The Regulatory Commission of Alaska has rejected the new contract between Marathon and Enstar for the supply of natural gas from the Cook Inlet basin.
“Enstar did not meet its burden of demonstrating that gas supplies pledged under the contract are reliable and that the price is reasonable,” the commission said in a Sept. 28 order that represented a majority decision by the commissioners (commissioners Dave Harbour and Mark Johnson dissented).
RCA is allowing the supply of gas under the new contract, but only provided that the new contract results in a decrease in the average cost of gas.
“We note, however, that Enstar’s tariff allows it to add base supply contracts having the effect of decreasing the cost of system gas without our approval,” the commission said. “We allow Enstar to add TA139-4 (the tariff advice letter that included the new contract) to its base supply under those limited conditions.”
Tony Izzo, then president of Enstar, announced the new contract in November 2005, saying that the contract should ensure that Enstar obtains adequate gas supplies through to 2016.
“The good news is that we’ve finally been able to negotiate supply for that period of serious uncertainty between now and … when we might see North Slope gas,” Izzo said.
The new contract specified volumes of natural gas that Marathon would supply to Enstar from 2009 onwards from known Cook Inlet gas reserves that Marathon owns. The volumes increased until 2016 and declined thereafter. Without additional gas sources, volumes would decline to zero at some time after 2018.
And, according to Enstar’s contract approval request to RCA, “Marathon was the only gas producer that offered to meet Enstar’s unmet requirements beginning in 2009 and continuing for a reasonable period.”
Henry Hub pricing
Following precedents set by earlier Enstar contracts with Unocal and NorthStar, the gas pricing would be indexed to the Henry Hub gas market in the Lower 48. Enstar and Marathon said that Lower 48 indexed prices are needed to encourage new gas exploration and development in the Cook Inlet.
Under the new Marathon contract, the price that Enstar would pay for the gas would be based on a 12-month trailing average of Henry Hub futures, with discounts if that index price climbs above $6 per thousand cubic feet. The price would have a floor of $4.25 per mcf and a cap of $15 per mcf. There would be an additional charge for peak gas volumes supplied at volume rates in excess of contracted peak volumes.
The contract specified a fixed transportation rate of 25 cents per mcf for all gas supplied, regardless of the source of the gas. The contract also required Enstar to reimburse Marathon for the production taxes that Marathon would incur on gas supplied under the contract, thus eliminating tax rate change risks from the production economics. The transportation and production tax charges would be additional to the Henry Hub indexed price.
Also under the terms of the contract Marathon would have an unlimited ability to meet its supply commitments by buying and reselling gas from third-party producers.
But the potential hike in Enstar’s gas prices as a result of the new contract triggered considerable controversy and discussion. In January RCA decided to investigate the new contract and that investigation culminated in a mammoth 12-day public hearing in July and August.
Enstar: supply security top priority
“A secure supply of gas that is reliably available when our customers most need it is Enstar’s absolute top priority,” Izzo said in prefiled testimony for the hearing.
And at the hearing Enstar defended the pricing formula in the new contract, saying that Henry Hub is a dominant market reference and that the commission had previously indicated that contracts with trailing averages of Henry Hub represent fair prices. The company said that the use of a 12-month trailing average would buffer price changes in the Unocal contract, which uses a 36-month trailing average. The 12-month averaging period would also make the gas price market responsive within the period of the new contract, the company said.
Enstar also said that the use of a fixed transportation fee would reduce risks arising from the new regulation of most Cook Inlet pipelines and that the use of actual pipeline tariffs would be unworkable because Marathon gas supplies would be delivered intermingled under two different supply contracts.
The company also pointed out that strong seasonal swings in gas demand and the need to accommodate extreme peaks in that demand impact gas pricing, because swings in gas supply to meet varying demand represent a cost to the gas producer and a value to the gas purchaser.
Enstar said that the contract provision requiring Enstar to reimburse Marathon for production taxes followed a precedent set by identical provisions in the Unocal and NorthStar contracts. And Marathon’s unlimited ability to purchase gas for resale to Enstar reflected the need for flexibility in gas supplies, perhaps with the use of gas storage, during the life of a relatively short-term contract.
Marathon said that it was the only gas producer that offered to meet Enstar’s needs; that it had invested significant capital in proving and developing its gas reserves to provide a long-term secure supply for Enstar; and that it had made significant concessions to benefit Enstar’s customers regarding the pricing of the gas and other key terms. Bruce Henning, an expert witness for Marathon, testified that the contract had a very high likelihood of reducing Enstar’s weighted average cost of gas.
Price concerns
The attorney general for the State of Alaska raised numerous concerns about the proposed contract and especially questioned whether the pricing was just and reasonable. The attorney general questioned the use of the Henry Hub price index. He also questioned whether the use of a 12-month trailing average price might prove unacceptably volatile, and whether the price floor and cap were reasonable.
Tesoro, the operator of the oil refinery at Nikiski on the Kenai Peninsula, also objected to the price levels in the new contract.
“Five years ago Enstar’s ratepayers paid the lowest price for gas in the western United States and Canada. Five years from now if the commission adopts the Henry Hub index Enstar’s ratepayers will pay the highest price for gas in the western United States and Canada,” said Robin Brena, counsel for Tesoro, during the hearing. “… Why should Enstar’s ratepayers pay Marathon a windfall profit to blow down proven reserves?”
Tesoro uses 4.5 million cubic feet per day of Cook Inlet natural gas at its Kenai Peninsula refinery, Brena said. A $1 per thousand cubic feet increase in the price of gas results in $5 million per year off the Tesoro refinery’s bottom line, he said.
Tesoro said that the Henry Hub price bears no logical relationship to the price of Cook Inlet natural gas and that the absence of any exploration obligation in the new contract defeated the purpose of the Henry Hub linkage (the Unocal and NorthStar contracts that use the Henry Hub price index include exploration obligations). Tesoro also complained that the premium prices for peak gas supply were, in effect, already built into Henry Hub pricing. The company also expressed concern that, with unlimited ability to resell third party gas under the contract, Marathon would be put in the position of a gas broker, able to arbitrage gas that it purchases from others.
Several other companies, organizations and private individuals complained about the new contract. These complaints mainly focused on concerns about the price levels and the potential for Marathon to corner the Cook Inlet gas market.
RCA: balance reliability with price
In its review of testimony and comments on the new contract, RCA took issue with Enstar’s focus on the security of gas supplies as the main issue for its customers. Instead, the commission intimated a standard of review that sought a balance between the reliability of gas supplies and reasonable gas pricing.
And on both of those criteria the commission found fault with the contract.
The commission commented that a clause in the new contract enabling Marathon’s previous commitments to other gas purchasers to take precedence over the company’s commitments in the new contract raised questions about the company’s ability to meet Enstar’s supply needs.
“During the hearing we became aware that Enstar had not fully evaluated the effect of section 2.7.4 (the contract section dealing with who has precedence to buy gas from Marathon) on its committed supplies from Marathon,” the commission said.
And the commission lambasted the use of a Henry Hub price index, saying that responsibility for paying gas prices that encourage future gas exploration and production should not reside exclusively with gas ratepayers. Ratepayers should pay “the going price in the regional market from which they buy. … They should not be required to pay a premium to achieve general economic goals (except under limited circumstances),” the commission said.
The commission said that, if implemented today, the new contract would invoke a gas price of $7.50 plus production taxes per mcf, compared with Enstar’s current weighted average cost of $5.
Failed economic experiment
The exploratory activity that the Henry Hub pricing in the Unocal and NorthStar contract was supposed to encourage has not materialized, the commission said.
“Despite Enstar’s ratepayers funding millions of dollars in an ‘exploration and development’ incentive plan, Cook Inlet reserves have declined. … We must reluctantly conclude … that the now five-year-old economic experiment promoted by Enstar in both the Unocal and NorthStar contracts has not produced noticeable results,” the commission said, adding that no party had presented evidence that Henry Hub pricing had resulted in more reserves for Enstar or how much price incentive the ratepayers might need to pay to increase the Cook Inlet reserves.
In fact, the commission said, the only driver that spurs substantial increases in Cook Inlet reserves seems to be the export of LNG to Japan. The commission said that Cook Inlet reserves additions were only reported in three of the years between 1977 and 2004; each of those reserve additions coincided with requests to the U.S. Department of Energy for extensions to the LNG export license.
The commission also said that it was unreasonable to layer a transportation fee and reimbursed production taxes on top of the Henry Hub indexed price. In general, gas sellers pay transportation costs to the hub at which the gas is priced, while buyers pay transportation costs away from the hub; production taxes are a normal part of gas production costs, the commission said.
And, for all of the reasons that it put forward, the commission concluded that the new contract did not meet its standard of review.
