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Vol. 11, No. 2 Week of January 08, 2006
Providing coverage of Alaska and northern Canada's oil and gas industry

New contract sparks debate

Cook Inlet explorers, state, individuals challenge Marathon-Enstar gas deal

Alan Bailey

Petroleum News

Ask residents of Anchorage, Alaska, about natural gas and most will probably cite escalating price levels as a prime concern. But with gas supplies from the neighboring Cook Inlet basin set to decline, people are also becoming increasingly aware of the possibility of gas shortages.

Ensuring continuity of future gas supplies has become a major focus for Enstar Natural Gas Co., the main gas utility serving the Anchorage area. And in November 2005 Enstar agreed to a new gas supply contract with Marathon Oil Corp. That contract would assure sufficient gas to meet Enstar’s needs through at least 2016, by which time there may be a spur pipeline delivering North Slope gas to the Anchorage area.

“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,” Tony Izzo, president and CEO of Enstar told an Anchorage Chamber of Commerce audience on Nov. 14.

But in focusing on continuity of supplies has Enstar conceded future price levels that are too high? And will the new contract stifle future gas exploration in the Cook Inlet basin? These are a couple of the questions that the State of Alaska, companies linked to the Cook Inlet gas industry and private individuals have raised with the Regulatory Commission of Alaska prior to an RCA decision on whether to investigate the contract.

Guaranteed delivery

At the core of the new contract are guaranteed volumes of natural gas that Marathon will supply to Enstar from 2009 onwards from known Cook Inlet gas reserves that Marathon owns. The guaranteed volumes increase until 2016 and decline thereafter. Without additional gas sources, volumes would decline to zero at some time after 2018.

When added to Enstar’s other contracted supplies (primarily from Chevron and another Marathon contract) Enstar should obtain sufficient gas to meet projected demand through 2016. Without the contract, Enstar could start to run short of gas as soon as 2009, Enstar has said.

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.”

Under the contract, the price that Enstar will pay for the gas will be based on a 12-month trailing average of gas prices at the Henry Hub gas market in the Lower 48, with discounts if that index price climbs above $6 per thousand cubic feet. The price will have a floor of $4.25 per mcf and a cap of $15 per mcf (the Henry Hub price was about $13.5 at the end of December). There is an additional charge for peak gas volumes supplied at volume rates in excess of contracted peak volumes.

Also under the terms of the contract Marathon will have an unlimited ability to meet its supply commitments by buying and reselling gas from third party producers.

Rather than adding variable gas pipeline tariff rates to Enstar’s cost for the gas, the contract specifies a fixed transportation rate of 25 cents per mcf for all gas supplied.

Questions of price

Much of the criticism of the contract revolves around the price levels on which Marathon and Enstar have agreed. And the state attorney general has said that because Enstar passes the gas prices that it pays directly through to its customers, the utility has little incentive to ensure low prices in its gas supply contracts.

Questions by the attorney general have particularly focused on price indexing to Henry Hub price levels. Earlier Enstar contracts with Unocal (now Chevron), in 2001, and NorthStar, in 2004, already use the Henry Hub price as an index, although both of those contracts used a 36-month trailing average price rather than the 12-month trailing average of the new contract.

The linkage to Lower 48 prices results from a need to attract new investment into Cook Inlet gas exploration — there’s little or no incentive for companies to explore for gas in the Cook Inlet basin if those same companies can explore for gas at higher prices elsewhere in the United States (or overseas). And without new Cook Inlet gas exploration, gas supplies in the Anchorage area will surely run dry before too long.

Earlier contracts specified exploration

But the earlier contracts with Enstar were exploration contracts that incorporated a need to find new gas reserves to satisfy the supply agreements. The new contract only depends on known Marathon gas reserves; commitments in the contract do not depend on exploring for further gas.

“Most notable for the purposes of the Commission’s review of this Marathon GSA (gas supply agreement) is that both the Unocal and NorthStar GSAs purported to be ‘exploration’ contracts and each company relied on this characterization as a justification to use HHI (Henry Hub) as a pricing index,” the attorney general said in his comments to RCA on the new contract.

Marathon has, however, commented that it has already “invested significant amounts of capital to prove up and develop gas reserves that can serve Enstar and other Cook Inlet markets” and “as a result, Marathon can now offer proven reserves to Enstar that will provide strong security of supply to Enstar and its customers.”

The attorney general and others have also pointed out that Henry Hub prices have been subject to recent spikes as a result of events such as hurricane Katrina. Why should Alaska residents have to suffer from price shocks that result from events that don’t impact Alaska gas supplies, these people ask.

Giard dissented to 2004 order

And in a dissenting statement to the 2004 RCA order approving the NorthStar/Enstar contract RCA Commissioner Kate Giard expressed a concern that by linking Cook Inlet gas prices to Henry Hub “captive (gas) ratepayers are at the mercy of a spot market in the Lower 48 that bears no relation to gas market conditions in Alaska.”

The attorney general also criticized the use of a 12-month trailing average price, rather than a 36-month trailing average: the 12-month average will increase price volatility and the possibility of rate shocks, the attorney general said. Marathon and Enstar have justified the use of a 12-month moving average on the grounds that it will provide diversification from the price formula in the 2001 Unocal contract and that it will buffer the Unocal price by “more quickly reflecting falling prices.”

And the attorney general has questioned the use of a fixed transportation fee, saying that this fee is “arbitrary, potentially discriminatory and unsupported.”

Aurora Gas LLC, an active explorer in the Cook Inlet basin and operator of five gas fields on the west side of the Inlet, supports gas price increases as necessary incentives for new Cook Inlet basin exploration but has expressed concern about the impact of the new contract on the taxes and royalties on production from its Moquawkie field. Aurora sells gas from Moquawkie at a lower price than that in the Marathon-Enstar contract, while production taxes and royalties are calculated from “prevailing value,” a weighted average of prices paid by utilities in the region.

“The scenario creates a situation whereby the smallest company, with the highest development costs per unit, is receiving the lowest net price for its gas,” Scott Pfoff, president of Aurora Power said in a letter to RCA about the new contract.

Market access

And companies such as Aurora feel particularly concerned about the way in which gas supply agreements such as the new Marathon-Enstar contract can close the gas market to new companies that want to explore the Cook Inlet basin.

“Having pounded the pavements in downtown Houston, downtown New York and in Calgary in search of private equity capital … we never had any problem selling anybody on the technical merits of looking for oil and gas in the Cook Inlet basin,” Pfoff said at the Resource Development Council annual conference in mid-November. “… The problem came when I got up and tried to talk about the market. There is no spot market up here — you don’t just find gas, hook it up to the nearest pipeline and start selling it. You’ve got to have contracts; you’ve got to have a way to sell your gas.”

Enstar and Marathon have pointed out that the new contract runs for a relatively short term compared with other Cook Inlet contracts. However, the new contract would, together with existing contracts, account for gas sales to Enstar until at least 2016.

So, Aurora and Trading Bay Oil and Gas LLC, another Cook Inlet lease owner, have requested that RCA requires a set-aside of about 10 percent of purchased gas for producers other than Marathon.

“If new companies fail to show up with new supply, then the existing producer community can compete for the set aside portion of the utility’s requirements,” Pfoff said.

Marathon can purchase from others

The attorney general and others have also criticized another aspect of the contract that they think limits competition in the Cook Inlet gas market: the contract allows Marathon an unlimited ability to meet its supply commitments by purchasing gas from third party producers. That would enable Marathon to resell the gas to Enstar at a profit, using the contract price.

“Under this GSA Marathon … could, if approved, enhance its windfall opportunities by simply acting as a middle-man to provide all or some of its commitments,” the attorney general said.

“It is highly improbable that the party selling gas to Marathon would be able to negotiate a gas sales price and related terms sufficient to encourage the level of exploration and production activity needed on a sustained basis between now and 2018,” said Paul Craig, manager of Trading Bay Oil and Gas.

Enstar, in its submission to RCA, justified the unrestricted ability of Marathon to purchase gas on the grounds that “when gas is scarce it is not desirable to make it more difficult to discover, produce or deliver or to otherwise limit the sellers alternatives to procure gas to meet Enstar’s requirements.” Enstar also pointed out that Marathon may want to develop gas storage facilities and then purchase gas, typically in the summer, to store to meet peak winter demand.

So, what will be the upshot of the debate regarding the new Marathon-Enstar contract? The RCA will at some stage rule on whether to investigate the contract. And Giard has said in the past that “the test for approving gas supply contracts is whether the contract provides a reliable source of gas at a reasonable price.”

But maintaining a Cook Inlet gas market that assures future supplies at reasonable prices clearly presents something of a challenge.

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