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Vol. 14, No. 10 Week of March 08, 2009
Providing coverage of Alaska and northern Canada's oil and gas industry

A call for peace in CI

Giard wants to clarify utility gas pricing to end the ‘Cook Inlet Gas War’

Alan Bailey

Petroleum News

In December Petroleum News referred to the Regulatory Commission of Alaska’s December decision to allow Enstar Natural Gas Company to obtain gas for a year under new contracts with two Cook Inlet gas producers as the closing of a chapter in a long regulatory process, with the book remaining open.

“Those in gas supply have a less literary description of the situation; they call it the ‘Cook Inlet Gas War,’” said RCA Commissioner Kate Giard in a statement accompanying an RCA Feb. 27 order closing the docket in which Enstar had requested approval of its new gas supply contracts with Marathon Oil Co. and ConocoPhillips.

The standoff that Giard characterizes as a war reflects two opposing views of “equitable” Cook Inlet gas pricing: The producers have said that gas prices need to reflect Lower 48 pricing, to attract capital investments in new exploration and development in the expensive Cook Inlet gas basin, while consumer advocates have claimed that this type of pricing is channeling excessive profits to the producers at the consumers’ expense.

For many years Cook Inlet utility gas consumers enjoyed an abundance of cheap gas from Cook Inlet oil and gas fields discovered several decades ago. But these fields have been running down, bringing supplies more into line with demand and reducing the Cook Inlet reserves-to-production ratio to a value similar to those found in the Lower 48 states. But, although tightening gas supplies argue for rising gas prices, the lack of a Cook Inlet spot market has made it impossible to establish equilibrium prices based on an open market.

Skeptical

Giard has long been skeptical about the producers’ position on gas prices. And in her Feb. 27 statement she set out her perspectives on the series of regulatory battles that have engulfed Cook Inlet utility gas. She also proposed a route towards a truce.

“The Cook Inlet Gas War is a story of misrepresentation, a story of greed and a story of abdicating regulatory responsibility,” Giard said. “All sides are equally guilty and there are no heroes.”

In 2004 Enstar’s gas consumers paid $66 million for 26.5 billion cubic feet of Cook Inlet gas, while in 2009 consumers are paying $228 million for the same volume of gas “with no major shifts in production, demand or supply,” Giard said. And in the intervening period the Agrium fertilizer plant, a major natural gas user on the Kenai Peninsula, went out of business with the loss of 230 jobs.

“Chugach (Electric Association) is fighting tooth and nail not to have its ratepayers become the third casualty,” Giard said, referring to Chugach’s attempts to negotiate new gas supply contracts for its gas-fired power plants.

Started in 1994

Giard said that the gas war started in 1994 when Marathon refused to sell 400 billion cubic feet of gas to Enstar. Instead, Marathon exported that gas to Japan through the Nikiski liquefied natural gas terminal, she said.

The prolific nature of the Cook Inlet basin for gas production coupled with geographic and regulatory limits on LNG exports have tended to dampen Cook Inlet gas prices, when compared with prices elsewhere in North America, Giard said. At the same time substantial capital investments in new Cook Inlet gas production have only occurred in connection with applications to renew the export license for the LNG terminal, she said.

“The most recent field investment activity in Cook Inlet started around 2003 with the request for LNG extension filed in 2007,” Giard said.

In 2001 RCA approved a new gas supply contract between Unocal and Enstar, with gas prices indexed to the Lower 48 Henry Hub gas market. This new contract would require Unocal to explore for new Cook Inlet gas rather than just using up existing reserves, Unocal and Enstar said at the time.

But the contract did not limit Unocal to just selling newly discovered gas, Giard said.

“Ratepayers were in danger of paying America’s higher prices for gas from Cook Inlet’s existing reserves,” Giard said. “But Unocal promised RCA commissioners that much of its existing reserves were under contract to Agrium.”

Approved by RCA

RCA approved the Unocal contract.

“Shortly thereafter, Unocal stopped supplying Agrium,” Giard said. All of Unocal’s existing gas production then became available to support the Enstar contract, she said.

And under that contract Enstar’s consumers have paid Unocal $522 million for 72 billion cubic feet of gas between 2004 and 2009, while Marathon, under the terms of an earlier Enstar contract, received $336 million for the same volume of gas during the same period, Giard said. That price differential has resulted from the use of the Henry Hub price index, she said.

“Enstar’s consumers have paid Unocal $184 million more, or about $850 per customer, under what was presented as an exploration contract,” Giard said. But no one other than Unocal knows how much of the Unocal gas supplied to Enstar came from new gas field developments, as distinct from the draining down of established gas reserves, she said.

Marathon contract

In 2005 Enstar requested RCA approval for a new gas supply agreement with Marathon. The gas pricing in that contract would have been indexed to Henry Hub, in a similar manner to the 2001 Unocal contract. But the Marathon contract anticipated drawing gas production from existing reserves rather than from new gas fields, Giard said.

“Enstar told the commission that the extreme shortage of natural gas in Cook Inlet justified pricing all gas in Cook Inlet at American Henry Hub prices,” Giard said.

But the commission rejected the Henry Hub pricing formula, saying that this would have resulted in gas prices that would be unacceptably high.

In a continuing attempt to plug an impending shortfall in its gas supplies, Enstar came back to the commission in 2008 asking for approval of the new Marathon and ConocoPhillips contracts that have recently gone into temporary play.

Tier pricing

The pricing formula that the producers originally wanted in these contracts, and which RCA rejected, would have set the base gas price to an index of North American market prices. Tier prices above that would then have applied to high levels of demand for gas in the winter.

“This time, the American index prices were used as a base, and they escalated up to 150 percent of the base during the coldest months of the year,” Giard said. “This new methodology sent gas prices in Cook Inlet soaring even higher than the American Henry Hub prices in the Unocal contract.”

And, according to information provided by electric utility Municipal Light and Power, part owner of the Beluga River gas field, the proposed pricing formula would have resulted in a 300 percent profit margin for the producers, were they to draw the gas from existing reserves, Giard said.

Extreme pressure

So, “under extreme pressure” following statements from Enstar about the possibility of having to cut supplies to as many as 400 businesses in early 2009, RCA imposed a price cap indexed to a basket of market prices from North American gas production basins, a series of price points that more accurately represents the Cook Inlet gas market than the more downstream (and higher priced) “city gate” markets that the producers wanted to use, the commission said.

But the Cook Inlet gas producers rejected the price cap and, to enable Enstar to meet all of its gas supply obligations, RCA allowed the new contracts to go into effect for one year with a weighted-average-cost-of-gas pricing formula.

“And thus the Cook Inlet Gas War is at a standoff,” Giard said. “In a traditional old western standoff, neither side knows who will pull the trigger first or who will end the day in a pine box. … Unocal has operated under a contract that was fully vetted and approved by the RCA. Marathon and ConocoPhillips reasonably expected parity for their contracts. … (But) somewhere in all of these hundreds upon hundreds of millions of dollars someone was supposed to protect the consumers.”

Food for thought

But, although Giard continues to question the gas producers’ claims of a Cook Inlet gas shortage, given the U.S. Department of Energy’s 2008 extension of the license for the export of LNG from the Kenai Peninsula LNG terminal, a recent event has given her food for thought.

A few months ago she was listening to Don Page, Unocal’s commercial manager, talking about his experience of keeping the utility gas flowing during an especially cold winter night.

“Mr. Page told a tale of a night of lost sleep and personal terror that the Southcentral pilot lights would be extinguished on his watch,” Giard said. “… He told it so convincingly; it was as if I were there watching as he drove to his office and worked dispatch, side-by-side with his people all night, pulling gas from wherever he could find gas and pushing it to Enstar’s system to ensure that my children and perhaps his own would sleep warm through the night.”

It seems reasonable that producers should be compensated for pushing gas on those frigid days “when all of Alaska shivers,” Giard said.

On the other hand, the cost of the base utility gas that flows every day of the year should also be reasonable, she said.

“It must not subsidize the export of LNG to Asia,” Giard said. “It must reflect the abundance of gas supply that exists in Cook Inlet which supports the export of excess supply to Asia.”

Giard said that she is going to propose regulations that would clarify future Cook Inlet gas pricing.

Perhaps in the past everyone has made mistakes in the gas pricing battles, she said.

“Perhaps as a commissioner I have tried too hard to ‘unring the bell’ and put ratepayers back into the time before the Henry Hub invaded Alaska under a cloak of darkness,” Giard said. “… Maybe we just need to find a different bell to ring, one that recognizes Cook Inlet as a vibrant basin and also recognizes that our Cook Inlet producers do more than supply gas. They push gas at 20 degrees below zero to keep us warm.”



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Agrium and the Cook Inlet gas market

When Agrium Inc. bought the Nikiski fertilizer plant on Alaska’s Kenai Peninsula from Unocal Corp. in 2000, Agrium expressed optimism that fertilizer production at Nikiski would enhance Agrium’s position in the North American fertilizer market. And as part of the takeover deal, Agrium inherited a 1998 Unocal supply agreement for natural gas, the plant’s main feedstock, from Unocal’s erstwhile Alaska fertilizer subsidiary. That agreement was due to expire in 2009.

In 2001 the Regulatory Commission of Alaska approved a new gas supply contract between Unocal and Enstar Natural Gas Co., the main Southcentral Alaska gas utility. That contract involved gas pricing intended to encourage new Cook Inlet gas exploration, given that much of Unocal’s existing gas reserves were dedicated to supplying Agrium, according to RCA records.

And in that same year Unocal announced a new $10 million gas exploration project on the Kenai Peninsula. The company also said that it was investing about $15 million in developing existing Cook Inlet gas fields in 2001.

But things had turned sour by early 2002 when Unocal announced that it had failed to discover commercial quantities of natural gas in a three-well drilling program in the southern Kenai Peninsula.

Litigation

Then, in the summer of 2002, litigation erupted between Unocal and Agrium over a dispute about the gas sales agreement for the fertilizer plant. According to Agrium the dispute, although financial in nature, hinged on issues relating to gas supplies from Unocal. And Unocal told Petroleum News at the time that, under the terms of the gas sale agreement, Unocal should be able to reduce its gas supplies to Agrium, to reflect a decline in Unocal’s Cook Inlet gas reserves.

In May 2003 Agrium laid off 65 employees, in part, the company said, because of gas supply issues with Unocal. And a month later Agrium announced that Unocal had intimated further cuts in gas supplies. Agrium said that it was seeking alternative supplies from other producers.

In March 2004 Bill Boycott, general manager of Agrium’s Kenai operations, told the Resource Development Council of Alaska that the fertilizer plant gas consumption of 53 billion cubic feet in 2001 had dropped to 40 bcf in 2004 and was expected to drop to 36 bcf in 2004.

Arbitration panel

And in July of that year an arbitration panel in the litigation between Agrium and Unocal awarded Agrium $38.5 million in damages plus interest for the under-delivery of gas. The panel accepted that the gas sales agreement involved delivery volumes linked to the levels of specific gas reserves dedicated to the agreement. However, Unocal’s gas deliveries had not met required minimums, the panel said.

But in October 2004 Unocal said that it was unlikely to be able to deliver on-going gas volumes specified by the arbitration panel, despite the fact that “Unocal is in full-out production” from gas fields dedicated to the Agrium contract. And the company said that if it found new gas sources it was not obliged to divert that gas to meet Agrium’s needs.

In December 2004 Agrium and Unocal settled their litigation with an agreement that involved the termination of gas supplies on Oct. 31, 2005, and a payment of $25 million in compensation to Agrium for the cessation of supplies prior to the June 2009 date in the original gas supply agreement.

Agrium continued to seek new gas supplies at prices that would be viable for fertilizer production. The company even investigated converting the Nikiski plant to use coal gasification rather than natural gas. But, with annual gas supplies to the plant dwindling to 10 billion cubic feet, the plant finally closed its doors in late 2007.

—Alan Bailey