Burn the Ships

 In 1519 the Spanish Conquistador, Hernán Cortés set out for the Yucatan Peninsula to conquer the Aztec Empire and seize their treasure. Upon landing he ordered his men to “burn the ships.” The phrase has now taken on the meaning of doing something that makes it impossible for you to change your plans and go back to a situation you were in before.

Cortez knew that conquerors with far more resources and men had tried and failed to conquer the Aztec Empire previously. But Cortéz believed he could succeed where others had failed, and he instilled in his men that same belief. To create additional incentives he burned his boats. With no exit strategy in place they had to succeed or die trying. Burning the boats created an unwavering commitment to attain their goal, the conquering of the Aztec Empire.

The State of Alaska could learn something from Cortéz. In the past, whenever the State committed to pursue a large diameter gas pipeline, they always had a real or imagined alternative available to them. Often the alternative looked better than the proposed project, even when there was no specific alternative in place.

What the State has failed to realize is that the possibility of success substantially increases with the full commitment of the stakeholders of the project. The lack of commitment, conversely, is one of the biggest reasons for failure of a project.

One of the reasons why a gas pipeline has not succeeded in the past is the lack of the complete commitment from the State in exploring alternatives when a roadblock comes up in the progress of the pipeline. Sometimes the roadblock is even of the State’s own making.

Under the Stranded Gas Development Act, the producers and the administration made a proposal that included incentives for the producers to move forward with the project. This option was rejected by the Alaska Legislature and the Alaska people. It was a common belief at the time that the project was strongly economic and that the producers did not need incentives. Alaska believed that a no project alternative was better than the proposed project.

If the State of Alaska had been fully committed to the project, it would have reviewed the proposal and submitted terms back to the producers that the State would find acceptable. This might have resulted in substantial political risk for those involved, a risk that most did not want to take, and the legislature would have had substantial difficulty in coming to a recommendation since the legislature was not in a consensus building mode. But a fully committed State would have attempted to overcome those obstacles. 

One argument that I tire of hearing is that we are at a substantial disadvantage at the negotiating table, that somehow the producers are more intelligent and have better negotiators and better lawyers. This is simply not true. The State has assembled some of the most experienced and knowledgeable personnel as a part of their AK LNG team. Many of the State’s team have as many or more years experience as those who are across the negotiating table from them. In the past, the State’s lawyers were as good or better than those on the other side of the table. I assume this is still the case. The only thing that is clear about those who tout the State’s weakness as an argument against the AK LNG project is that we certainly don’t want them at the negotiating table representing the interests of the State of Alaska.

One of the issues that seems to be at the forefront of the discussion of the AK LNG project is that some believe the State needs a back-up plan in case the producers decide not to move forward with the project. But if the State was fully committed to getting a gas pipeline, it would take a different approach. The State would “burn its boats” and focus entirely on making the project a success. The following is what a committed State would do.

If the State is concerned with the producers not proceeding with the project, the State should negotiate terms in the contract that would allow the State to move forward with the project without the producers that no longer want to participate in the project; the state should negotiate strong milestones that would require the producers to make decisions in a reasonable length of time; and the State should make sure that its voting rights are not diluted to the point where it does not have an effective voice in the decision-making process.

 The State should spend a substantial amount of energy looking for ways to make the project economic. If the State moved forward with an alternative “back-up” project, it would still be required to make the project economic. These same alternatives that would make a State “back-up” project economic should be proposed in the AK LNG project.

If there are other concerns that limit the State’s commitment to the AK LNG project, the State should first look at options and alternatives that would solve its concerns within the AK LNG project negotiations. 

There is nothing to be gained in a “back-up” project that cannot be gained through participation in the AK LNG project. And there is substantial risk in keeping the “back-up” project around. It allows the state to not fully commit to the AK LNG project and it allows the State to believe it has a viable alternative to the AK LNG project. This is the type of thinking that precipitates the failure of the project due to lack of the full commitment of the State.

Whether the Governor vetoes the SB 132 legislation and whether the Legislature overrides the Governor’s veto is like arguing over what color we are going to paint a sinking ship. It’s time for the Governor and the Legislature to begin to work together to find ways to change the economics of the pipeline. It’s time for the State to consider burning its boats and fully commit to getting a large gas pipeline completed. 

                                           

In Support of a Pipeline but Which One

HB 132 passed the House pretty much along party lines on March 23, 2015 and was then transmitted to the Senate. Interestingly this is not a party-lines issue; it is not a conservative vs liberal issue; and it is not a pro oil industry vs anti oil industry vote, but the legislative and executive decision makers are acting like it is. The various proponents are arguing over whether to pursue a gas pipeline that will compete with the AK LNG project or throw all of their effort into making the AK LNG project a success when the focus of the debate should be on identifying alternatives and options that may enhance the economics any large diameter gas pipeline project.

The governor has proposed converting Alaska’s in-state gas pipeline project, the Alaska Stand Alone Pipeline (ASAP) to a large volume pipeline to compete with the AK LNG project. The governor argues that the new ASAP project will create competition with the AK LNG project. If the State has an alternative project, he argues, it will encourage the producers to stay on track and on schedule; and it will create a stronger negotiating position for the State. Although this may seem like a good idea at first blush, as explained below it does nothing to enhance the State’s negotiating position and does not create an alternative the State could pursue if the other project is determined to be uneconomic.

The governor argues that the producers have competing projects all over the world that are competing with the Alaska project for finances and funding. If another project wins out, the Alaska LNG project will not go forward. The governor argues that all we are doing is creating a competing project so that we have alternatives if the producers do not move forward with the AK LNG project.

There are several problems with the position the governor has taken. First, the producers generally have or can find the finances or funding to pursue any economic project they wish to pursue. Their projects don't compete with each other. The marginal projects, like the AK LNG project run the risk of not being pursued if the costs and risk of the project are too great. The focus on project economics is paramount. Secondly, even assuming the governor is correct, that the producers have projects all around the world that compete with the Alaska project, there is a substantial difference between evaluating projects all around the world to determine which project the company wants to invest in and competing with yourself on the same project. The producers don’t make a substantial commitment to moving a project forward then set up a project that competes with their own project. If they have a multi-billion dollar project they are pursuing in China, they do not set up and fund a project that competes with their own project in order to give them leverage. They understand that creating such “competition” does not creat leverage. It merely wastes additional assets trying to get the same gas to market.They will not spend double the costs for any portion of the project merely to create an illusion that there is competition.

The governor misunderstands global competition. Global competition is about countries working on alternatives and options that enhance the economics of their project over projects in other countries around the world. Neither the countries nor the producers set up alternative projects to compete with their own project.

The governor argues that we need an alternative in case the producers decide to not move forward on the AK LNG project. The governor is willing to fund a parallel process to be ready to proceed forward if the producers don’t. The governor has failed to understand that the producers will not move forward with the project only if they determine the risks are too high and the project is uneconomic. They will not commit to ship gas on an uneconomic project. If the producers do not move forward because their project is uneconomic, the State’s alternative will encounter the same problem. If the producer’s project is uneconomic, the State’s project will also be uneconomic. For those who remember the Alaska Gasline Inducement Act, it had the same problem. The State cannot “induce” a company to risk capital on an uneconomic project. A better alternative if the State wants to move forward with a project is to negotiate contract terms that allow it to move forward with the project if the producers elect not to do so. No waste of assets, no waste of time.

The governor argues that having two competing projects will enhance the State’s negotiating position with the producers as it negotiates the various project agreements. He likens it to having two cars to buy or two houses to purchase. If you have a viable alternative, you have a stronger negotiating position because you can choose the other alternative. The problem is that the State has not created another car or house; it has created a cardboard cutout illusion of an alternative. The reason the producers are not concerned is they understand that if their project doesn’t go forward, the other project will not go forward either because the economics of each project does not change merely because the number of project alternatives increases.

One probable result of the governor’s competing project proposal is the producers will try to figure out ways to leverage the proposal in the negotiations with the State team. They will argue that the competing project is creating uncertainty (which it is not). Based on that uncertainty they will request certain concessions and guarantees from the State to protect the producers from that risk. Instead of creating an advantage at the negotiation table, the governor has created a disadvantage and provided the producers with potential leverage. Their uncertainty concerns should be ignored because they don’t really exist.

The governor also misunderstands the State’s negotiating position with the producers. The State is in a strong negotiating position. The producers need the State as a partner. They call it alignment of interests. It is really more about the State carrying a proportionate share of the risk and protecting the producers form changes in the economics of the pipeline through increases in taxes or other charges against the project than it is about aligning interests, whatever that means. In the past the producers have tried to negotiate a “poison pill” provision that stated if the economics of the project change through an action by the legislature or a borough, the loss is born by the State’s interest in the project. Obviously this would not be a good provision to agree to.

The governor argues that the producers own the car and can ask any price for the car, and we would have to pay their price. The governor needs to understand that the producers don’t own the car, the State does. We can negotiate strong terms for the State. The producers can accept them or risk not having the state as a partner. That doesn’t mean that we should try to extract more value from the project by increased charges and taxes. That would create a further impediment to the economics of the project. But the State should negotiate strong protection provisions. The State should make sure that there are provisions in the AK LNG project contract agreements that allow the State and anyone else that wants to continue to participate in the project to move forward with the project. If a company wants to withdraw from the project, they should be allowed to do so prior to the project commitment decision. But they leave all their interests in the work product and permits with those who want to continue the project. And the parties that continue the project should not pay the withdrawing companies anything for the value of the permits they left behind because the withdrawing companies will be able to write off the assets; and if the remaining parties are successful in building the pipeline, the withdrawing companies will be able to make billions of dollars shipping gas on a pipline that the other parties took the risk to build.

One of the arguments the governor makes that I don’t understand is the argument that not allowing the alternative project prevents the State from marketing its gas. The reason this doesn’t make sense to me is that the State’s AK LNG team has a marketing group whose job it is to find markets for the State’s gas. Nothing is preventing the State from marketing its gas now as a part of the AK LNG project. The governor should talk to the State’s AK LNG marketing manager to determine the difficulties with obtaining long term contracts. He will find that the difficulty is not with having an alternate contract. The difficulty is with delivering the gas to the buyer at a competitive price. Strong economics and a lower tariff are the primary ways to bring gas to market, not trying to develop a cardboard cutout alternative that none of the producers believe is a viable project.

It is possible that the governor is arguing for what some have called a market driven approach. The theory is that the buyers of the gas want our gas so much that they are willing to share the risk of building the pipeline. They are willing to make firm shipping commitments without owning the gas or knowing the ultimate cost of the gas or the tariff. The governor has tried this for a number of years through the Alaska Gasline Port Authority. It didn’t work then and it can’t work now. The reason it doesn’t work is that the market will not assume the risk of the project without some level of understanding of the cost. A market driven approach shifts the risk of the project to the buyers. That is not a risk the buyers are used to accepting without more certainty of costs.

The governor is right about the ASAP gas pipeline. It seems that there is universal agreement that the ASAP pipeline is uneconomic. The Alaska Gasline Development Corporaiton still has around $200 million they are able to spend in furtherance of the project, but spending more money on an uneconomic project does not sound like a logical decision to pursue. The governor has proposed to change to focus of the ASAP team to develop a proposal for a large volume pipeline. For reasons stated above, this is not a good option. The legislature, on the other hand would allow the ASAP project to proceed forward with a snall volume uneconomic pipeline, presumably to prevent the governor from making the mistake of converting the ASAP project to a competing project to the AK LNG project. This too is a wrong approach.

What the legislature and the governor should do is direct the ASAP project team to support the State’s AK LNG team at the direction of the AK LNG team. Those members of the ASAP team that can find positions in the AK LNG team should do so. The rest of the team should be funded through the end of the year at which time the ASAP project should close its doors.

Recommendation

Regarding AGDC, as stated above, AGDC has a couple hundred million dollars in reserve. That money should not be wasted on the development of an alternative project. It should be used to support the State of Alaska’s participation in the Alaska LNG project. The ADGC team should be meeting with the State of Alaska’s management team to see how they can support the project. The ADGC team and the Alaska LNG team should look at ways that the ADGC professional staff can be utilized effectively on the AK LNG project.

Regarding contract negotiations, set strong milestone timelines that can only be changed with a 100% vote or a vote that allows the State of Alaska to veto delay of the project.

Include a provision that allows the State of Alaska the right to take over the project and transfer all the permits and data to the State and other remaining participants so that no time is lost in moving the project forward.

The State should spend more time looking for ways to make the project economic instead of wasting time on an alternative that will never occur. Focus on financing, the tariff, the cost of debt, return on equity, debt/equity ratios, transportation infrastructure,  reducing cost overrun risk, and reducing the cost of the project, anything that will make the project more economic and more likely to succeed.

What the State has failed to figure out is that projects move forward because they are economic and can make money for their investors.

It’s time to quit wasting assets on things that are not going to bring value to the project. Launching a competing project when there will be only one project that succeeds is wasting time and money. The State should focus its efforts on making one project more economic not creating alternative projects. Just make sure the State of Alaska has the right to proceed ahead with the project if the producers don’t want to move the project forward timely or if the producers determine the project is uneconomic and decide once again to shelve the project.

More Alaska Production Act – Success or Failure

Senate Bill 21, commonly known as the More Alaska Production Act, was passed by the Alaska Legislature on April 14, 2013 and signed into law by the governor on May 21, 2013. The stated goal of the Act was to create a more business friendly tax structure that would result in more production. But is more production in a “tax friendly” environment the right answer, and how do you measure success?

State’s responsibility to the people of Alaska

The State of Alaska has a limited amount of non-renewable resources, and it is the State’s responsibility to manage those resources wisely. The revenue from those resources must be used to meet the needs of the current generation while saving a part of that revenue for future generations when the non-renewable energy resources will be gone. The state does this by receiving a royalty share from the sale of the oil. In addition the state has the power to tax the developers of that resource to obtain a fair value for the right to exploit that resource. The issue the State continues to grapple with is what is fair value for the State and what is fair value for the developer.

Corporation’s responsibility to its shareholders

The corporations who have contracted for the right to develop the resource have no obligation to either the present of future generations of Alaskans. They are not beholden to the State for what the State may have done for them last legislative session or even last week or yesterday  They have no loyalty to Alaska, and once the resources are depleted, they will leave the State. They have a responsibility to maximize the value to their shareholders. A part of that responsibility is the pay as low a tax as possible. Because of the risks the industry is willing to take to develop Alaska’s resources they should get a fair value for their efforts and the risks they have taken to develop those resources.

Alaska’s Clear and Equitable Share (ACES)

SB 2001, commonly referred to as Alaska’s Clear and Equitable Share (ACES), was passed by a special session of the Alaska legislature in November 2007. It is important to review the circumstances surrounding the passage of the bill to determine if anything changed that merited passage of SB21 and how the passage remedied the problem.

During the special session the contractors and analysts modeled a substantial number of scenarios to determine the range of progressivity that would encourage development of the existing fields while maximizing revenue to the state.

They took each variable in the model and ran it through a broad range of inputs. When they had completed dozens of modeling scenarios an economic picture began to arise. There was actually an economic “sweet spot” where it looked like the state could receive the optimum revenue from the production of oil, the industry would get a fair return on their investment, and the vast majority of the reserves in Kuparuk and Prudhoe Bay would be produced. The sweet spot was the progressivity factor of 0.4%. The models did not accommodate the economics of heavy oil; so it was possible that in the future some incentive might be necessary to encourage their development.

This modeling was completed prior to the Senate Judiciary Committee receiving the bill but after Senate Resources had completed their review. The 0.4% progressivity was presented to the Senate Judiciary Committee. The Committee amended the legislation to include the progressivity factor, and it was eventually passed by the entire legislature. On December 19, 2007 Governor Palin signed the bill into law.

SB21 - More Alaska Production Act

With the continued decline in production on the North Slope, the governor and the majority in the legislature believed that a reduction in tax to a more business friendly tax structure would result in more production. The result of the new law seems to be more activity on the North Slope, more jobs, and more production than would have occurred had the original tax remained in place. It looks like SB 21 accomplished its goal, but the question remains, was it the wrong goal, and are present and future generations of Alaskans harmed by the outcome.

Additional Production v. Added Reserves

The goal of any change to the tax structure should have been to increase reserves and thus extend the life of the pipeline while adding revenue to the state over the long run. But there has been no mention of the need to add reserves to the books in the SB21 discussion. If the industry merely produces existing reserves faster at a lesser tax, they meet the intent of the tax while the state loses value in the long run. The state will receive less tax for their resources and the life of the pipeline will be shortened. For example, assume there are a billion barrels of known reserves remaining in Kuparuk and Prudhoe Bay and assume the industry under the old law would have produced those reserves at 50 thousand barrels per year for twenty years. Assume the industry steps up production and produces 100 thousand barrels per year for ten years. The same amount of oil gets produced, but the result is a shortening of the life of the pipeline by depleting the reservoirs faster, and the industry pays less tax per barrel for their effort. The State loses twice.

But the Department of Revenue projects that reserves will increase due to current and projected drilling programs within the Kuparuk and Prudhoe Bay fields.  Certainly, additional drilling has and will result in incremental reserves additions, but as stated above these incremental additions were expected to be produced under ACES. And even if they weren’t, the incremental additions to the reserves base and the increased production doesn’t come near to covering the loss in revenue that the change in tax created.

More Alaska production, without the accompanying increase in reserves, merely depletes the State’s resources and allows the industry a reduction in taxes for doing so.

Low risk v. High Risk Investment

On June 24, 2014, Ryan Lance, ConocoPhillips chairman and CEO, spoke to the Resource Development Council (RDC)  regarding “The U.S Oil & Gas Renaissance – Alaska’s Role.” In his presentation he made an important point. He stated that the best opportunities to find additional oil are in legacy fields. Drilling in legacy fields like Prudhoe Bay and Kuparuk are low cost, low risk, high chance factor wells as compared to true exploration. This type of drilling will slow the decline of production of existing fields and will add to the overall reserves base of the Units. But they will not substantially change the reserves picture in the State. This type of additions to production are exactly the types of wells ACES was projected to produce. They may not have been produced this year, but as oil prices increase and production decreases, these reserves were expected to be produced.

Regardless of the price of oil, by only drilling wells within the Unit boundaries the major producers are not spending capital on exploration and not increasing the reserves necessary to make up for the benefit they are receiving in the changed tax. Basically they are in a harvest mode in the State of Alaska. 

What the State of Alaska really needs is for the industry to invest in true exploration, exploration several miles outside the unit boundaries. This is where incremental value can really be added in Alaska. Sadly, the major producers on the North Slope have limited capital budgets committed to exploration. Their announcements primarily deal with increased activity inside the Unit boundaries. They are committed to the production of the low cost, low-risk resources. SB21 doesn’t seem to have changed this policy. It appears that SB21 has incentivized the industry to produce known and potential reserves inside the Units faster and as an added benefit they pay less tax.

The Price Factor

After the vote defeating Referendum #1, the proposed repeal of the More Alaska Production Act, one of the leading proponents of the More Alaska Production Act was quoted as saying “The vote in August sent a clear message to the producers that Alaskans expected more production investment. And even with the collapse in oil price that nobody saw coming, the producers are keeping their promises and we should stay the course.” What the individual didn’t take into account is that when prices fall, industry becomes capital constrained and projects are delayed or they begin to fall off the books because industry doesn’t have sufficient funds to move their projects forward.

The ConocoPhillips announcement on January 29, 2015 to slow the pace of investment on Greater Mooses Tooth Project is one of the casualties of the drop in oil price. There will be other announcements forthcoming from the industry of additional investments delayed or taken off the books. I assume that one of them will be the new drilling rig, the Doyon 142, scheduled to begin drilling in Kuparuk in February 2016. I assume that ConocoPhillips will take delivery of the rig, if at all, at a substantially later date than the February 2016 projected date.

These decisions by the industry to reduce capital outlay in a low price environment should not be perceived as the industry going back on its word. The industry is merely doing what it must to survive in a capital constrained environment. What is also clear from these decisions is that oil price has a substantially greater impact on investment decisions than any tax, whether it is ACES or the More Alaska Production Act. In a low oil price environment the industry will cut back on capital spending, and in a high price environment industry will increase spending regardless of the tax.

The impact of price on the revenue stream coming from the More Alaska Production Act is significant. In a low price environment the State of Alaska saves a couple hundred million dollars per year under the Act as opposed to ACES. In a high oil price environment the State of Alaska loses a couple billion dollars per year under the Act as opposed to ACES. The cross-over point seems to be about $80/bbl. Below that oil price the More Alaska Production Act brings in incrementally more revenue. Above that amount, ACES brings in substantially more revenue. According to the Revenue Sources Book Fall 2014, the Department of Revenue projects the price of oil will exceed $80/bbl in 2017 and exceed $100/bbl by 2018 and beyond. This means that the legislature has a couple of years to fix the tax until it begins to lose billions of dollars in tax revenue to the industry.

A Fair Tax

Again I would like to cite the Ryan Lance’s presentation to the RDC on June 24, 2014. In that presentation he noted that the “ELF” Tax Period Encouraged Significant New Production. I assume that he believed that the ELF tax was a reasonable tax. It is important to note that the tax was changed from the ELF tax specifically because it was not a fair tax to the State of Alaska. Each year under ELF Kuparuk was paying less and less tax. The projections were that Kuparuk might get to the point where it paid no tax even when the oil price exceeded $100/bbl. This is the tax that Ryan Lance refers to as a reasonable tax for the oil and gas industry. The point here is not that Ryan Lance believes the State of Alaska should go back to the ELF tax; the point is that the industry believes that any reduction in tax is a good tax, even to the point of not paying any tax at all. This means that the State of Alaska must not depend on what the industry says to make decisions about taxes, but it should evaluate what a fair tax would be independent of any oil industry input.

Conclusion

Governor Parnell in a Compass Article dated May 22, 2013 stated, “Our new tax system centers on the idea that not only our generation, but future generations of Alaskans ought to benefit from Alaska's massive resource basin on the North Slope.” The problem is that the governor actually sacrificed long term revenue for short term jobs and increased production without the accompanying requirement to increase our reserves base.

What the legislature should have done was fix ACES in a low oil price environment and possibly modify the credits and deductions, if appropriate, and keep the progressivity of ACES. If all of the reserves aren’t getting produced, a change in the tax may be appropriate, but that time is several years in the future. If the legislature decides to add progressivity back into the tax, the State of Alaska will have protected both present and future generations of Alaskans.

Economics of the Producers and Economics of the Pipeline

 I sit here thinking about the decisions before the legislature.  The legislature will make many decisions this year and in coming years regarding the gas pipeline, capital budgets, operating budgets, long-term fiscal plans, and the many needs of the people of Alaska that must be balanced against the ability to pay for those needs. All of the decisions, taken together results in a path forward. As Alaskans look back on those decisions, they will see where the legislature made good decisions and bad decisions. We can only hope that the good decisions will be of great benefit and result in lasting value and the bad decisions will be short-lived and not result in any great damage to the state.

Regarding the pipeline, there are at least two paths the legislature could take. One would be to spend much of its effort changing the economics of the pipeline and the second is to change the economics of the producer. The legislature has chosen the path that would change the economics of the producer although it could still do some things that would change the economics of the pipeline as well.

Changing the economics of the producer

This path primarily focuses on what the state can give up in order to get the producers to move forward with the project. The ultimate decision remains with the producers regardless of what the state gives up in the process.

I use the term project to refer to the pipeline because that is how the producers look at it. I understand that there will be several smaller decisions/contracts regarding gas treatment plants, pipeline participation, etc., but the producers will look at each of these in relation to how they can maximize their individual profits on the whole. Each negotiation will result in winners and losers. The negotiations will not be about all of the parties participating in a bigger pie even though the pie will certainly be bigger. The negotiations, at each stage, will be about reducing risk and costs and maximizing value to each producer from their individual perspective.

The path the legislature has chosen will course through many decisions. The bill before the legislature is not the first decision, and it is not the last the legislature will have to make. The decisions made in the current legislation will refine the path. Luckily, so far the legislation does not contain any major long term commitments, it merely sets direction.

What the legislature doesn’t understand is that unless it works to change the economics of the pipeline, it has done little to move the project forward. Any commitment regarding oil, for example, does little to change the economics of the pipeline.

Things that will change the economics of the pipeline are reducing the costs of infrastructure to the pipeline, maintaining infrastructure during the construction of the pipeline, understanding debt/equity ratios, making sure that the interest earned on equity and the interest on debt are as low as possible, making sure that Alaskans only pay for distance based tariffs for their gas (make sure you understand what the producers mean when they agree to distance based tariffs. It may be different that what you think), making sure that the tax on gas is fair to the state and to the producers, understanding where risk shifts to the state so that the decisions you make regarding that risk will be intentional, no surprises, making decisions to support a particular issue regarding the pipeline because you understand the consequences and agree they are acceptable, not because they are politically correct in an election year.

The most important thing to remember is that this path requires the legislature to depend on the producers to move the project forward. If the producers feel, at any stage along the way, that the economics are not sufficient to move the project forward, they will return to the state, not with hat in hand asking for more, but with a club demanding more; and the state will be at a disadvantage of not knowing if the producers really need whatever they are demanding to move the pipeline forward or if they are merely taking advantage of the situation. The state will be in a position of acquiescing to the producers demands or reaping the wrath of their constituents for killing the pipeline. The producers will certainly have their contractors and supporters writing letters and testifying to the need for whatever the producers request. I am not accusing the producers of being bad. I just understand what they will do when given the leverage to extract additional concessions along the way. It will become clear that what you thought was the deal today will not be the deal two years from now or even months from now when another decision-making milestone is reached. You have released control of decision-making to the producers and you will reap the outcome.

Economics of the pipeline

The legislature can have a substantial impact on the economics of the pipeline, but it is a more difficult path than the one chosen. It requires more research and understanding. It requires a different kind of risk-taking. The difference between changing the economics of the pipeline and changing the economics of the producers is partially the difference between taking the risk with current dollars (changing the economics of the pipeline) which the legislature could be held accountable for on the failure leg, and taking the risk with future dollars (changing the economics of the producers) which the legislature will probably not be held accountable for if history is a indicator of reality.

There are many ways to impact the economics of the pipeline. I would recommend the legislature understand these as best they can before they proceed forward with agreeing to anything with the producers.

Paying for the cost of infrastructure and not placing that burden on the pipeline will have an incremental impact on tariff. The legislature needs to understand how much before they agree to those costs. Some have said that the producers have not asked the state to pay for the costs of infrastructure. My answer is wait. It's in the legislation and it will be in the proposal when the administration returns to the legislature in the next phase. Interestingly, the administration should have been focused on improving infrastructure for the last several years in anticipation of moving the pipeline forward and the state should continue to do so in the future. I am not against the state paying for infrastructure, or at least a portion of infrastructure. I just want to make sure the state understands the value of that payment and captures the accompanying value for the state.

The legislature needs to understand the impact of equity and debt on the pipeline. The debt/equity ratio will have a substantial impact on the tariff. The pipeline owners (especially TransCanada since that is where they will capture their value) will want to argue for a high proportion and large return on equity. The producers will join TransCanada in asking for a large return on equity. This is a way for them to balance their risk. They will also argue that, if the State participates as an owner, it will join the other owners in reaping the benefit of that return on equity. This is a two-edged sword and it cuts both ways. I believe that a lower return on equity and a lower proportion of equity serves the state in the long run, and it certainly serves explorers and those not fortunate enough to own a piece of the pipeline.

Regarding debt/equity ratio, the state should argue for the smallest equity and the largest debt that financing will allow while not significantly impacting the cost of debt. The interest on equity and the interest on debt are substantially different and the legislature should understand those before it agrees to anything in this area. Interest on equity is often more than twice as much as interest on debt; so every dollar of equity allowed impacts the cost of the tariff substantially more than a dollar of debt.

One of the ways to impact the tariff has to do with the timing of paying back the equity. If payment on the equity was delayed until most or all of the debt was paid back, the tariff would substantially benefit, and it would also reduce the cost of the debt which would have an additional impact on the tariff. Of course, the only party that would agree to such a deal would be the state. But the state may want to consider such a decision since this decision would have a substantial impact on the tariff and a corresponding impact on the economics of the pipeline.

The financing of the pipeline and the various elements of the project needs to be understood thoroughly. Many of the options that would impact financing have not even been considered. The producers will suggest that this will be dealt with in the contract negotiations, but some of the possible alternatives will be taken off the table if the state does not evaluate its options now. State ownership, how much of the pipeline the state should own, and how it should manage its ownership are decisions to be made sooner rather than later.

There are many more issues that should be addressed, but the above issues are some of the most important.

Some would ask why they should consider anything I write, especially since I have been out of the state for several years. A good question. The answer is that I worked in the oil and gas industry for over 20 years and participated in several failed attempts to move a pipeline project forward. I also represented the state in pipeline contract negotiations with the producers during the Murkowski administration. I watched the producers negotiate with the state and with each other. I observed their areas of agreement and their differences. There were two points that became clear through the negotiations: 1) each producer attempted to reduce individual risk and maximize individual value. Interestingly what each producer valued was different and led to more conflict between the producers than conflict with the state, and 2) the producers were in alignment in attempting to shift as much of the risk and cost as possible to the state and obtain as much value through reduced taxes and other fees as they could.

The state has many decisions to make regarding the pipeline. My hope is that you don’t make any commitments without fully understanding the value and impact of those commitments and that you make commitments for the shortest timeframe possible so that bad decisions don’t linger for that many years. My hope is that there will be many more good decisions than bad.

 

An analysis of SB138

The Alaska Legislature is currently considering SB138 at the request of the governor. The substance of the bill cannot be reviewed without understanding the context in which it was submitted. The proposed legislation was submitted based on a commitment the governor made to the producers when the governor, through the Departments of Natural Resources and Revenue and the Alaska Gasline Development Corporation signed the Heads of Agreement (HOA) dated January 14, 2014. SB 138 is the result of the governor’s commitment, and most of the provisions of the legislation come directly from that commitment.

 Article 4.4 of the Heads of Agreement (HOA) states that “A decision by the Alaska LNG Parties to advance the Alaska LNG Project to FEED is subject to, among other things:

a. Enabling Legislation and other laws and regulations of the State to advance the Alaska LNG Project, including necessary fiscal and commercial terms as set forth in this HOA;”

Article 7.3 of the Heads of Agreement (HOA) requires the administration “to the extent permitted by law” to “include and support the provisions of Articles 5 through 12, inclusive, in any future legislation or contractual arrangements.”

 The question the legislature should be asking is what did the governor commit to in the HOA? How does that affect the governor’s ability to seriously consider any changes the legislature may propose? What are the actual impacts to the state of the proposed legislation? And what commitments are reasonable for the state to make to encourage the development of a major gas pipeline project? This final question is the most important, and the legislature should come to its own conclusions regarding what the state is willing to do to encourage a large diameter gas pipeline.

 

The fact that the governor signed a document in January to support certain terms does not change the decisions the legislature should make. A decision not to follow what the producers requested in the HOA is not a decision against the pipeline even though that is exactly what the producers will argue. The legislature has a responsibility to review the terms of the proposed legislation and make sure the interests of the state are protected. There will be a bias toward giving the producers whatever they want in order to be seen as supporting the gas pipeline. The legislature must understand this bias and guard against making decisions that are not supported by sound reasoning and economic justification.

The producers are generally going to attempt to change the economics of the pipeline and shift risk to the state through several means:

1)      Reducing/protecting the tax on oil.
2)      Reducing/protecting the tax on gas.
3)      Providing “fiscal certainty” on the benefits gained for the longest number of years.
4)      Getting the state to pay for as much of the cost of the pipeline as possible.
5)      Shifting as much of the risk of the pipeline to the state as possible.
6)      Having the state be an owner of the pipeline so that the producers can have the state pay for any loss of fiscal certainty or risk through the state’s revenue stream.
7)      Alignment of the parties

 Reducing/protecting the tax on oil.

The producers are well aware of the initiative process that would repeal the current tax and revert back to the prior tax. The producers will use the agreement to move forward on the gas pipeline as leverage during the vote to argue that a vote for repeal is a vote against the pipeline. Interestingly the oil tax does not have a major impact on gas pipeline economics. The pipeline economics models upon which the producers depend will attribute no more than a 5% change in economics based on the fiscal certainty on oil. The producers will argue that they must have fiscal certainty on oil or the gas pipeline cannot move forward. Their argument is that the legislature may change the tax on oil if they don’t like the deal they are receiving on gas. There is always a risk that the tax structure will change if the industry is obtaining a disproportionate value from the oil and gas resources in Alaska. That is exactly what happened to the Economic Limit Factor. When the state finally figured out that Kuparuk would pay little or no severance tax while the producers were receiving billions in revenue, it was time to change the tax. Likewise, the state should be cautious when agreeing to protect the current or a proposed tax on oil and gas for more than 15 to 20 years. My guess is that the producers will request 35 years. The state cannot project more than about 10 years into the future when it comes to taxes, and the economics of oil and gas could change substantially in that time. The longer the term of fiscal certainty, the greater the risk to the state that it made a bad decision. 

Reducing/protecting the tax on gas.

The proposed legislation sets the tax on gas with little or no analysis of what the state would receive under the current law or what the state would receive if current law is repealed by a vote of the people. When the value of what the state is giving up in the legislation is not well considered, there is a significant chance that the state is giving up more revenue than it should, especially when the proposed tax rate probably came from the producers as did much of SB 138. There has been very little review and analysis of one of the most significant terms of the legislation. There should be extensive fiscal notes and presentations of the probable revenue impacts from a proposed tax on gas.

 
Providing “fiscal certainty” on the benefits gained for the longest number of years.

This issue has been discussed above, but the key is the legislature should only provide fiscal certainty, if at all, for a limited term. Twenty years is more than enough for the producers to obtain the benefit of their bargain to commit their gas to the pipeline.

Getting the state to pay for as much of the cost of the pipeline as possible.

 
The building of infrastructure is an important aspect of the overall economics of a large-diameter gas pipeline. If infrastructure (roads and bridges, etc.) is built and maintained properly throughout the project, the result could be substantial cost savings or a higher likelihood that there will not be cost overruns due to infrastructure failure. The issue will be how to allocate the cost of infrastructure between the parties. There are suggestions in the proposed legislation and in the Heads of Agreement that the producers will attempt to shift as much of the burden of paying for the cost of infrastructure onto the State of Alaska as possible.
 
Section 31.25.005(5) states that the state corporation to the fullest extent possible should “advance an Alaska liquefied natural gas project by developing infrastructure and providing related services.”
 
Article 10 of the HOA refers to additional State Support for the Alaska LNG Project. Article 10c references “appropriations and permitting for the construction of necessary in-state infrastructure (e.g. roads and bridges) including drafting, introducing and supporting legislation.”

The cost of infrastructure improvements and maintenance required to build the pipeline could be around one to two billion dollars. As much of the cost of infrastructure as possible should be shifted to the federal government. If the state decides to pay a part of the infrastructure costs from the general fund, it should make sure it receives value for that investment.

 Shifting as much of the risk of the pipeline to the state as possible and Alignment of the parties

 
You will hear a lot of talk about alignment of the parties. Much of the alignment will be the producers, in the contractual agreement with the state, shifting risk and costs from the producers to the state. Specifically the producers will require the state to accept the risk of any legislative changes to either the oil or gas tax. This will be similar to a “poison pill.” If the legislature or any local government finds a way to extract additional revenue from the producers, the state will be required to pay the difference in revenue from the state’s portion of the pipeline revenue.
 
Another area where the producers will attempt to limit risk and liability for the pipeline is through the creation of subsidiaries. The producers will propose shell corporations that will protect the parent corporations from any liability and risk associated with the pipeline. The state should require a parent guarantee if the state decides to participate with the producers in the pipeline project. The state should not be the only deep pocket in the room. I assume the producers will argue that the state could also create a shell corporation. The difference is that the producers can allow the pipeline to go belly up and only lose what was invested in the shell corporation (still a significant value), but the state will be stuck with a similar loss as the producers plus the state will be stuck with the result of the failure even if it has created a shell to protect it from liability.

There are other areas where the producers have shifted the cost of the pipeline to the state. One example is workforce training. The producers added a credit for workforce training to the legislation. Because there is already a cap on the total credit allowed, the producers will merely shift what it normally contributes to the university and other organizations currently identified in the credit to training on the pipeline, effectively transferring to the state the cost of pipeline workforce development with a concurrent loss of revenue to the university and other educational institutions. The fiscal note on this issue is similar to a ostrich burying its head in the sand. The fiscal note argues that it cannot determine the revenue impact to the state because it cannot predict the decisions of the producers in advance.

 Summary

 It will be argued that the legislation as proposed does not commit the State of Alaska to anything. The proposed contract that will be presented to the legislature in the future is where the legislature will get an opportunity to examine the terms of the deal. Actually what the legislature is agreeing to in SB 138 is the sideboards of the agreement, and it is clear that the proposed contract, when it is submitted to the legislature, will ask for incrementally more from the state. The legislature needs to understand and be clear about what it is agreeing to in the proposed legislation. This is not legislation to support the Alaska Gas Pipeline. This is legislation that will set the terms of the deal between the producers and the state for a future gas pipeline and the accompanying revenue from that endeavor. Proceed with caution.