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Vol. 9, No. 47 Week of November 21, 2004
Providing coverage of Alaska and northern Canada's oil and gas industry

Economist says auction off Alaska pipeline, facilities

Nobel Prize winning economist Vernon Smith proposes experimenting with auction model for North Slope access, letting the market set the price

Kristen Nelson

Petroleum News Editor-in-Chief

It’s probably not surprising that a Nobel Prize winning economist would look at Alaska North Slope facility and pipeline access issues from a different perspective, and pose some interesting questions.

Would an auction model for oil and gas facilities access and pricing be less acrimonious than what happens now? Could such a change be a smoother way to resolve changing facilities needs as fields age, and as new discoveries need to be brought on line? And would the way joint ventures are structured need to change to make that happen?

Vernon Smith, a Nobel Prize winner in economics and holder of the visiting Rasmuson Chair in Economics at the University of Alaska Anchorage, says experimental auctions could test alternatives for access to and pricing of oil and gas processing facilities and pipelines. Smith, a professor of economics and law at George Mason University in Virginia, shared the 2002 Nobel Prize in economics for establishing laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms.

Smith told the Alaska Support Industry Alliance Nov. 11 in Anchorage that at a UAA roundtable on oil and gas this summer he heard complaints from just about everyone about pricing and access for the trans-Alaska pipeline, which got him interested in “a possible alternative for structuring the access to and pricing of joint facilities that are used in either oil or gas development,” and in designing an experiment to test such an alternative.

The idea, he said, is to have the market set the price for facility access or expansion, rather than looking to historic costs, the model traditionally used by regulators. The historic-costs model works, he said, in a monopoly utility situation where the utility always recovers its costs because it sets the price.

But oil and gas prices are not set by the sellers but by the market.

Looking for the structural answer

“I think that it’s clear there are severe problems inherent in the use of the historical cost as the price to determine the price of access to regulated pipelines,” and those problems are the reason “the system has been very adversarial and costly,” Smith said. “ … When I think something is not working right, I look for what it is about the system that’s not making it work right, rather than finding out who’s to blame. There’s always plenty of blame to go around in these controversies,” he said. “But I think if you get the structure right, you have a much better chance of people pulling together and not only enhancing their own interests but the interests of everyone.”

The oil and gas industry is “highly dynamic, subject to rapid change, prices basically coming from world markets, and I see a basic incompatibility between that kind of an environment and any kind of a method that’s going to set prices based upon backward-looking historical costs,” Smith said.

An auction would let the market set prices for access. And how it works would evolve over time. “You start somewhere, and maybe you start doing experiments,” trying the ideas out on industry people: “Industry people can always tell you lots of things that are wrong about what you’re doing.” And then you go back to the drawing board.

Industry starts by exploring and making discoveries, Smith said, and those discoveries are the basis for capital investment in facilities and pipelines. New discoveries occur and more facilities are needed, or the pumping capacity of the pipeline needs to be increased, he said.

It’s hard for regulators to deal with the changes that occur over time, he said. The original companies may not continue to make discoveries comparable to their original ones, and new explorers make discoveries and need access to facilities. “And you need a mechanism whereby as older fields mature and new fields are discovered, the property rights can be transferred naturally from the old to the new owners.”

Smith said that “as an economist, I look at the oil and gas industry as highly dynamic, subject to rapid change, prices basically coming from world markets. And I see a basic incompatibility between that kind of an environment and any kind of a method that’s going to set prices based upon backward-looking historical costs.

“At each point in time … efficient facility utilization and investment must always reflect current and expected future revenues and costs. The system has got to look forward: that’s where all the action is, where the planning is, where the decisions have to be made. “And to me, the historical cost is irrelevant,” Smith said.

Historical cost base works for regulated monopoly utilities, he said, because they have no competition and set the price.

But the oil and gas industry does not set the price: its product goes into a world market, with market prices. “It’s from those prices that we find out what the value of the pipeline transportation (and) operating facilities” are, based on the market value of the hydrocarbon.

How to share the risk?

The existing regulatory system, “for independents, leads to high cost and interminable delay in gaining access,” Smith said. And it’s not much better for the original risk bearers.

“It’s heads I lose my investment and I have no one to share the losses with, or tails I win, but I have to share the gain with latecomers. That’s the implication of any kind of historical cost-based pricing, and to me it’s just not realistic,” he said.

Pipelines are built based on an expectation of market prices, and if the prices are lower than expected, the value of facilities is below what was paid for them, “And nobody’s going to want in at historical cost.”

If market prices are higher than expected, the value is more than what was paid, “because that risk … has been resolved, these things are valuable. Well of course latecomers are wanting in there at an historical cost…

“But you see,” Smith said, “that sets up a situation where everyone would aspire to be a latecomer, to take advantage of after-the-fact knowledge of whether the investment is a winner or a loser.”

Co-tenancy joint ventures a problem

One problem in dealing with changes comes, Smith said, from the nature of co-tenancy joint venture agreements, the basis for most facility ownership: The joint venture agreements create property rights that are a problem in changing situations.

“If any co-tenant wishes to sell some part of his capacity rights, his co-tenant partners must be offered the right of first refusal. So he’s not free, in the typical arrangement, to sell his share without getting approval from the others. Also, if anyone wants to expand capacity, this must be part of the joint venture agreement, so all the members of the group have to reach agreement on whether the capacity should be increased.

“Both of these rules I see as non-favorable to a flexible property-rights system that would be governed by markets,” Smith said, because they “provide too much potential for blocking change.”

The rules would need to be changed, Smith said. “Each co-tenant should be free to sell, lease or rent his capacity share to any co-tenant or any external party unconstrained by a right of first refusal.”

Transfers of rights could occur at periodic state-scheduled auctions, and a co-tenant or group of co-tenants or outside parties would be free to expand capacity.

Another function of the auction, Smith said, is to identify when additions are needed: “New capacity additions could be automatically triggered by the market whenever the transfer price at auction of existing capacity rises above the cost of making a capital addition.”

The experimental design

Smith said an experimental design for such an auction would include initial conditions that would specify incumbents, potential entrants, and periodic auctions. And you could vary the experiment to see if it works differently when you have just two or three incumbents, as opposed to five or six.

There would be an initial resource base shared by incumbents and existing facilities.

Over time, you might need to expand capacity with exploration success nearby, or build lines if discoveries are farther away.

“Over time … some of the reservoirs will start to deplete” and there would be an opportunity in the experiment for “people to trade, to back out wells when new people want to bring in new wells.”

The auctions would be combinational, he said, would use a computer to make sure no money is left on the table. “It looks at all the complex bids … and makes the allocation so as to maximize that surplus.”

In combinational auctions, Smith said, a bidder may want to acquire both operating and processing facilities (A and B), for example, and the bid would only be successful if both were acquired, since one by itself would not be useful.

Bids could also specify capacity in either of two processing facilities (A or B), where the bidder can use either option.

And the auction could also accept budget constraints, so that a bidder can bid on multiple options, not knowing which he will win, but stay within a budget.

Combine lease and capacity auctions

Smith said he thinks it would enhance the value of both facility access rights and exploration rights if they were combined in the same auction, so a bidder would simultaneously bid for exploration leases and for access to facilities.

If an existing capacity holder makes a discovery that exceeds his capacity, or if a new entrant makes a discovery, “the entity must acquire rights to separation and pipeline operations capacity.”

Smith said he seems to him that it would “enhance the value of both access rights and exploration leases” if they were auctioned simultaneously. “There’s a real advantage in auctioning things when everybody faces the same amount of uncertainty,” he said.

The idea of an experimental auction, he said, is to practice, and to find out, “by trial and error, what real people do.”

And while an initial experimental auction could keep things simple, and focus on “elements that we would need to learn the most about,” over time, Smith said, the components of the auction could be as sophisticated as desired. “You could have a full-blown engineering model of the process for separating oil, gas and water from the wells, recycling the gas and water and sending the oil down the pipeline.”

Smith estimates four months to develop an experimental design for a gas-only auction, two months for testing and modification including experiments with experienced subjects and two months of testing, modification and redesign.

A fourth stage would be a joint oil and gas experimental auction design.

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