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Vol. 13, No. 36 Week of September 07, 2008
Providing coverage of Alaska and northern Canada's oil and gas industry

Clock ticks for decision

RCA must rule on Enstar contracts by January; parties reiterate arguments

Alan Bailey

Petroleum News

The extensive 13-day public hearing ended in mid August and the commissioners are weighing the evidence. But the question of whether the Regulatory Commission of Alaska decides to accept or reject Enstar Natural Gas Co’s new gas supply contracts with Marathon Oil Co. and ConocoPhillips Alaska will surely hit the pocketbooks of most people in Southcentral Alaska by setting a precedent for utility gas pricing for years to come.

And time is of the essence. By statute, the commissioners have until Jan.6 to make a decision, while Enstar says that in January it will start to run short of sufficient contracted gas supplies to meet its anticipated gas demand.

Meantime, the various parties in the case have presented their arguments in post-hearing briefs to the commissioners — Chugach Electric Association, a major Southcentral Alaska electric utility, and the attorney general for the State of Alaska have both intervened in the case to oppose the contracts.

Reasonable pricing

The case revolves around the question of whether the pricing in the contracts is reasonable. The base contract prices use indices, each referred to as a “Cook Inlet Composite Index,” that represent trailing averages of prices from several gas market hubs in North America. Price tiering increases the price to levels above the base rate for “swing” gas during periods of high gas demand, during the cold Alaska winters. One tier represents moderate levels of swing, while a higher tier represents so-called needle peak demand during the coldest days of winter. The rates of supply that trigger the two price tiers are calculated in advance for each winter as percentages of the maximum anticipated peak demand for the winter.

Enstar and the gas producers have in the past argued that Cook Inlet gas prices should reflect gas prices elsewhere, to encourage new investment in gas exploration and development in the Cook Inlet region. But the introduction of tiered pricing in the new contracts represents the first attempt in the Cook Inlet to unbundle contract pricing to reflect different prices for different levels of supply service.

Market power

In their post-hearing briefs, both Chugach Electric and the attorney general made much of what they characterized as the market power of the gas producers in the Cook Inlet.

“Lower 48 consumption market prices have no link to Cook Inlet, and tier prices, adders and penalties raise the all-in price even more,” said attorneys Wei-Drin Lee and Eric Redman representing Chugach Electric. “… Pricing should not be left to the mercy of producer market power where the commission has the duty and authority to regulate utility contracts.”

RCA should view the contract terms as unreasonable and issue an order “to change circumstances for the better” for Enstar, Lee and Redman asserted. Enstar “sits atop a natural gas basin” and Cook Inlet gas prices should be based on Lower 48 production area pricing rather than pricing at the city gate, with RCA providing guidance on what form of price formula would be acceptable, they said.

Contract provisions include unreasonable pricing, the lack of a meaningful price cap or collar, the inclusion of “take or pay” type clauses, the inclusion of excess royalty fees and the need for Enstar to have storage facilities by 2011, the attorney general said. Enstar can pass its unreasonable gas costs through to its ratepayers, he said.

And both Chugach Electric and the attorney general slammed the tiered pricing formula in the contracts.

“The tier methodologies as used in these GSAs are unacceptable because they do not value deliverability in any absolute sense but are based on Enstar’s peak day forecast,” said the attorney general. “… The tier methodology ensures that suppliers earn their target gas prices, but does not foster a more competitive market by unbundling tiers in any logical way.”

The attorney general said that he supports the use of Cook Inlet Composite Index pricing but that this pricing would already fully compensate the producers for its swing and needle peak needs — the tiered pricing unreasonable adds a markup to premium Lower 48 pricing and represent “double dipping” for costs associated with peak delivery, he said.

Supply crisis

Lee and Redman questioned whether the Cook Inlet region is truly facing a natural gas supply crisis that would justify premium pricing, saying that in applying for an extension to the export license for the Nikiski LNG terminal on the Kenai Peninsula the producers had submitted estimates of proved gas reserves of 1,211 billion cubic feet and probable reserves of an additional 514 billion cubic feet.

“These are huge numbers when compared to the 37 billion cubic feet to be provided by the GSAs (gas supply agreements),” Lee and Redman said.

Future LNG export license extensions should require RCA-approved utility gas supply contracts to be in place, they said.

Lee and Redman also cited testimony by attorney Spencer Hosie that, under the terms of their Cook Inlet leases, the producers cannot simply move capital investments away from the Cook Inlet to obtain higher returns. Profits, not prices, drive new gas development and in the Cook Inlet LNG exports provide a greater incentive for new gas development than the utility gas supply agreements, they said.

But the attorney general dismissed any attempt by Enstar to justify the new contract prices by comparing them with price of LNG exported at Nikiski. The U.S. Department of Energy has limited the amount of LNG that can be exported from Nikiski, so gas not sold to local utilities could not necessarily be exported as LNG at a higher price, he said.

Rather than threatening the withdrawal of service from some commercial customers in 2009, Enstar should be seeking other means of obtaining additional gas, were the commission to reject the new contracts, Lee and Redman said. Possibilities include obtaining additional gas under Enstar’s existing supply contracts or obtaining gas from an independent producer.

The attorney general said that Enstar could meet its 2009 shortfall by enforcing provisions in its existing Unocal contract. However, the attorney general also expressed caution with the regard to that projected shortfall.

“The attorney general … cannot recommend outright rejection of these flawed GSAs because they supply Enstar’s forecasted needs starting as soon as January 2009,” the attorney general said. “The evidence presented in this hearing did not resolve a critical point: whether Enstar’s forecasted natural gas needs starting in January 2009 are reasonably cautious estimates or if they are inflated.”

In response to points made by Enstar about the new contracts providing a bridge to future arrangements in which Enstar would operate its own gas storage and might operate a gas line from the North Slope, Lee and Redman requested that RCA opens a docket to review Enstar’s capital expenditure plans.

Enstar: realistic pricing

For its part, Enstar is adamant that the pricing in the new contracts represents the realities of the current Cook Inlet gas market.

The commission should approve the new contracts because of “ample … evidence proving that the contracts provide reliable supplies at reasonable prices,” said attorney William Saupe in his post-hearing brief for Enstar.

The proposed price indices are “plainly reasonable” and the tiering has been tailored to Enstar’s load profile, Saupe said. The way in which the prices at the North American trading points are averaged in the Cook Inlet Composite Index eliminates seasonal variation and the index price does not include the seasonal swing, as claimed by the attorney general, Saupe said. Saupe also rejected the idea of indexing Cook Inlet to production basin prices, citing the lack of a suitable Lower 48 price point and the fact that Enstar benefits from gas transportation and storage services upstream of its supply points.

There is abundant evidence that Cook Inlet gas supplies have become tight, Saupe said. And the parity in reserves-to-production ratios that now exists between the Cook Inlet and the Lower 48 argues for Lower 48 gas prices being appropriate in Cook Inlet, he said.

In addition, RCA rejection of a previous contract with Marathon weakened Enstar’s bargaining position with the gas producers and rejection of the new contracts would weaken that bargaining position further because the LNG export license for the Nikiski terminal has been issued and Enstar has an imminent need for additional gas, Saupe argued.

And contrary to the testimony of Spencer Hosie, the producers would not be in violation of their lease terms if they refused to respond to future requests for proposals for gas supplies, offered gas at the same terms as in the new contracts or sold gas to third parties at higher prices, Saupe said.

“The overwhelming evidence is … that any ‘duty to produce’ gas has no bearing on the terms on which producers will sell their gas to local utilities,” he said, adding that any state enforcement action over the “duty to produce” would take years to resolve.

Enstar needs to secure new gas supplies after the end of 2008 because Enstar’s current three supply contracts specify fixed annual contract quantities without any obligation by any producer to cover additional requirements, Saupe said.

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