Alaska’s natural gas strategy

Doug Reynolds, Ph.D.

For Petroleum News

Alaska faces two important natural gas pipeline issues. One is the route and the other is Alaska’s fiscal system. Both will determine state revenues for decades to come. First consider the route.

If Alaska wanted an All-Alaska, liquefied natural gas project of say 3 billion cubic feet a day, that would require huge liquefaction facilities in Valdez. Typically a one-half bcf LNG module — also called a train — would take two and a half years to build. Usually two trains built simultaneously takes three years. So six such trains built two at a time would take about nine years to complete. You could try to build more trains simultaneously, but given the cramped area in Valdez, that would be very risky in terms of docking collisions, bottlenecks and severe cost overruns. Constructing an infrastructure in Valdez with more roads and a huge new port to offload all the capital and equipment would take another two years. So an All-Alaska line would easily take 11 years to build, the same as Nigeria’s 3 bcf Bonny Island facility. This is being optimistic since Valdez has fisheries, oil terminals, and tourists that cramp the small bay. Physical space in Valdez is extremely limited so there are likely to be bottlenecks at every turn during construction.

So if a 3 bcf pipeline to Valdez is built and made ready for the first two LNG trains then it will sit partially unused for the rest of the six years needed to finish the remaining trains. In other words all the interest paid on the initial debt to build the pipeline and the conditioning plant would accrue for those years. The end result would easily be a four or five dollar tariff for natural gas even with tax breaks. Plus the LNG will likely receive a substantially lower price on the Pacific Rim than in Chicago.

The alternative is a 4 bcf AlCan route that can be built in four years, have a two and a half dollar tariff and receive a higher price at the end of the line. Even if construction will not start in four years, the AlCan route could actually be finished before an LNG facility is fully finished. It will cost less and give Alaska a greater value increasing PFD dividends substantially.

New tax system more important

There are a number of reasons to expect high oil and gas prices. Mature basins such as those in the United States face declining production. Large producers such as Russia are government-owned enterprises, which will be concentrating on rent extraction rather than on developing more incentives to expand production. Therefore they will have little incentive to expand production. Also OPEC producers are at their capacity limits of production. Any new production from OPEC will now require entirely new upstream exploration and development. Again, they will not have much incentive to aggressively expand their capacities since they are already making plenty of money. Venezuela for example recently changed all oil and gas contracts retroactively to increase government revenues and reduce incentives to oil and gas companies working within their borders.

Interestingly most LNG producers who are in competition with Alaska are also government-owned producers. That means they will less aggressively expand their production than will privately owned gas producers. Plus since oil and gas are substitutes for each other on a number of dimensions, then oil and gas prices will follow each other closely, no matter the level of natural gas supplies. Therefore future oil and gas prices look to be high.

Progressive tax: why Norway does better than Alaska

Oil companies might fear such a progressive tax — if too steep on the upside — will take away any incentive for expanding production. However, marginal fields only provide the state with small amounts of new revenues. There will still be plenty of incentives to aggressively exploit those fields, so why worry about an extra 5 or 10 percent of production output by giving away an extra 30 or 50 percent of revenues. It would be much better to extract more rent and not to worry about expanding production rates. Plus current reserves will naturally expand to keep the pipeline full.

What kind of progressive tax should we fight for? Start with a base price of about $5 per thousand cubic feet at the Henry Hub. Index the base price to inflation. At the base price then have a 12.5 percent royalty and a 15 percent severance tax with no economic limit factor. Then for every 10 percent increase in the Henry Hub price above the base price, increase the severance tax by 1 percent. So at a $5.50 Henry Hub price, the severance would be 16 percent and so on up to a maximum of say 35 percent at a price of $34 per mcf. In exchange, give down side tax reductions.

For oil we should start with a base price of $30 per barrel and create a similar progressive tax with no ELF where the severance tax increases by 1 percent for every 10 percent that the price increases. Also include lower severance taxes for prices below $30 per barrel.

If we look to other countries, we can see the difference. Norway for example has a substantial welfare state, yet Norway’s petroleum fund is already at $150 billion, about five times bigger than Alaska’s Permanent Fund even though Norway only produces about three times as much oil as we do. Part of the difference is that we are a state and the federal government takes a share. Also we have higher costs, but the bottom line is that Norway extracts a higher percent of the rent available than does Alaska. Now we can rectify this lack of revenues especially in light of the new market reality.

Dr. Doug Reynolds is an associate professor of energy and oil economics at the University of Alaska Fairbanks. This paper is part of Prof. Reynolds’ university-required public service to the community.