 1979 two letters acknowledging press re-

ports about increased profits earned by the major oil

companies and explaining that these increases were

not a result of any violations of the restriction.”

There is no evidence indicating that Minister Yamani

or any other representative of the SAG responded to

these letters or other reports about profits in any

fashion which would indicate a Saudi belief that these

increased oil company profits during the years

1979-81 violated the 1979 restriction.

Returns, Notices of Deficiency, Petitions

Texaco timely filed consolidated corporate income

tax returns on behalf of itself and the Texaco petition-

ers for the taxable years ended December 31, 1979,

1980, 1981, and 1982, with the Internal Revenue Ser-

vice Center, Austin, Texas. A notice of deficiency for

*® Charles Hedlund’s letter indicated that much of the im-

provement in Exxon’s earnings was due to unrelated factors,

such as the recovery of the dollar, increased sales of natural gas

and heating oil, increased demand for chemical products,

increased Alaskan pipeline operation, and increased production

in new areas.

98a

the years 1979, 1980, 1981, and 1982 was issued by the

District Director, Internal Revenue Service, Hous-

ton, Texas, and was timely mailed to Texaco on July

21, 1989. In the July 21, 1989, Texaco notice of defi-

ciency, respondent increased the income of Textrad in

the amounts of $402,974,246, $982,635,616, and

$382,457,742 for the years 1979, 1980, and 1981, respec-

tively, stating that respondent was doing so “In

~ accordance with the provisions of Section 482, and/or

Section 61 of the Internal Revenue Code, * * * in

order to properly reflect the substance of the

transactions between Texaco International Trader

Inc. (Textrad)” and certain listed Texaco subsidiaries

“and in order to prevent the evasion of tax and/or to

clearly reflect the income of Textrad.”" This

allocation from the refinery to the offtaker level is

based upon the theory that, as articulated in respon-

dent’s trial memorandum, the offtakers “were the

entities in the controlled group that exercised the

ultimate direction and control over the earning of the

ARAMCO Advantage profits” and that the offtakers

transferred the Saudi crude to their foreign affiliates

at artificially low prices so that the profits obtained

as a result of the lower Saudi price were earned by

entities outside the U.S. tax system.

Texaco timely filed a petition with this Court on

October 16, 1989, contesting the deficiencies in tax

proposed by the respondent for the taxable years 1979

31 As an alternative adjustment in the same paragraph of

the notice of deficiency, respondent also stated that “in transac-

tions with Caltex Trading and Transport Corporation (CTTC),

Texaco International Trader Inc. (Textrad) failed to charge

arms-length prices and/or fair market values”. Alternate ad-

justments pursuant to this theory were also made to Textrad’s

income.

A a ar

99a

through 1982, asserting, inter alia, that respondent’s

determinations were erroneous because

(I) Texaco and its affiliated and related com-

panies were subject to pricing restrictions which

prevented them from having the power or control

necessary to establish or determine the transfer

prices of the Saudi Arabian crude oil; (ii) Textrad

sold the Saudi Arabian crude oil at arm’s length

prices; and (iii) Textrad did not earn the income

attributed to it b

This text is long and has been trimmed here. Open the source document for the complete record.