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Vol 21, No. 36 Week of September 04, 2016
Providing coverage of Alaska and northern Canada's oil and gas industry

Plan faces uphill slog

Consultants, tax attorneys point out weaknesses in governor’s LNG plan


For Petroleum News

Gov. Bill Walker’s proposal for a state-led natural gas pipeline is creative and could greatly improve the project’s competitiveness, North Slope gas producers say. But can it work?

The problem is that two key tenets of the plan, tax-exempt status for a state-led gas project or cost reductions through a third-party investor, face huge hurdles, tax attorneys and a consultant to the Legislature told state lawmakers in a hearing Aug. 25.

Charles Schuetze, a tax attorney with Manley & Brautigam in Anchorage, said it might be possible to gain tax-exempt status for a project totally owned by the state but recent changes to regulations by the Internal Revenue Service will make it difficult.

If the state, through the state-owned Alaska Gasline Development Corp., brings in private partners as investors, as the governor is planning, it would make securing tax-exempt status very difficult, Schuetze said. The IRS lays out certain tests for tax-exempt status. “The entity must be classed as a ‘political subdivision,’ with sovereign (governmental) powers. The (AGDC) project could possibly qualify under this,” he said.

However, last February the IRS issued revised rules that added further qualifications, the most important being that the project is under “government control” and “government ownership,” Schuetze told the legislators.

This means Walker’s plan to bring in new partners would likely cause the project to fail the “government ownership” test, because some of the benefits would flow to private investors, Schuetze said.

Hurdles even for railroad bonding

Eric Wohlforth, a veteran Alaska bond attorney with decades of experience, said flatly that it will not be possible to secure tax-exempt status on bonds issued by AGDC for the project after changes in federal tax law in the federal Tax Reform Act of 1986, and that while it might be possible to get tax-exempt status on bonds issued by the state-owned Alaska Railroad Corp. for the project, there are hurdles even there.

“In my opinion there is no possibility that interest on state of Alaska or Alaska Gasline Development Corp. bonds to finance the project would be exempt from federal income taxation under federal tax law generally applicable to state and local government financing,” Wohlforth wrote in a memorandum to legislators.

The Alaska Railroad does has unique and special authority to issue tax-exempt bonds granted by Congress and among its powers the railroad corporation has authority to build pipelines, Wohlforth told legislator at the Aug. 25 hearing.

However, the benefits of the financing have to accrue to the railroad under the federal law that transferred the railroad to the state, he said.

Third-party problems

Meanwhile, a consultant to the Legislature, Nikos Tsafos, with enalytica, a consulting firm, pointed out flaws in the notion that third parties investing in a utility-type project might result in lower costs.

He particularly warned legislators to steer clear any proposal that the state itself buy gas from producers and sell it on world markets, a so-called “merchant” model for the project.

There are huge risks for the state in this idea, Tsafos warned, to the point that financial markets will would be so leery that the state will be unable to get outside funding for gas purchases. “If they (the producers) offer you gas, don’t buy it,” Tsafos warned legislators.

Producers praise creativity

Despite the uphill fight the governor’s plan faces, the three North Slope producers, who are partners with the state in the current Alaska LNG Project pre-feasibility engineering work, praise the creativity of Walker’s ideas.

They are ready to turn over the keys to the project to the governor at the end of the year, all three companies said.

Dave Van Tuyl, BP’s Alaska manager, recognizes big challenges Alaska LNG faces in its current joint-venture organization but told the committee, “BP is not giving up on the project. Instead we need to change gears and figure out how we can reduce the cost of supply so that the project can be competitive.”

“We believe the best way to make that happen is with a state-led project and we support the state’s efforts. We are determined to find a way to lower the cost of supply and make Alaska competitive in the global marketplace,” Van Tuyl said.

He cited major conclusions of a presentation made a day earlier to the legislators, on Aug. 24, that Alaska LNG’s current joint-venture configuration is uneconomic and that a third-party investor, in combination with possible exemption from federal tax, would reduce the cost of supply for Alaska LNG to ranges where it might compete with other LNG.

Van Tuyl said the concept of a third-party investor with a utility-type toll, “would represent a major step-change in the cost of supply. That step alone, converting the up-front capital (invested by producers) into a toll over time, could allow the project to compete globally,” Van Tuyl said.

However, “the details matter and there are many that still many that remain to be worked out,” he cautioned.

In principle, however, “the state should be able to access lower-cost financing than a taxable entity like BP if the project was financed as a utility, and through the use of things like tax-exempt financing,” if those tools are available, he said.

Comments at the hearing by ExxonMobil and ConocoPhillips, two other producers who are partners in Alaska LNG, were similar to those by BP.

Critique of tolling model

Tsafos was quite direct in his critique of the governor’s plan, however.

“By itself, a (third party investor) ‘tolling’ model doesn’t reduce the cost of supply,” he said. The only way to reduce the cost is to accept a lower return on capital invested to build the project. The concept laid out in the Wood Mackenzie presentation was a third-party investor accepting an 8 percent return on investment compared with 12 percent the North Slope producers would likely require.

Wood Mackenzie also assumed that a state-led project would not pay taxes like the state property tax and state corporate income tax.

Tsafos told legislators that a key weakness in this is that any gain from an increase in LNG market prices would go to the gas owners (of which the state is one, through its royalty gas) and not to the third-party investors in the project who bear all the risk of constructing the project.

Tsafos also questioned whether investors could be brought in at the front end, before the project is built, and agree to an 8 percent return. There are examples, he said, where investors including entities like pension funds buy oil and gas infrastructure, Norway being one example, but this is always done after the project is built and there is no more construction risk, he said.

Even then equity investors may want more than 8 percent, he said. The Permanent Fund itself has a target for a 5 percent total return (not including inflation) but since a good portion of the Fund is invested in low-yield government bonds the Fund’s other investments, including in infrastructure, must have higher returns to achieve an average 5 percent total return.

Plausible elements

However, there are plausible elements to the state’s plan, Tsafos acknowledged.

In Indonesia, for example, the government owns infrastructure including LNG plants, but construction and operations are managed by companies that supply gas. “They want to make sure things are done right,” Tsafos told the legislators.

Tsafos also said it isn’t clear what the governor is achieving by switching to a state-led project now. It certainly isn’t an acceleration of schedule, to move to the project’s next step of Front-End Engineering and Design, or FEED.

The state’s AGDC has said its target for initiating the FEED is late 2018, which is actually later than the target for the current Alaska LNG joint-venture.

He also said the Legislature should know what was proposed by the Alaska LNG joint-venture for a 2017 budget. “What’s in that (proposed) budget? It would be interesting to know what we’re tossing out,” by moving to a project led by the state, he said.

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