Alaska LNG may be too costly

Larry Persily

Petroleum News Government Affairs Editor

An Alaska Department of Revenue memo says proponents of a state- or municipally owned North Slope natural gas project could be basing their pipeline tariff estimates on faulty assumptions, missing the real cost of service by more than $1 per thousand cubic feet.

A leading advocate of a publicly owned project strongly disputes the memo’s numbers.

But, if true, such a significantly higher tariff could seriously damage the project’s chances for success in the highly price-competitive Pacific Rim market for liquefied natural gas.

The memo said the economic models used by advocates of a publicly owned project could be seriously underestimating debt and transportation costs and overestimating any tax benefits of public ownership. The memo also questions several of the non-tariff assumptions such as gas supply costs and reserves, market demand and prices.

“There may ultimately be a role for LNG or public ownership in commercializing North Slope gas,” the memo said. “However, such a project should be based on solid commercial principles.” Tax Division petroleum economist Roger Marks prepared the nine-page analysis from research with financial consultants and using a tax and tariff model he developed. (See sidebar on the memo with this story.)

LNG advocate says memo ‘flawed’

The purpose of the late-March report is not to pronounce judgment on either project — the Alaska Gasline Port Authority or the state-owned Alaska Natural Gas Development Authority — said Steve Porter, deputy commissioner at the Department of Revenue, who reviewed the memo.

“The focus of that memo is to identify those areas that need further research,” he said in an April 8 interview. “We’ve got to make sure we fine tune all these feasibility issues.”

Porter told the state gas authority board of directors last fall that the department would review the economic assumptions behind the authority’s business plan. The state authority, created by Alaska voters in 2002, has based its plan on financial models promoted by the municipal port authority and Yukon Pacific Corp., which in 2001 shut down its 20-year effort to develop a privately owned Alaska LNG project.

“These models conclude that the project is economic,” Revenue’s memo said of the Yukon Pacific and port authority assumptions embraced by the state gas authority. But, the memo advised, “Many critical assumptions in the model are uncertain and should be researched.”

Memo lists items that need more study

Rather than rely on North Slope producers to develop the companies’ preferred gas pipeline through Canada to serve North American markets, supporters of public ownership say the state or municipalities should take on the job.

The major North Slope producers have done their own financial analysis of exporting Alaska LNG to U.S. West Coast or overseas markets and determined the project is not commercially feasible. But proponents of a publicly owned project say tax and financing savings could give their proposal a competitive advantage in the marketplace.

However, the Department of Revenue memo said possibly faulty tax and financing assumptions in the LNG supporters’ models could mean they are underestimating the pipeline tariff by up to $1.34 per mcf. Plus the memo also questions the assumptions on tanker charges, saying the additional cost of U.S.-built and U.S.-crewed tankers, as required by the federal Jones Act, could add at least another 55 cents to the tariff for serving the California market.

Higher tariffs could be a problem

Finding a market for at least 2 billion cubic feet of Alaska LNG also could be a faulty assumption, the memo said. The U.S. West Coast doesn’t need that much gas, and it would be difficult for Alaska to compete with less expensive LNG supplies closer to Far East markets. The cost of an arctic pipeline also puts Alaska LNG at a disadvantage, the memo said.

Those statements prompted a strong reaction from Whitaker. “It is near ludicrous to suggest a market does not exist,” the mayor said.

But the memo’s statements make sense to Larry Houle, general manager of the Alaska Support Industry Alliance, who sent copies of the memo to all of his directors. “It just sort of validates what I put together in the past,” said Houle, who opposed the 2002 voter initiative that created the state gas authority.

Regardless of the serious questions raised by the memo, Houle doesn’t expect it will change many minds among supporters of a publicly owned LNG project. “The true believers are so committed out there,” he said.

Port authority moving ahead with project

“We are well beyond memos in moving our project forward,” the mayor said. The authority is talking with potential buyers for its gas, while it investigates financing options and looks for ways to buy gas from North Slope producers.

A key part of both the port authority’s plan and the state gas authority’s model is borrowing all of the billions of dollars needed to build the pipe, liquefaction plant and terminal at Valdez and, for the state authority, even the LNG tankers.

But that likely will be a problem, the memo said.

“It is difficult to find any similar, single-purpose commercial endeavor that has been financed at 100 percent debt,” the memo said. “The reasons are clear. … Equity is the shock absorber for financial distress. Otherwise, if something goes wrong, the debt is at risk. In addition, equity contributions make creditors comfortable that project sponsors are serious.

“The more risky the project, the more debt holders want additional equity in the project. Typically, LNG projects have 70 percent debt,” the report said.

“This report highlights that projects like this are not 100 percent financeable,” Houle said.

State memo questions assumptions of LNG project proponents

Larry Persily

Petroleum News government affairs editor

Many of the issues are already on the Alaska Natural Gas Development Authority’s assignment list for consulting contracts, as the authority works to put together its development plan for a state-owned natural gas pipeline.

The memo raised several issues, not all of which would apply to every proposed project development plan:

Market size and timing issues

“Moreover, this market will grow incrementally, not all at once. Getting the entire 1 bcf/d into the market at once will be particularly difficult.”

Taking Alaska LNG to Far East buyers also could be a problem, the memo said, considering the distance and the reality of lower-cost, nearby producers chasing the same customers.

The memo estimates the additional cost of phasing Alaska LNG into the markets with a longer ramp-up period — six years instead of two years — could add 48 cents per thousand cubic feet to the cost of service, as the project developer would need a higher tariff to make up for smaller returns in the early, low-volume years.

Supporters see the market differently, and believe they could sell enough LNG without undue delays.

LNG market prices

Price volatility is a constant worry, the memo said, especially for Alaska projects that must compete with low-cost suppliers. “The excess supply of potential LNG for Asia is already pushing prices down to the cost of marginal supply. Indonesia recently made a 15-year deal with China to supply LNG at $2.90.”

Federal Jones Act a problem

Project supporters have said perhaps Alaska could obtain a congressional waiver from the Jones Act.

Memo questions 100% debt financing

Building the project with 30 percent equity and 70 percent debt is a more likely assumption, the memo said.

And since equity investors demand a higher return than lenders — since lenders get paid first and therefore equity investors take more risk of not getting paid — the return on equity investment would add an estimated 69 cents per mcf to the tariff, the memo said.

Cost of borrowing

The port authority and state gas authority have underestimated by 2 full percentage points the interest rate they would need to pay for borrowed money to build the project, the memo said. “With no assets, no collateral, borrowing by a public entity (not backed by the full faith and credit of the state) of any amount will be difficult, especially for the commercialization of an asset with so much price volatility.”

The higher-cost debt could add 29 cents per mcf to the tariff, the memo estimated.

Tax-free debt

The state has been looking the past couple of years at perhaps issuing tax-exempt bonds for a natural gas project through the Alaska Railroad Corp., pointing to a provision in the federal law that transferred the railroad to the state that allows for tax-exempt financing. However, the provision does not explicitly allow for financing of non-railroad projects, and the memo recommends that advocates of a publicly owned LNG project research the issue further before counting on the savings.

Tax-exempt bonds generally carry a lower interest rate than taxable bonds. The higher cost of taxable bonds could add 21 cents per mcf to the cost of an Alaska LNG project, the memo estimated.

Federal income tax status

Project supporters have relied on a 2000 letter from the Internal Revenue Service, stating that the Alaska Gasline Port Authority would be exempt from federal corporate income tax on its profits, but the Department of Revenue memo questions that assumption.

The IRS based its ruling on statements that most of the gas would be used in-state.

“However, it appears that given the rather limited opportunities for in-state use of gas, most of the port authority’s revenues would be derived from the commercial sales of gas to either East Asia or the West Coast,” the memo said.

“This distinction may be very significant for the (IRS) ruling,” and could jeopardize the port authority’s reported tax-exempt status, the memo said, estimating that federal taxes on equity investment in an LNG project could add 15 cents per mcf to the tariff (assuming the project is financed 30 percent with equity and 70 percent debt).