Producers can’t warehouse North Slope natural gas

Legislators told leases require companies to develop and market gas; can turn down other pipeline projects only if they market gas

Kristen Nelson

Petroleum News Editor-in-Chief

The Alaska Legislature’s Legislative Budget and Audit and Senate Resources committees heard from attorneys April 20 on the subject of what leaseholders are required to do under their leases to develop and market North Slope gas. (Part 1 of this article appeared in the April 24 issue of Petroleum News.)

Attorney Spencer Hosie, with San Francisco-based Hosie Frost Large & McArthur, outside counsel to the Alaska Department of Law, said leaseholders have an obligation to develop and market natural gas, and such a development project doesn’t have to be the most profitable project in their portfolios, just “reasonably profitable.”

In Stranded Gas Development Act negotiations, he said, the state shouldn’t be competing “penny for penny to make its project as economic as the others that Exxon or the other producers” have available to them.

“Finally, here’s what the producers cannot do: they cannot say no to an offer such as the port authority offer and then say no to someone who comes to them and says listen, we want you to enter binding shipping commitments so we can build the infrastructure and get the gas to market. They can’t say no to that, and then say, oh, yes, having said no to a purchase offer, having said no to an offer to enter a shipping commitment, we won’t develop the reserves ourselves.

“The law is clear on this: producers cannot just warehouse the hydrocarbon because it makes sense from their perspective to do so. It probably does make sense, from Exxon’s perspective, not to produce gas in Alaska today. It’s got other irons in hotter fires cooking as we speak,” and might prefer to leave Alaska’s gas in the ground for another 10 or 15 years, Hosie said. “It doesn’t need to book those reserves today. ConocoPhillips may well view that differently, but an Exxon, it has a much longer term horizon.

“But that’s not a decision the oil companies get to make without regard to the interests of their royalty owner, the state of Alaska. In asking that kind of question and in looking at the economics, they have to take into account your interests, and your interest lies in having a gas line” and receiving economic value for the gas for the state. “And even though they might prefer to spend their dollars elsewhere, if the gas line is economic, measured objectively,” then under Alaska law “they have a duty to go forward.”

‘Reasonably profitable?’

Hosie said this is “fact specific.” The state, he said, should look at the kinds of returns these companies have accepted on past projects, such as the central gas facility at Prudhoe Bay built in the mid-1980s, and investments in natural gas straddle plants in the Gulf of Mexico. Are they really getting 25 percent returns across the board — or 15 percent?

Most importantly, Hosie said, the answer has to be in the context of the existing Alaska North Slope business, “the money they’ve already made on the oil and their obligation to the state to develop reasonably.”

It’s a different situation, he said, than if the producers had approached the state cold and said we understand you want our development dollars. What can you do for us?

“That may be the negotiation in Qatar. It probably is the negotiation in Kazakhstan. But it surely shouldn’t be the negotiation here, because that’s not the deal.”

Relationship of mutual benefit

Hosie said it was in the context of a long fight over how royalties should be calculated and paid, and was originally filed by the Alaska Attorney General’s office in 1977.

“In the course of the case … the question arose: what relationship exists between the producers and the state of Alaska? Are they arms-length third parties fighting with bare knuckles in the hurly burley of the commercial marketplace? That was the producers’ perspective… The state specifically had argued that they were fiduciary, which meant they had to treat the state with the utmost care and confidence.”

The judge disagreed with both arguments and ruled in line with what is true in other oil producing states, that the “basic lease, the basic bargain where you tender your land and they develop it for their interest and your interest, that that relationship creates this obligation … to operate the property for the mutual benefit of both the oil company and the state.” In the late 1980s, the judge issued a decision which “talked about the implied duties, including the duty to develop and the duty to market, where he found that those duties were present in the DL-1 lease form (the state’s original lease form). That issue has been litigated here. That is the law today. The producers were party to that case, or their predecessors were, and that decision is as binding on them as it is on the state. There is this relationship of mutual benefit, and I again would say … that nothing I have just said, in any way, is controversial or stretches the law. Not at all; that is crystal clear in this state, given this decision, and in other states given parallel decisions.

“And it’s important, because if you think about the basic bargain, you really have to trust the producers on some level. You can’t tell them to whom to sell the oil or gas. You can’t tell them how to drill a well. You can’t say: listen, we really want you to do X and Y here and not X and Y over there. They control the process. They get to decide … what gets developed when and how, and they do have substantial authority to do that… But with that right comes a concomitant obligation: to make those decisions with your interests in mind also. No question but that they have to have due regard for the state’s interests. And as I said, they might want to spend the money in Kazakhstan, but it doesn’t do anything for the state of Alaska and here, unlike there, they have a preexisting relationship” with the leaseholder under the lease form, and under which they have made enormous profits.

What options does the state have?

Hosie said that if, after a reasonable review, the state is convinced “that the project is economic and the producers refuse to go forward,” the state can live with the producers’ refusal or it can file a lawsuit. “I have to say that litigation is never a good solution to a problem… it’s slow, it’s expensive and it’s unpredictable. But sometimes you have no choice.”

The Alaska North Slope royalties case “was right out of Dickens. It was like Bleak House: the case went on for 17 years,” Hosie said.

He said a duty to develop case would be far simpler, but would still probably take two to three years.

Sen. Fred Dyson, R-Eagle River, asked Hosie if the state had the option of a reserves tax.

It’s “absolutely within the state’s prerogative to do that,” Hosie said. The state “can negotiate and you give and you give and they take and they take but they’re never satisfied.” The companies say it’s not enough, and they refuse to go forward.

“You don’t want to sue them, because that really doesn’t work terribly well, it’s the last thing you want to do… maybe a reserves tax makes sense.”

The lease agreement doesn’t preclude a reserves tax, he said.

“My own personal belief is that the producers will acknowledge they have a duty to develop here, it’s just a question about how much money gets put to their side of the table vs. left on your side of the table.”

But if negotiations don’t work and the producers refuse to develop, then the state will be faced with imposing a reserves tax or litigating, “because one thing the producers cannot do … is warehouse the hydrocarbons because it is in their economic best interest to do so. It may well be, but that’s not a call they get to make.”

What’s a reasonable price?

Hosie said no, that “it goes back to the fundamental test: is it a reasonably profitable development measured objectively?”

An uneconomic price wouldn’t meet “the basic test of reasonably profitability measured objectively.”

The producers can say no to a “commercially reasonable” offer, “but it increases their duty to do something else.”

The effect is sequential, Hosie said: “If they say no to something like the port authority, well they can do that, I suspect they will do that.” They may also say no to a company that can get financing to build a pipeline and asks the producers for “binding shipping commitments, which is a standard in this business.”

Hosie said the bottom line for the producers is “they want to hold the reserves: they want the profits on the upside — they don’t want to give up the reserves.”

Once they’ve said no to a couple of offers, then there is “a great deal of pressure” for them to develop the gas.

The port authority offer is good from the state’s perspective because “it shows that there is commercial interest from third parties in trying to find a way of commercializing North Slope gas.”

If the producers continue to say no to offers, “I think you’ve built your factual record that they really just don’t want to develop the gas: they want to warehouse it.”

Therriault asked if the producers can simply say “no, because we’re currently working on putting together a project that’s going to guarantee us, and you our partner,” a higher return.

Hosie said the producers can say that “and I think that would be a great thing to have them say, because if that’s true, that they are moving forward and are willing to build something” they would be meeting their obligation. It’s the sequential series of refusals that create a problem for the producers, “because that is proof that they’re warehousing,” not working with the state to find a way forward.

Remedies?

“I don’t think there would be an antitrust implication to them working together on a development project,” Hosie said. “I think they would be expected to do that because they would do it together.”

As far as the remedy, “what courts like to do is issue a conditional remedy.” He said he thought the state would probably ask the court to “order a development to go forward on a particular schedule and a consequence” and if the schedule was not met, the producers would lose the gas.

“So it’s a conditional forfeiture, where they have a chance to do what the court says is proper in terms of developing the project. And that’s fair. Because if they really truly think that North Slope gas is uneconomic, if they really aren’t going to develop it, shouldn’t they let it go so that you, the state of Alaska, can see if some other company might think about it?”

There is a cost to the state of delay, Hosie said, and “perhaps a benefit to them of delay.” The state and the producers may be at cross purposes “on this development issue which is why your rights under the implied covenant are so terribly important. It all cycles back to that.”

Rep. Beth Kerttula, D-Juneau, asked Hosie if an agreement with fellow companies not to develop isn’t closing down that market.

Hosie said he hasn’t looked at the antitrust issue here, but has handled antitrust cases and thinks the producers “would say we are in this deal together, there’s a unit agreement, we need to cooperate, we need to talk with one another about the economics.” He said he thought a court would find that acceptable.

Asked by Sen. Ben Stevens, R-Anchorage, about his involvement in the stranded gas negotiations, Hosie said he was not involved in the negotiations but because of the work he has done for the state he has been “extensively briefed” by both the Department of Law and the Department of Natural Resources on the proposals and the back and forth of the negotiations.

Therriault asked Hosie if there was an offer from a standalone gas pipeline — such as the port authority project or TransCanada — could the producers say they can’t see their way forward unless they know what the wellhead tax will be.

Hosie said the producers would have to persuade the state “that absent that concession and that prospective certainty, what would otherwise be an economic project is suddenly uneconomic.”

The taxes would have to be “the pivotal point.”

But, he said, he can’t see a court telling the producers they must go forward on a marginally economic project because the cost is so great. “If the project is marginally economic I can’t imagine a court saying you must go forward and risk 20 billion dollars.”

Things happen, such as the oil price crash in 1986. “Nobody thought that was going to happen.”

But it happened, he said: “… there’s always a risk if you’re talking about a sum this large… And so if fiscal certainty, if taxes, a guaranteed tax regime reaching forward to the future, becomes the pivotal point economically, then they can certainly ask for it and it’s in the state’s discretion” whether or not to negotiate.

State not in weak negotiating position

Cotham said that, based on case law and his 23 years’ experience as a lawyer in this field, he found five misconceptions in discussions about developing North Slope gas: that the oil companies own the North Slope gas; that they have complete legal control over if and when the gas is produced; that they can choose how much profit they want “and delay developing and marketing the North Slope gas until their profit goals through state concessions or otherwise are met;” that owning the leases gives the oil companies “a legal right to dictate the location, ownership and structure of the pipeline;” and that the state is in a weak position in negotiating on gas.

The producers’ leases, Cotham said, “give them the right to develop and market the gas,” but with corresponding responsibilities. “And if, in fact, those corresponding responsibilities are not met, it is my position that under the clear terms of the lease those leases can be absolutely cancelled, such that the state of Alaska becomes the owner of that gas if the oil companies refuse to adhere to their duties.”

The leases convey, he said, “an exclusive right to explore and produce,” but the producers don’t own the gas, and have specific contractual duties spelled out in their leases. “They must diligently develop and produce the gas.” And if they don’t meet the terms of the lease, “the lease is subject to being cancelled.”

In calculating profit from developing North Slope gas, Cotham said “very, very small changes have to happen at the North Slope” to begin selling gas down a pipeline, rather than re-injecting it.

The port authority “has offered to specifically build the treatment facility, to assume 100 percent of the risk along with the federal government loan guarantee” for the pipeline, so “the oil companies bear none of the risk of financing the pipeline.”

The port authority has estimated that the oil companies would “net a billion dollars a year even if the projections turned out to be far less than frankly everyone’s suggested they might be,” Cotham said.

Categories of budgets

The economic returns will vary among the discretionary projects, but Alaska “does not have to go out and compete with these other projects. Instead, the question is, are these commercial such that a reasonably prudent operator would develop them. And again, I think unquestionably that situation exists today.”

Just because the producers have leases, they do not have the right to dictate who owns the pipeline and where it goes, Cotham said: rather, they have “a duty to prudently develop and market this gas, independent of any other profit-making opportunities that they may have.”

If the companies refuse to sell the gas, that action could be construed as “monopoly leveraging” where monopoly power in one market is leveraged to gain an advantage in a related market.

Hosie disagreed with Cotham on this point, telling legislators that monopoly leveraging is not actionable in the 9th Circuit. Cotham disagreed with Hosie’s position on a remedy if the producers refuse to market or develop the gas. Cotham said that while conditional cancellation is a traditional remedy, he believes “based on the language that is listed here in the leases that an unconditional cancellation would be perfectly within the state’s right … It might require a judicial proceeding, but that is a power that the lease specifically affords the state.”

Cotham also said he believed that if the producers refuse to market the gas, “the damages for this could be enormous.”

And he said “anticompetitive refusal to deal would be actionable under the antitrust laws. And these laws provide mandatory present damages and injunctive relief.” Hosie disagreed on the antitrust issue: “I truly think it is not per se improper for the oil companies to say we don’t want to sell to the pipeline because we have our own plan going forward,” Hosie said.