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.