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.