Oil companies have a duty to develop hydrocarbons under their state leases, Alaska legislators were told April 20, and a development project doesn’t have to be the most profitable project a company has in its portfolio — just “reasonably profitable.”
In other words, Alaska North Slope gas doesn’t have to compete with other projects leaseholders have available to them around the world.
Spencer Hosie, with San Francisco-based Hosie Frost Large & McArthur, outside counsel to Alaska’s Department of Law, told a joint meeting of the Legislative Budget and Audit and Senate Resources committees that his firm was asked to look at two questions: “Is there a duty under Alaska law to market or to develop the stranded gas? And second, if there is such a duty, what might that mean?”
The answer to the first question, Hosie said, is unequivocal: “There is a duty under Alaska law to market hydrocarbons and to develop hydrocarbons.” That isn’t even a controversial statement, he said.
That duty relates to the bargain struck under the state’s original leasing form. The same, he said, is true under any lease in this country: the state contributes the land, the prospect, and the oil companies “promise to use their expertise to produce the hydrocarbons and to market the hydrocarbons.”
Production isn’t the end of the duty, Hosie said: oil and gas companies also have marketing expertise, and are obligated under the state lease to both develop and market the hydrocarbons.
“And as a consequence of those commitments, they got the lion’s share of the value of the hydrocarbons produced,” 87.5 percent, with the state getting only 12.5 percent under the original leases.
The leases create a relationship between the state, as royalty owner, and the oil companies as producers. The oil companies do not have a fiduciary relationship to the state; instead the courts have called the relationship one of “mutual benefit,” Hosie said. “What that means is that these oil companies cannot make decisions in their unilateral best interest without due regard to the interests of the royalty owner, the state of Alaska. They don’t have to treat the state any better than they treat themselves, but they can never treat the state worse.”
Company, royalty owner economic interests may diverge
Problems arise in oil and gas law when the economic interests of the oil companies “diverge from the economic interests of the royalty owner,” Hosie said, especially in cases of “additional or further development.”
Exxon, for example, may wish to put its development dollars into projects abroad, he said, “and it may wish to do that for the most rational reason possible: those projects promise the highest rate of return, the biggest bang for its buck.”
But Exxon acting for its own self-interest “does nothing for the state of Alaska.” The state receives royalties from its hydrocarbons only when they are produced. In situations where additional development is at issue, Hosie said, the interests of oil companies and a royalty owner diverge.
“What might be in their economic and rational best interest, writ on an international stage, might not be in the royalty owner’s best interest, which is ‘we care about what happens here, not what happens in Kazakhstan.’”
Implied covenants are the way the law addresses this type of conflict, he said.
In this case these are an implied covenant to market and an implied covenant to develop. The term implied is somewhat of a misnomer, Hosie said. The covenants are “implied because they’re not explicitly in the text of the lease, but they’re as real as though they were typewritten right in there. These are real, concrete obligations.”
This issue has already been litigated in Alaska, he said, in the context of the Amerada Hess case — the Alaska North Slope royalty case — when the state asked for a ruling that the producers had a fiduciary relationship to the state. The court said the relationship is not fiduciary, but is one of mutual trust, a cooperative venture, and ruled that under Alaska law, the state’s leases include implied duties. “That is the law of this state: it’s binding on the state and it’s no less binding on the producers.”
What it means, Hosie said, is “that the producers have to make their economic decisions with due regard to the interests of their royalty holder,” the state of Alaska.
Project needs to be ‘reasonably profitable’
The duty to market, he said, means that “if an Alaska gas project is reasonably profitable, taken on its own merits, standing alone, the producers have a duty to go forward with that project.”
And it’s an objective test, Hosie said.
If “Exxon, say, has an internal rate of return for upstream projects of 25-30 percent, that’s its subjective hurdle rate, but that is not necessarily the objective test of what a reasonably profitable project might be.”
The test of reasonably profitable, he said, is objective, and focuses on this project alone.
The state of Alaska “is not in the business of proving to the industry that the gas projects here are every bit as economic as any other project they might have available elsewhere in the world.” Alaska, he said, does not have to make its project “as economic as the best” of other projects.
How to make Alaska’s project as economic as other projects, Hosie said, “is the wrong question and it’s phrased to the state incorrectly as a matter of law. You don’t have to compete penny for penny with all of these other projects. Rather the question for this state, given this lease form and this relationship, is simply whether the gas projects are, on their own merits, reasonably profitable. That is the right question to ask.”
This, he said, goes back to “the basic bargain struck in the lease form.” In signing the leases, he said, the producers “took on obligations — the obligation to produce and market,” in exchange for the “lion’s share of the production.”
He acknowledged that the producers faced risk when they signed those leases, and face risk now. “The producers aren’t entitled to a risk-free deal, but under the relationship and under the lease form, the question is not whether this is the best product or program that they have for their upstream dollars, it’s simply whether it’s a reasonably profitable project.”
How does case determine profitability?
As to how the state determines if a project is reasonably profitable, Hosie said case law shows that when courts look at “the economics of the individual project, they look at things such as are there other oil companies who’ve expressed interest in the project? Have other producers tried to get in and do the development?” They look at rates of returns the companies have accepted for other projects.
“But most importantly the courts look to the producers’ own internal analyses of project’s profitability.”
The producers have certainly done detailed economic analyses of gas line projects, he said. “Their own internal economic analyses will tell you what they really think about rates of return, what they really think their costs have been and what they really think the value of their equity is.” The state, he told legislators, should get these documents “so that you can have informed negotiations with the producers. They are there. The state is entitled to get them” under the lease form as the royalty owner and under the stranded gas act.
Those analyses, he said, may tell you “that the producers are right when they say the gas line is not economic without concessions. It may be that the gas is stranded — that is uneconomic without concessions.”
But if the producers are asking for concessions and tax relief, the state has the right to look at the companies’ internal documents so it can respond to concession requests “in an informed manner.”
There is a preexisting relationship
The other thing the state should look for in the companies’ analyses is reasons why the companies do not think the Alaska gas line project is economic: “They may have artificially high rates of return, 25 percent, 30 percent, 35 percent returns on equity.”
Hosie cited a recent Wall Street Journal story on a Saudi project for which Exxon wanted a rate of return the Saudi government found too high. The government split up the project and found other companies willing to accept pieces of the project at a lower rate of return than Exxon, and the project is moving ahead on that basis.
It is essential, he told legislators, that the state “understand that neither the state nor the producers write on a blank slate. There’s a preexisting relationship, a lease relationship, a lease under which the producers have benefited enormously, and these negotiations have to be viewed in that larger context.”
The producers haven’t come to the state as commercial strangers. They can’t just table their most aggressive offer and walk away from the table if they don’t get what they want.
If there was no preexisting relationship and no obligations under the lease form that would be true, he said. “But there are. They do have an obligation to develop. They do have an obligation to market. If they can do so in a reasonably profitable way: not the most profitable project they might have on their books anywhere in the country or in the world, but just reasonably profitable. And again, that goes back to the basic bargain that they struck and under which they’ve produced tens of billions of dollars worth of oil.”
