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.