The Alaska Legislature served notice in late April that it believes producers have a duty to develop and market North Slope gas if such a project is reasonably profitable, introducing legislation that defines how the commissioner of Natural Resources would determine such profitability and setting a seven-year clock for production to begin after a determination was made.
Industry reacted strongly, telling legislators the bill proposes an unconstitutional change in existing contracts, reminding them that negotiations are under way with the administration for a North Slope gas project and demanding to know, if a project was determined reasonably profitable by the commissioner, who would reimburse producers for their investment if the state was wrong and a multi-billion-dollar project proved uneconomic.
On April 20 attorney Spencer Hosie told the Legislative Budget and Audit and Senate Resources committees that lessees have a duty to develop and market the state’s oil and gas under the terms of their oil and gas leases. (See articles in April 24 issue of Petroleum News and on page 5 of this issue.) On April 28 the House amended an exploration incentive bill on the floor to give the commissioner of the Department of Natural Resources authority to determine when it is reasonably profitable to develop oil and gas.
Senate Resources took testimony on the amended bill May 2, discussed it again and held it May 4, effectively tabling the bill, since Committee Chairman Tom Wagoner, R-Kenai, said the May 4 meeting was expected to be the committee’s last for the year.
What if the numbers are wrong?
If the administration successfully negotiates a fiscal contract under Alaska’s Stranded Gas Development Act the Legislature will have to approve the contract. Legislative Budget and Audit, a joint committee of the House and Senate, held extensive hearings beginning last year on a variety of issues around commercializing North Slope gas.
Rep. Ralph Samuels, R-Anchorage, vice chair of Budget and Audit, told Senate Resources May 4 that industry has “an extremely valid point” about the possibility that the state would get the numbers wrong and require a project that proved uneconomic.
“Who would pay if our numbers were wrong? And philosophically speaking, the point of the amendment, and to get the debate going, is the fact that it cuts both ways. Who is going to pay if the numbers are right and the project is not developed?” If the gas isn’t developed, Samuels said, it means the loss of jobs for Alaskans and revenues for the state.
“They’re both extremely valid points and the point of the amendment was to make sure that both points are up for debate … before we adjourn.” The goal was “to make sure we had some hearings on this subject” so the Hosie testimony is not just left hanging until fall, when Samuels said he hopes the Legislature will be back to vote on a fiscal contract negotiated under the stranded gas act.
Samuels said the Legislature, and the governor, “will never have a bigger choice to make than this gas pipeline… We’re fortunate to be serving at this time, but along with that honor of serving right now comes a responsibility to know everything that you can about every possible aspect of this project — duties, rights and responsibilities, both of the industry and of the state.
“If we’re scared to discuss it, then I think that come fall it’s going to be problematic, and that was the point behind amendment No. 1.”
Incentives moving separately
Wagoner reminded the committee that the amended bill, House Bill 71, was originally the Alaska Peninsula lease sale exploration incentive credit bill and had been expanded to include the Nenana basin, Healy, Red Dog and Cook Inlet.
The exploration incentives in the original bill were moved out of Senate Resources May 4 as part of a committee substitute for Senate Bill 286. House Bill 297 also moved out of the House Special Committee on Oil and Gas May 4, as what Chairman Vic Kohring, R-Wasilla, described as a back-up measure to ensure the incentives bill, proposed by Gov. Frank Murkowski in support of the upcoming Alaska Peninsula oil and gas lease sale, gets through the Legislature this session.
The bill changes the incentive requirements for Cook Inlet. The date by which work must be completed is extended to 2010 for areas south of the Brooks Range, allowing opportunity for the incentives to be used by explorers who acquire leases at the Alaska Peninsula sale scheduled for this fall.
Amendment: definitions, determination
The amendment language says its provisions “clarify and interpret the obligations of an oil and gas lessee or unit operator where an explicit or implied term of a state oil and gas lease or unit agreement requires the development, production, processing, or marketing of gas meeting economic standards such as ‘reasonable profit,’ ‘economically recoverable,’ ‘reasonable development as the facts may justify,’ ‘reasonable diligence,’ ‘covenant to develop as a reasonably prudent operator in a reasonably prudent manner,’ ‘good and diligent oil and gas production practices,’ ‘economically feasible,’ or ‘having due regard for the interests of lessor as well as the interests of lessee.’”
The commissioner of the Alaska Department of Natural Resources would determine whether the estimated revenue from the project, “based on the department’s mean gas price forecast for that project, minus the currently estimated new costs of that project, appears sufficient to allow for a rate of return on new capital invested” at the rate of return allowed by the Federal Energy Regulatory Commission or the Regulatory Commission of Alaska for portions of the project with regulated tariffs. For portions of the project not subject to tariff regulation, the allowed rate of return would be “the most recent 10-year simple average of overall company returns on capital employed for a sample group of oil and gas companies” which may include the four largest international oil and gas companies and the parent companies of the largest oil and gas companies operating in Alaska.
A determination by the commissioner that “development, production, processing, or marketing of gas is required from a lease or unit area” triggers a seven-year clock, which, if not met, results in remedies for failure provided in the lease, unit or other document, or as provided by law.
A billion dollars a year
Bonnie Robson, an oil and gas attorney who is a consultant to Legislative Budget and Audit and a former deputy director of the Alaska Division of Oil and Gas, told the committee May 2 that the bill “does not resolve any dispute the lessees may raise over whether the obligation to develop and market exists, but simply defines ‘reasonably profitable’ and related terms.” The definitions, she said, would only be used if the obligation exists.
The amended bill also sets a seven-year clock for getting gas to market. At current gas prices, she said, it costs the state “substantially more than $1 billion per year” for every year the gas isn’t sold.
Robson said the bill uses “average prices and average returns” for a determination of profitability, defining an undefined term in leases and unit agreements, “rather than leaving that definition to other branches of government.” The administration already has this tool at its disposal, she said: the bill gives guidance on using that tool. “The seven-year clock, when and if used, is intended to assure not just the promise of a pipeline or an option on changes to tax and royalties terms in the event a pipeline is built, but the pipeline itself, at the earliest reasonable date…”
The 10-year average return on capital employed for ExxonMobil, Royal Dutch Shell, BP, ChevronTexaco and ConocoPhillips is 14 percent, according to Value Line data in a spreadsheet Robson included in her testimony. The 14 percent would be used for non-tariff regulated operations, and the FERC-regulated rate for pipeline operations.
But, she said, a 14 percent return on capital “does not mean a 14 percent return on shareholders’ equity” unless projects are financed with 100 percent equity. Debt financing is cheaper than equity financing, currently 6 percent so at 50 percent equity and 50 percent debt financing the return on equity would be 22 percent, she said. But if the federal loan guarantee, up to 80 percent or $18 billion were used, then at 80 percent debt and 20 percent equity the return would be 46 percent.
Robson argued “the federal government has significantly reduced the risks and costs” with its loan guarantee, seven-year accelerated depreciation for the pipeline and tax credits for the gas treatment plant needed for the project at Prudhoe Bay. And there are, she said, no exploration risks since most of this gas will come from Prudhoe Bay gas.
Some estimates available from gas owners
The majority Prudhoe Bay owners (now BP, ConocoPhillips and ExxonMobil) spent $125 million studying a gas pipeline project, Robson said, and released an estimate of an average toll of $2.39 per thousand cubic feet from the North Slope to Chicago, including a new gas treatment plant and extraction facilities for natural gas liquids. They said the figures were plus or minus 20 percent, yielding a range of $1.90 per mcf to $2.85 per mcf. Gas is sold in British thermal units, a measure of heating value, not in thousand cubic feet, and Prudhoe Bay and Point Thomson gas contains liquids and has more than 1,000 Btu per cubic feet. At 1,070 Btu per cubic foot the toll range drops to $1.78-$2.55 per million Btu and as the Btu measure increases, the toll drops.
Robson noted these calculations were made before tax credits for the gas treatment plant, federal loan guarantees and accelerated depreciation became available, and also assume new pipe needs to be built all the way to Chicago. It is more probable, she said, that new pipe will only be needed as far as Alberta, and that existing pipelines will be used to take the gas to Lower 48 markets.
“In fairness, we mention that these cost savings undoubtedly are offset to some degree by increased steel prices,” Robson said.
Prices are expected to average in excess of $4.50 per million Btu against costs of less than $3 per million Btu, with the difference between price and cost “indicative of wellhead value.” This is “very rough math,” she said: “The real math we must keep confidential, but we are not here to mislead you today.”
The leases already vest control in the Department of Natural Resources on when gas will be produced, she said. “The lessees may not appreciate that DNR, rather than the lessees or the court system, is vested with primary responsibility for decision making on this issue, but they granted DNR that authority decades ago when they signed the unit agreements. This legislation does nothing to alter the original bargain over the party vested with control.”
Robson: legislation does not encourage litigation
The proposed legislation does not encourage litigation, she said. “First, it lets the administration determine whether it thinks there is, in fact, a preexisting duty under the state’s oil and gas leases and unit agreements for the lessees to develop and market gas when reasonably profitable. If the administration concludes such a duty exists, it can choose to enforce the duty — or not — now or later.”
If negotiations under the stranded gas act reach an impasse, “the administration may choose to enforce the duty, subject, of course, to finding that production and marketing of the lessees’ gas would return at least a reasonable profit to the lessees.”
Robson said the Department of Natural Resources would probably make such a determination in conjunction with reviewing the next plan of production for Prudhoe Bay, and could condition approval of a plan on a firm commitment to develop and market a minimum quantity of gas by a set date.
If there is litigation, Robson said “the lessees have suggested that they may claim that the legislation is unconstitutional when applied to Prudhoe Bay and Point Thomson because it changes preexisting contract terms.” She said the legislation would not change preexisting contract terms, but “simply defines in a reasonable way terms that are currently undefined.” DNR already has the right to order gas development, and litigation would be “no more likely because ‘reasonably profitable’ has been defined as a minimum of a 14 percent return on capital than because some other standard was used by DNR in determining what constitutes a ‘reasonable profit.’”
Robson said she could not guarantee that the Alaska Supreme Court would find the legislation constitutional but said the legislation can be applied in a constitutional manner, “and, in any case, it is a vehicle for sharing with the administration the Legislature’s thoughts on what constitutes ‘reasonably profitable’ and the time frame within which a gas pipeline should be built.”
The seven-year clock in the legislation runs from the commissioner’s decision, whether or not a court strikes down the definition in the legislation and imposes some other definition. “Hence, lessees are encouraged to spend their time after issuance of DNR’s determination working on a gas pipeline project rather than litigating.”
Organizations object to process, content
The amendment received no support from organizations testifying.
Tadd Owens, executive director of the Resource Development Council, told the committee May 2 that his organization is concerned about the process, with the bill “radically altered on the House floor.” It was, he said, a “major policy decision … without the benefit of a single committee hearing.”
Owens said “RDC fears that House Bill 71 may change the terms of existing state oil and gas leases and unit agreements” and “is likely to have a detrimental effect on the state’s ongoing negotiations” under the stranded act because if lessees question the constitutionality of the bill or disagree “with the state’s interpretation of reasonable profitability or other terms that a costly time-consuming legal challenge may evolve,” a situation which would not move Alaska closer to seeing North Slope gas marketed.
Owens said the bill “sends a troubling message to existing and prospective investors looking to do business in Alaska’s oil patch” and urged the committee to hold the bill for more thorough analysis.
Larry Houle, general manager of the Alaska Support Industry Alliance said his organization sees “several problems with the amendment’s language” and characterized it as “totally inconsistent with and contrary to any free market principles and our free enterprise system.” Houle said the Alliance would like the committee to examine whether it is a “proper role of government to dictate to industry when a market exists” and what a “reasonable rate of return should be.”
The Alliance knows of “no other state in the union where the state government has this latitude,” he said.
Houle said the Alliance is concerned about “the type of message that this sends to investment bankers and the financial institutions that underwrite projects in Alaska.” The Alliance fears the amendment “might further erode Alaska’s competitive position as an oil and gas province” and “sends the wrong message to Alaska’s largest investors and if passed will most certainly cost Alaskan families paychecks and oil patch jobs,” Houle said.
Judy Brady, executive director of the Alaska Oil and Gas Association, said the timing of the amendment, coming in the middle of negotiations over a huge gas pipeline project, is not good: The world is watching, she said: comments by the governor and legislators are carried by international financial insider reports. “And the concern level is higher than sometimes we hear it here about the financing,” she said.
In prepared comments AOGA said it was concerned with the addition of the amendment on the floor of the House without committee work and with wording in the bill prescribing what oil and gas leases mean and “how they are to be interpreted and applied,” which AOGA characterized as an unconstitutional attempt “to usurp the function and authority of the Judicial Branch. The interpretation in the bill, AOGA said, “would materially alter the terms and conditions” of the oil and gas leases, each of which “is a contract” between the state and the lessee, the terms of which “cannot be altered by either party unilaterally.” And, if the Legislature can rewrite the terms of oil and gas leases, “it can be done for any other kind of state contract as well.”
BP: ‘deeply disappointed’
BP is no happier with the amendment.
Ken Konrad, BP Exploration (Alaska)’s senior vice president responsible for BP’s on-going ANS gas commercialization efforts, told the committee BP is “deeply disappointed in both the process and the content” of the amendment to HB 71.
He described the amendment as “a very bad idea” slipped into legislation by advisors “under cover of darkness.”
Konrad said the amendment was an attempt “to alter existing contracts entered between the state and leaseholders” which “would make government the all-powerful decision maker regarding project development, determining what level of profitability is acceptable regardless of the risks involved.” He called the amendment “inconsistent with America’s market-based society” and at one point asked the committee: “Are we still in America?”
The amendment “suggests that government, and government alone, should be able to force investors into a multi-billion-dollar project that is by all accounts a project with significant risk. Of course the amendment does not suggest compensating investors when the government assumptions and its all-knowing economic model are wrong.”
Konrad said that under the amendment the commissioner of the Department of Natural Resources “would use a state-developed economic model to determine whether a private company must invest in a project and when that investment must occur.”
The proposed historical rate of return benchmark “is a fundamentally flawed approach that fails to recognize unique risk-return characteristics in every individual project,” Konrad said.
BP: in conflict with constitutional principles
Konrad said “no other state has anything remotely similar to what’s contained in this amendment.” The proposals in the amendment are “in direct conflict with basic state and federal constitutional principles,” violating “basic state and federal constitutional prohibitions against legislative impairment of contacts.”
He said the amendment was a “legislative effort to alter contracts after the fact… (and) also violates fundamental government separation of power principles by infringing on the role of the courts in adjudicating contracts.”
Predicting a cascade of court challenges, Konrad said someone had suggested renaming the bill “the lifetime employment for lawyers act.” And, he said, the amendment “has implications for all leases … (and) casts doubt on the sanctity of any contract at any time.”
Konrad said BP has fulfilled the obligations of its lease contracts, and has “always, by definition, agreed with the AOGCC and the Alaska Department of Natural Resources in terms of how those leases have been developed and continue to be developed.”
There are contracts in place, he said: “We have mutually agreed over 25-30 years that those contracts are being met. The commissioner of Natural Resources currently has the ability to make his own judgments around that; the courts will adjudicate whether — whose opinion around the contract may be right or wrong … if there ever is a conflict we would see it as the role of the judiciary to settle that dispute, not the role of the Legislature to presuppose that a dispute’s actually going to occur, or to create the probability of a dispute.”
Patrick Coughlin, senior counsel for BP, and like Robson a former deputy director of the Alaska Division of Oil and Gas, said the commissioner of Natural Resources has “certain authority” under the lease, but if there is a dispute “about what a term means, then both sides get the opportunity to go to court” and argue the meaning of reasonably profitable. Under the proposed amendment the Legislature sets standards and the commissioner applies them and comes “to a conclusion whether or not the oil and gas companies have to build a pipeline or give up the leases. And that fundamentally changes the balance that was struck in this agreement, which is that where you have a dispute you go to court and let the court decide.”
“Well, what you’re saying is we’re going to go to court either way anyway,” Wagoner said.
“No, we’re going to build a gas pipeline,” Konrad responded.
ConocoPhillips: interpretation a judicial function
Joe Farrell, managing attorney for ConocoPhillips Alaska, told the committee that “interpretation of lease obligations is a judicial function,” and is “not a proper subject for legislative action.” Just this year, he said, the Alaska Supreme Court reaffirmed that oil and gas leases are contracts, “which become fixed when originally signed.” Farrell said the contracts have been defined in the Alaskan courts as take-it-or-leave-it contracts.
He said contracts “contain rights and obligations on each of the parties,” and in interpreting those rights and obligations, “initially the parties will discuss those things, just as they would in any other contractual relationship.”
If the parties cannot reach agreement, “then the proper forum” to decide on an interpretation would be the courts. “And so there would be an exchange of information and the precise obligations that are imposed under the contracts would be analyzed in the courts and ultimately the courts would make a decision as to what the proper obligations are.”
He said both state and federal constitutions “prohibit the state from passing laws impairing the obligations of contracts.”
Neither lease terms nor oil and gas law support the content of the changes, he said, which propose “that lessees must build a pipeline project if the state’s estimate of the rate of return for the pipeline project, based upon the state’s modeling of future costs, production and prices, exceeds the historical return on capital employed, the ROCE, achieved by the lessees on their worldwide activities.”
He said no lease term or case identified, or that ConocoPhillips has been able to find, “supports this astounding proposition.”
No cases have been shown, he said, “where this kind of test was applied to determine whether a lessee could be forced into risking its money in an investment for the benefit of the lessor,” much less any cases where such a “mechanical” approach was used to determine “when investment duties are created.”
Farrell said there is “no mathematical formula or model under the lease or general oil and gas law that determines when a duty arises: it’s always a fact-specific analysis and depends on all pertinent factors including risk.” It is critical that the Legislature understand that decisions to develop or construct projects cannot be determined by reference to a single financial parameter…” Decisions to invest in a major project “must address a wide variety of risks and uncertainties, including the potential for low prices, capital cost overruns, regulatory and permitting problems and schedule delay,” Farrell said. “No prudent operator looks at a single financial parameter… And as the cost and scale of the project increases, the risk associated increases and so does the rigor to address uncertainties, which take higher priority.”
Unocal: amendment applies to all leases
Kevin Tabler, Unocal’s land and government affairs manager in Alaska, said that while the amendment appears to be targeting certain leases, in fact “this amendment applies to all leases statewide” and also appears to include oil. He said the language leads Unocal to believe that the Department of Natural Resources “would have the unlimited authority to create their own standards … We question the state’s authority to unilaterally amend the contractual obligations within the existing leases.”
Tabler said the producers would take all the risk under HB 71, but based on someone else’s forecast. “What happens when the state’s forecast is wrong? Who assumes the liability then? Will the state offer up its royalty share to cover the downside of a faulty analysis?”
Asked by Sen. Kim Elton, D-Juneau, if forecast concern could be mitigated if there were an arbitration process for a forecast, Tabler said “no two companies risk things or model things the same. And we all use different forecasts in our modeling, our economic models.”
He said he thought shareholders would “take exception” to a requirement that the state dictate parameters for modeling.
Elton said it appeared that “any one individual producer can in effect make a ‘no’ decision based on something that they keep internal.”
“That’s correct,” Tabler said.
Elton said that seemed “fundamentally unfair to the resource owner.”
Tabler said altering lease contract terms after the fact “seems fundamentally unfair.”
The amendments, he said, would change a lease which requires consent of the lessee, dictating criteria by which investments are made: “The state is not making the investment; the lessee is taking all the risk…”
Robson: No one objected to 7 years
Senate Resources closed public testimony May 2, but had Bonnie Robson back May 4 to talk about the May 2 testimony.
Robson said one of the points she noted about HB 71 testimony was what the committee did not hear: when Spencer Hosie testified in April on behalf of the administration, he said “that there was in oil and gas leases an obligation to develop and market oil and gas when reasonably profitable to do so.”
When the lessees testified May 2, “I did not hear anyone deny that such a duty exists … Nobody denied that the obligation was there. Nobody suggested that lessees can warehouse leases long term without having an obligation to develop and market.” While the lessees “did dispute how you’d go about enforcing that duty and what would be the standard for measuring reasonable profits … nobody disputed that the obligation was there.”
The other thing no one disputed, Robson said, was that seven years was a reasonable time to get gas to market, once the commissioner made a determination that the project was reasonably profitable.
Leases: not fixed in stone
Robson also addressed several concerns about leases raised by lessees and committee members in the May 2 hearing.
Said the state’s oil and gas leases were characterized at the hearing as take-it-or-leave-it, and were also called contracts of adhesion, a contract where “you didn’t have any choice” where there was “no balance of power.” Robson said the leases are between the state and the largest international petroleum companies, “so there isn’t the disequilibrium in bargaining power” that would characterize an adhesion contract.
As for the contention that the state oil and gas leases are take-it-or-leave-it, Robson said the state’s oil and gas lease form used to be in regulations, which meant there were public hearings, the companies had an opportunity to comment and the form was developed through a public process. And lease contracts are awarded in competitive bidding, so there is a variable, price, “and so I don’t think that this body wants to think of every competitive bid in the oil and gas industry and in the United States of America as a contract of adhesion or a take-it-or-leave-it contract.”
As for the content of the leases, Robson said it is “not correct” to say that the terms of the lease cannot be changed unilaterally.
One section of the Alaska lease, paragraph 20 on diligence, says the lessee is to “conform to regulations of lessor related to the matters covered by this paragraph in effect on the effective date hereof or hereinafter in effect if not inconsistent with any specific provision of this lease.” Robson said that elsewhere in the lease there is a provision that only regulations in effect when the lease is issued will govern operations under the lease, “but this specific paragraph with regard to diligence and the obligation to diligently produce oil and gas allows the lessor to proceed to adopt regulations thereafter covering this subject matter, regulations such as how you define reasonable profitability.”
As for unit agreements, those are the result of extensive negotiation, she said, with reams of paper from those negotiations in the state’s archives. The unit agreements allow the Department of Natural Resources to modify the rate of production from unit areas from time to time.
Alternatives for production
The committee may have been left with the impression that if the lessees did not comply with a determination that it was reasonably profitable to develop and market North Slope gas, that they would lose their interest in Prudhoe Bay.
Robson said the lessees could meet an obligation to develop and market by selling gas in the field and allowing someone else to build all of the facilities. “So if there is an offer to purchase gas at Prudhoe Bay and Point Thomson and that offer includes a reasonable profit to the lessees,” that would be “a low-risk” option for meeting the obligation, “particularly at Prudhoe Bay where they’re producing over 8 bcf a day right now and paying to put it back in the ground.”
Another option would be if someone else builds the pipeline: “the lessees could ship their gas on the pipeline and then they would be in a position to capture the high side when gas prices go high,” although they would have the obligation to pay for transportation.
And the lessees could build their own gas treatment plant and pipeline.
If the lessees turned down offers to sell the gas, to ship on an independent line and did not built their own line after a determination was made that such a project would be reasonably profitable, they would not be in compliance with their leases.
They might be liable to the state of Alaska “for royalties as if they had developed and marketed their gas,” or the gas could be severed from the leases at Prudhoe Bay, and the gas returned to the state.
Point Thomson is different, Robson said, with some leases more than 40 years old and no development. If the lessees turned down opportunities to sell or ship gas from Point Thomson, and didn’t market the gas themselves, “it may be appropriate for the state to seek the remedy of return of those leases” so that the leases could be re-let to someone who would get the gas to market.
Profitability standard: who decides?
Robson said she would have some concerns about the proposed standard of profitability, “but for some information that unfortunately I’m not in a position to share with you today because of the confidentiality requirements.”
She said there were suggestions that the free market should set the level of profitability. “That is that basically you should leave it to the lessees to decide” what rate of return is appropriate for development. “That means in effect there is no duty to develop and market when reasonably profitable. If you leave a lessee’s obligations to the lessee to decide and enforce it is effectively no obligation at all.”
The lessees also argued that the courts, not the administration, should determine when the gas should be developed.
There is a reason why the lessees prefer the court system to make the initial determination, she said.
It forces the state to be the one to file suit “and it is not easy or undertaken lightly in this state for the administration to sue big oil.”
Secondly, if the court makes the initial determination, then the Department of Natural Resources doesn’t, and “if there’s no DNR decision preceding going to court, then there is no deference afforded the DNR decision.”
Also, using the court for the preliminary decision “may provide an opportunity for lessees to withhold information until such time as you get into court.”
