Legislature(2007 - 2008)

04/18/2007 04:03 PM RES

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04:03:17 PM Start
04:03:27 PM HB177
06:00:13 PM Adjourn
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
HB 177-NATURAL GAS PIPELINE PROJECT                                                                                           
4:03:27 PM                                                                                                                    
CO-CHAIR GATTO  announced that the  only order of  business would                                                               
be HOUSE  BILL NO. 177,  "An Act  relating to the  Alaska Gasline                                                               
Inducement Act;  establishing the  Alaska Gasline  Inducement Act                                                               
matching  contribution  fund;  providing for  an  Alaska  Gasline                                                               
Inducement  Act coordinator;  making  conforming amendments;  and                                                               
providing  for an  effective date."   [Before  the committee  was                                                               
CSHB 177(O&G).]                                                                                                                 
4:04:31 PM                                                                                                                    
ANTONY  SCOTT,  Commercial  Analyst,   Division  of  Oil  &  Gas,                                                               
Department  of Natural  Resources (DNR),  provided the  committee                                                               
with  a  PowerPoint  presentation titled  "Analysis  of  Producer                                                               
Returns, Investment  Attractiveness, and Fiscal  Certainty" dated                                                               
April 18,  2007.  He described  net present value ("NPV")  as the                                                               
"current value of  a stream of future cash flows."   He explained                                                               
that future cash  flows are discounted to  account for inflation,                                                               
impatience, and risk.   He said that a cash flow  20 years in the                                                               
future  is  less certain  than  a  present  day  cash flow.    He                                                               
explained that  companies discount future  cash flows by  what is                                                               
called the "discount rate."   He suggested that investors without                                                               
any  capital  constraints  will  be  likely  to  invest  in  "all                                                               
projects  that  have  a  net present  value  greater  than  zero"                                                               
because those  are the  type of  projects that  add value  to the                                                               
company.    He  opined  that  the discount  rate  is  clearly  an                                                               
important factor  in making an  investment decision and  that his                                                               
presentation  and analysis  will  assume a  discount  rate of  10                                                               
4:08:36 PM                                                                                                                    
DR.   SCOTT  explained   that  another   measure  of   investment                                                               
attractiveness  is   the  internal  rate  of   return,  which  is                                                               
"basically  solving for  the  discount rate  that  makes the  net                                                               
present  value of  a  project's cash  flow equal  to  zero."   He                                                               
offered that, "bigger numbers, in  general, are better."  He went                                                               
on  to  say  that  an additional  factor  is  the  "profitability                                                               
index,"  which is  basically a  measure of  the present  value of                                                               
cash  inflows."   He  reiterated  that  present value  means  the                                                               
discount rate divided by the present  value of cash outflow.  For                                                               
example,  a profitability  index of  two  means if  you invest  a                                                               
single dollar in a project you get two dollars of profit back."                                                                 
4:09:28 PM                                                                                                                    
DR. SCOTT  explained that  the NPV per  barrel of  oil equivalent                                                               
means  taking the  NPV  and dividing  by  the undiscounted  total                                                               
barrel  of oil  equivalent  off  the project.    He provided  the                                                               
committee with materials prepared  by the state's consultant Econ                                                               
One,  which he  said explains  the  meaning and  use of  numerous                                                               
financial terms.   He referred  to slide  3 which sets  forth the                                                               
potential  economics of  a $20  billion gas  pipeline with  a 4.3                                                               
billion cubic  feet (Bcf)  per day  capacity to  Alberta, Canada.                                                               
Under the  scenario, a $4.00 "real  gas price" provides a  NPV to                                                               
the  producers, collectively  discounted at  10 percent,  of $6.1                                                               
billion.   If  one assumes  a  $5.50 gas  price, the  NPV of  the                                                               
project  to the  producers  collectively is  around $12  billion,                                                               
with corresponding internal rates of  return of nearly 40 percent                                                               
and perhaps  over 60 percent.   He said the  profitability ratios                                                               
of the scenarios are estimated at 4.3 and 7.5.                                                                                  
4:11:49 PM                                                                                                                    
REPRESENTATIVE SEATON asked for clarification  of "NPV 10" - does                                                               
that mean  one discounts  future profits  by 10  percent annually                                                               
back to the present day to determine present value?                                                                             
DR. SCOTT agreed that the  aforementioned description "is exactly                                                               
right."  He  explained that in a business  analysis, one examines                                                               
the profits  as well as  the investments.  Since  the investments                                                               
occur  before  the  profits,  they  get  discounted  less.    The                                                               
discount rates compound to result  in an annual discount rate, he                                                               
4:12:47 PM                                                                                                                    
DR. SCOTT explained  that if the proposed pipeline  project has a                                                               
cost  overrun of  50 percent,  the predicted  NPV of  the project                                                               
falls.   If  the price  of gas  is $5.50,  a cost  overrun of  50                                                               
percent would reduce the NPV  from $12.1 billion to $9.2 billion.                                                               
He characterized  the project  cost overrun risk  as "real."   He                                                               
noted  in the  event of  a cost  overrun, the  internal rates  of                                                               
return are still "quite high"  and remain significantly above the                                                               
company's "hurdle  rates."   He reminded  the committee  that the                                                               
numbers presented  are based on the  producers' upstream returns.                                                               
The predictions  made assume that  the producers invest in  a gas                                                               
treatment  plant  (GTP)  and  that  the GTP  is  not  subject  to                                                               
production  profits tax  (PPT) deduction  credits.   Furthermore,                                                               
the scenario  assumes that the  producers make all  the necessary                                                               
upstream investment  for Point Thomson and  associated pipelines,                                                               
but "not in the pipeline itself" he said.                                                                                       
4:14:11 PM                                                                                                                    
CO-CHAIR  JOHNSON asked  for clarification  as  to whether  field                                                               
infrastructure  is included  in  the  predicted future  scenarios                                                               
regarding pipeline development.                                                                                                 
DR. SCOTT  responded that "it does  include field infrastructure"                                                               
and assumes that the producers invest  in and own a GTP.  However                                                               
the model  also assumes the GTP  is not a deductible  expense for                                                               
PPT purposes.                                                                                                                   
4:14:52 PM                                                                                                                    
CO-CHAIR  JOHNSON   asked  how   a  value   was  placed   on  the                                                               
infrastructure used in the economic models.                                                                                     
DR. SCOTT  explained that information  provided by  the producers                                                               
and  knowledge   of  Prudhoe  Bay   fields  indicates   that  the                                                               
incremental in-field investments required  at Prudhoe Bay will be                                                               
relatively modest.   He  noted there is  a significant  amount of                                                               
infrastructure at Prudhoe Bay producing  both oil and gas "except                                                               
of course, the gas treatment plant."   He said that the 2001 cost                                                               
study estimated  the cost for the  GTP to be around  $2.3 billion                                                               
in 2001 dollars.   He said the  cost of the GTP  has been "scaled                                                               
up"  to  reflect  the  general  estimate that  the  cost  of  the                                                               
pipeline has  gone from  $20 billion to  $30 billion  [assuming a                                                               
project to Chicago, Illinois.]                                                                                                  
4:16:41 PM                                                                                                                    
REPRESENTATIVE SEATON  noted that the future  scenarios presented                                                               
consider differing gas  prices, but do not  appear to incorporate                                                               
predicted tariffs.                                                                                                              
DR. SCOTT  replied that the  tariff for the  economic predictions                                                               
is assumed based  on the parameters listed in an  appendix to the                                                               
Econ One report.   The parameters used assume a 70  to 30 debt to                                                               
equity ratio, a  14 percent return on equity, and  a debt cost of                                                               
6.5 percent.   When rolled  together, these factors result  in an                                                               
estimated tariff from  $1.96 to $2.00.  He noted  that if another                                                               
debt  to equity  ratio was  used  or if  the rate  of return  was                                                               
different, the estimates would change.                                                                                          
4:17:43 PM                                                                                                                    
CO-CHAIR GATTO asked what the tariff  would be were the gas to be                                                               
converted  to  liquefied natural  gas  (LNG)  for shipment  on  a                                                               
DR.  SCOTT  responded that  he  could  not answer  that  question                                                               
4:17:59 PM                                                                                                                    
DR.  SCOTT referred  to  slide 5  which  predicts the  producers'                                                               
returns if they were both shippers  and pipeline owners.  He said                                                               
that  this scenario  requires a  much greater  investment by  the                                                               
producers.  He directed the  committee's attention to slide 3 and                                                               
explained that if  the producers were both  shippers and pipeline                                                               
owners, one sees  very substantial declines in  internal rates of                                                               
return,  the profitability  index, and  net present  value.   The                                                               
reason for the  decline in NPV is because the  tariff "off of the                                                               
pipeline throws off a return  of about eight and one-half percent                                                               
on a weighted average cost  of capital basis whereas the discount                                                               
rate  is  greater  than  that",  he  explained.    As  a  result,                                                               
investment in the  pipeline at a 10 percent  discount rate "costs                                                               
you money."  If the discount  rate is lower than 10 percent, then                                                               
the "pipeline  doesn't cost  you money," he  said.   He explained                                                               
that pipeline  companies have different  discount rates  and that                                                               
10 percent is not a particularly low discount rate.                                                                             
4:19:49 PM                                                                                                                    
REPRESENTATIVE  WILSON  suggested   that  if  the  aforementioned                                                               
predictions regarding  pipeline economics  are factual,  then the                                                               
shippers would not want to own the pipeline.                                                                                    
DR. SCOTT  responded by characterizing  the above comment  as "an                                                               
extremely interesting  and provocative  question" which  he would                                                               
address shortly.                                                                                                                
DR. SCOTT explained  that slide 6 titled  "Producer NPV: Relative                                                               
likelihood,"  shows the  distribution of  NPV from  an integrated                                                               
upstream  investment and  the  relative  likelihood of  different                                                               
outcomes.  He  indicated that DNR believes that  from an upstream                                                               
only investment perspective,  half of the time  [represented by a                                                               
blue bar]  the NPV,  discounted at  10 percent,  is at  least $13                                                               
billion.   That means there is  a 50 percent likelihood  that the                                                               
NPV will be  at least $13 billion and a  50 percent likelihood it                                                               
will be below  $13 billion.  He said that  the further one strays                                                               
from the  $13 billion figure,  the "less likely the  outcome is."                                                               
He said there is a small  chance the returns off the project will                                                               
exceed $30 billion.                                                                                                             
4:22:19 PM                                                                                                                    
REPRESENTATIVE  ROSES   sought  further  explanation   about  the                                                               
likelihood that the percentage of return would be $13 billion.                                                                  
DR. SCOTT referred  to slide 6 and noted that  if returns were $6                                                               
billion, then  the likelihood that  project returns  would exceed                                                               
$6 billion is considerably greater  than 50 percent, indeed it is                                                               
around 75 percent.                                                                                                              
4:23:30 PM                                                                                                                    
DR. SCOTT  explained that  slide 7  shows the  relative frequency                                                               
distribution of the internal rate  of return (IRR).  He explained                                                               
that for the upstream there is  a median IRR of 57 percent, which                                                               
means that there  is a 50 percent likelihood that  the IRR on the                                                               
upstream investment  only will  be 57 percent.   However,  for an                                                               
integrated  project  the  "spread   is  much  narrower"  and  the                                                               
probability  of  the  IRR reaching  60  percent  is  "essentially                                                               
zero,"  he  said.   The  reason  is  that an  integrated  project                                                               
requires the  producers to make  an "enormous  upfront investment                                                               
in the pipeline and it drags the [IRR] down," he explained.                                                                     
4:24:27 PM                                                                                                                    
DR. SCOTT  explained that  slide 8  sets forth  the results  of a                                                               
frequency distribution  analysis of the  producers' profitability                                                               
ratio  for  both  an  integrated  project  and  an  upstream-only                                                               
project.  He summarized the  presentation to this point as having                                                               
provided a  general overview of  potential producer  returns from                                                               
this project.   He  indicated that  a response  to Representative                                                               
Wilson's question regarding  why the producers would  want to own                                                               
the pipeline first requires acknowledgement  that there are other                                                               
investment  opportunities worldwide  as shown  on slide  9 titled                                                               
"Comparative  Project Opportunities."   He  opined that  the data                                                               
used by Econ One to compile the  graph on slide 9 is accurate and                                                               
recent.  He said the NPV  predictions vary depending on the price                                                               
of oil,  noting that  a higher  oil price  supports a  higher NPV                                                               
4:27:18 PM                                                                                                                    
DR. SCOTT  explained that slide  10 predicts the economics  of an                                                               
Alaska  gas pipeline  project  which ends  at  either Alberta  or                                                               
Chicago.  When based  on oil prices of $25 or  $35 per barrel the                                                               
project is the "most attractive  project," to the producers on an                                                               
NPV basis.   He said there  is a "significant spread"  in the NPV                                                               
between  Alberta   and  Chicago,  with  termination   in  Alberta                                                               
providing  a  greater  rate  of   return  due  to  the  need  for                                                               
significantly less infrastructure investment.   He explained that                                                               
he updated the information used in  slide 10 for slide 11 to show                                                               
the  current gas  pipeline  economics using  PPT  instead of  the                                                               
prior  economic  limit  factor  [ELF].    The  current  gas  line                                                               
economic model, from an upstream  perspective, indicates that the                                                               
Alaska  project  is  "still  either  the  first  or  second  most                                                               
attractive  project"  in  the  producers'   portfolio.    If  one                                                               
considers  it  from  the integrated  perspective,  the  project's                                                               
attractiveness drops to "maybe the  third most attractive project                                                               
in the portfolio."  In response  to a question, he clarified that                                                               
the upstream analysis assumes "zero percent pipeline ownership."                                                                
4:31:41 PM                                                                                                                    
DR.  SCOTT opined  that when  one considers  profitability ratios                                                               
from an upstream perspective, the  Alaska project has "by far the                                                               
most  attractive  profitability  index ratio  investment  in  the                                                               
[producers'] portfolio."   Its profitability  does not  even "fit                                                               
on the chart," he explained, referring  to slide 12.  However, if                                                               
this  scenario is  considered from  the  prospective of  producer                                                               
ownership of  the pipeline, the profitability  ratio decreases to                                                               
around the  25th percentile, meaning that  roughly three-quarters                                                               
of  the  investment  opportunities  in  the  portfolio  are  more                                                               
attractive than the  Alaska pipeline project.   He explained that                                                               
the most  important factors that  decrease profitability  are the                                                               
increased construction costs and the change  from ELF to PPT.  He                                                               
opined the change  "really shows up" in Prudhoe Bay  as the prior                                                               
effective tax rate  there was around seven to  seven and one-half                                                               
percent while  the current effective  tax rate on gas  at Prudhoe                                                               
Bay under PPT is around 20 percent,  he explained.  He went on to                                                               
discuss the  internal rates  of return under  PPT and  noted that                                                               
"if you don't own the pipeline  ... in terms of internal rates of                                                               
return, this is a very attractive project in the portfolio."                                                                    
4:34:11 PM                                                                                                                    
DR.  SCOTT   directed  attention   to  slide  14   and  addressed                                                               
Representative Wilson's  prior question  as to why  the producers                                                               
would  want to  own the  pipeline.   He suggested  that some  may                                                               
believe that the producers "have to"  own the project as they are                                                               
the only  companies that  can obtain  the financing  necessary to                                                               
build the  pipeline.  He opined  that this "isn't so,"  and noted                                                               
that there are  pipeline companies that are ready  and willing to                                                               
invest in the  project and that "they can handle  it, they can do                                                               
this."  He said that  these companies require firm transportation                                                               
(FT) commitments so as to obtain  financing.  He stressed that it                                                               
is "extremely important" to recognize  that this project will not                                                               
be financed  by "Exxon's balance  sheet."  He explained  that the                                                               
project  will be  financed  on a  "project  finance basis"  which                                                               
means that the  expected project revenues will  provide the basis                                                               
for lenders to  provide project financing.  He  opined that "it's                                                               
the gas  in the  ground that matters,"  as these  proved reserves                                                               
provide  assurance that  there will  be enough  gas to  "keep the                                                               
project  full, with  no  decline, for  at least  15  years."   He                                                               
characterized  the  existence  of  this large  amount  of  proved                                                               
reserves as an "exceptionally unusual  circumstance" for a basin-                                                               
opening project.  He said that  during debate on the extension of                                                               
federal loan  guarantees, it was  determined that the  Alaska gas                                                               
project may be sufficiently attractive  from a credit perspective                                                               
that the federal government "will  back this."  He indicated that                                                               
a  federal  report  on  this   project  stated  that  without  FT                                                               
commitments the  project "will  be rated -  on a  project finance                                                               
basis,  double  B [BB]  instead  of  triple B  [BBB],  investment                                                               
grade."  He  stressed that it is  the "gas in the  ground that is                                                               
providing the financing."                                                                                                       
4:38:31 PM                                                                                                                    
REPRESENTATIVE WILSON  asked whether even without  FT commitments                                                               
"they could still get the loan."                                                                                                
DR.  SCOTT replied  "that  is  exactly what  we're  saying."   He                                                               
cautioned  that an  independent  pipeline developer  needs an  FT                                                               
commitment from  the producers  in order to  go forward  with the                                                               
project.    If the  builders  contribute  20 percent  equity,  or                                                               
approximately $4  billion, to  the project  and build  without FT                                                               
commitments they  run the risk that  the holders of the  gas will                                                               
leverage the  shipper to reduce  its tariffs prior  to committing                                                               
their  gas to  the  project.   He  emphasized  that the  pipeline                                                               
developer  "absolutely has  to have  shipping commitments  - it's                                                               
because of what we call 'hold-up' risk."                                                                                        
4:40:53 PM                                                                                                                    
CO-CHAIR  GATTO  asked  whether  it is  conversely  true  that  a                                                               
producer-owner could claim "the tariff is too low."                                                                             
DR. SCOTT replied  "not necessarily, no."  He  expanded his point                                                               
by opining  that for  an integrated project,  such as  the Trans-                                                               
Alaska Pipeline System  (TAPS), the incentive is  for the "lowest                                                               
cost  project" with  the  "highest tariff."    He explained  that                                                               
commercial incentive  exists because the taxes  and royalties are                                                               
paid after  subtraction of  tariff costs.   A pipeline  owner who                                                               
also owns  the gas is "indifferent  to what the tariff  is ... it                                                               
only matters  where you take your  profits - do you  take them on                                                               
the  pipeline or  do you  take them  on the  gas?"   The tax  and                                                               
royalty burden decreases  if the pipeline tariffs  are higher, he                                                               
4:42:01 PM                                                                                                                    
DR. SCOTT suggested that another  reason the producers would want                                                               
to  own  the  pipeline  is  to control  costs,  a  motivation  he                                                               
characterized  as  "fair   enough."    He  offered   that  it  is                                                               
understandable that  parties want some cost  control abilities if                                                               
they are going  to enter shipping commitments  since the shipping                                                               
tariffs  are  based in  part  on  pipeline  costs.   However,  he                                                               
cautioned  that  there  is  an   incorrect  perception  that  the                                                               
shippers pay for  the cost of the project "no  matter what" since                                                               
the  pipeline business  is a  "cost plus"  business in  which the                                                               
shippers charge  "whatever it costs,  plus a return."   He opined                                                               
that  this  characterization  is  not accurate  when  applied  to                                                               
today's  pipeline  business.    He said  that  most  newly  built                                                               
pipelines are built on the  basis of rates negotiated between the                                                               
shippers and  pipeline entities  prior to  pipeline construction.                                                               
He opined  that the  risk of  cost overruns  is addressed  in the                                                               
negotiated rate discussions.   He offered that a  great number of                                                               
pipelines are built in the Lower  48 on the basis of "fixed price                                                               
negotiated  rates."   In  some  instances,  the shipper  is  then                                                               
assured of  a "set  it and  forget it,"  rate while  the pipeline                                                               
company bears all of the cost overrun risk.                                                                                     
4:44:37 PM                                                                                                                    
DR. SCOTT  opined that  the Alaska  pipeline project  will likely                                                               
not have negotiated  rates because the project lead  times are so                                                               
long  that there  are  numerous cost  factors  "not in  anybody's                                                               
control."   This  factor of  uncertain costs  does not  place the                                                               
Alaska  project "in  a cost  plus environment,"  rather "what  we                                                               
absolutely  expect  is that  risk  sharing  is to  be  negotiated                                                               
between the  pipeline entity  and the shippers,"  he opined.   He                                                               
gave as an example the Rockies  Express Pipeline in the Lower 48,                                                               
which  has three  different negotiated  rates, each  reflecting a                                                               
different  risk scenario  and the  parties' "differing  appetites                                                               
for  risk."    He  explained  that one  variable  that  could  be                                                               
included  in negotiated  rates for  the Alaska  project would  be                                                               
"steel price  escalators," since steel prices  are a significant,                                                               
but uncontrollable factor that will affect pipeline costs.                                                                      
4:46:07 PM                                                                                                                    
REPRESENTATIVE WILSON asked about the  role of the Federal Energy                                                               
Regulatory Commission  (FERC) if negotiated rates  are determined                                                               
prior to open season.                                                                                                           
DR. SCOTT explained that these  rates will be negotiated prior to                                                               
open season,  but "consummated  at the open  season,"   He agreed                                                               
that the parties  will negotiate prior to  any FERC determination                                                               
of a  "cost-based tariff."   He said that  FERC does not  rule on                                                               
whether  a  negotiated  rate  is  in the  public  interest.    He                                                               
explained  that FERC  will exercise  its regulatory  jurisdiction                                                               
only  over the  "maximum or  recourse  rate," which  is the  rate                                                               
available  to any  shipper without  negotiation.   He said  it is                                                               
possible  that there  could  be  no shippers  ever  on the  "FERC                                                               
established rate,"  and explained that there  are pipelines where                                                               
all shippers pay at negotiated rates.                                                                                           
4:48:02 PM                                                                                                                    
REPRESENTATIVE  WILSON expressed  concern as  to why  issues have                                                               
been raised  about the  tariff provisions  of the  bill if  it is                                                               
"irrelevant most of the time."                                                                                                  
DR. SCOTT  replied that  the recourse rate  will be  important to                                                               
the state's interest because it  will provide a benchmark for the                                                               
state to  consider when  determining the  tax and  royalty rates,                                                               
particularly if  the pipeline owners  are also the shippers.   In                                                               
that instance,  the owner/shipper  may negotiate  a rate  that is                                                               
much  higher than  the  "FERC cost  of service  rate."   In  that                                                               
instance, the  state must decide  whether to establish  taxes and                                                               
royalties based  on the negotiated rate,  or on the FERC  cost of                                                               
service rate.                                                                                                                   
[Co-Chair Gatto turned the gavel over to Co-Chair Johnson.]                                                                     
4:49:54 PM                                                                                                                    
DR. SCOTT summarized that there  are valid commercial reasons why                                                               
a producer would like to own  the pipeline, such as cost control.                                                               
He  suggested  that  there  is a  perception  that  the  pipeline                                                               
company  has  no incentive  to  control  costs in  an  integrated                                                               
project, but opined  that this conclusion is not  accurate and is                                                               
"not to be expected on this project."                                                                                           
4:50:28 PM                                                                                                                    
REPRESENTATIVE ROSES  asked whether it  is in the  best interests                                                               
of the producers  for the state to create a  mechanism that gives                                                               
them the maximum amount of  flexibility possible to allow them to                                                               
"really play with the cards and the economics."                                                                                 
DR. SCOTT  responded that the  aforementioned statement  could be                                                               
considered a "commercially reasonable statement."                                                                               
4:51:04 PM                                                                                                                    
DR.  SCOTT went  on  to say  that there  will  likely be  further                                                               
discussion as  to whether a FT  commitment is the same  as a debt                                                               
obligation.   He  offered his  understanding that  the producers'                                                               
stated view  is that an FT  commitment is exactly like  issuing a                                                               
debt  obligation.    He  indicated   that  DNR  has  studied  and                                                               
considered  this issue  "for a  number of  years."   He said  his                                                               
opinion  on this  issue  has  been formed  by  market factors  as                                                               
"that's ... reality."  He opined  that the first thing to note is                                                               
that  an  FT commitment  shows  up  as  a footnote  on  financial                                                               
statements,  but  "does not  go  against"  the company's  balance                                                               
sheet.  He  suggested that a contention that an  FT commitment is                                                               
a debt  equivalent is  akin to  stating an  FT commitment  is the                                                               
same as a lease.  He  offered that characterization of the nature                                                               
of the  obligation "does not  really play  out" in terms  of "how                                                               
the IRS {Internal Revenue Service]  views it."  He suggested that                                                               
if the  IRS viewed FT  commitments as equivalent to  leases, then                                                               
depreciation benefits  under tax provisions would  flow to leases                                                               
[lessees]  as opposed  to  owners.   He  explained  that the  tax                                                               
treatment of depreciation "does not  flow from a pipeline company                                                               
to a shipper."   He reiterated that  the IRS does not  "view a FT                                                               
commitment as a debt or lease equivalent."                                                                                      
4:54:57 PM                                                                                                                    
DR. SCOTT explained  that analysts in the  credit rating agencies                                                               
have been  asked by [state economists]  if an FT commitment  is a                                                               
debt equivalent  which would reduce the  company's future ability                                                               
to issue debt.   He said that the credit  rating agencies replied                                                               
"absolutely  not, that's  not how  we look  at things."   He  put                                                               
forth  that credit  rating agencies  may potentially  consider FT                                                               
commitments  in  assessing  the   overall  risk  profile  of  the                                                               
company.  However, in general  FT commitments are "not considered                                                               
at all," a point he indicated  is supported by a Moody's Investor                                                               
Service report of  2003 which states "in general  we [Moody's] do                                                               
not  look at  FT  commitments when  assessing  E/P [earnings  and                                                               
profits]  credit strength."    He opined  that  this makes  sense                                                               
because FT  commitments may actually increase  a company's credit                                                               
increase by establishing positive future cash flows.                                                                            
4:57:47 PM                                                                                                                    
REPRESENTATIVE ROSES indicated  he understands the aforementioned                                                               
analysis, but  asked what happens  should the pipeline  volume be                                                               
insufficient to meet the FT commitment requirements.                                                                            
4:58:07 PM                                                                                                                    
DR. SCOTT  replied that it is  exactly right that an  entity that                                                               
makes a FT  commitment does not do  so on a risk  free basis, and                                                               
he did not mean to so imply.   One risk related to FT commitments                                                               
is  that of  price, the  second  is reserve  risk, he  said.   He                                                               
explained that  an entity  that makes an  FT commitment  does not                                                               
pay if the pipeline is not completed  or is not in operation.  He                                                               
said that the biggest risk facing  the Alaska project is the risk                                                               
of low  production.  The  pipeline developer bears the  risk that                                                               
there   may  be   insufficient  production   despite  significant                                                               
investments made in the development of  the pipeline.  One way to                                                               
manage risk  is to  "bring in  new parties and  get them  to bear                                                               
some," he suggested.  He said  that shippers do not normally have                                                               
to pay  if for  some reason  the pipeline is  not operating.   In                                                               
that instance, it is the pipeline  company that "is on the hook,"                                                               
he said.                                                                                                                        
5:01:30 PM                                                                                                                    
DR. SCOTT  explained that another reason  for integrated pipeline                                                               
ownership is control  or influence over the  pipeline terms, such                                                               
as tariffs, recourse  rates, and expansion.  He  opined that AGIA                                                               
seeks to  assure that  the pipeline owner,  whoever that  may be,                                                               
will  act  like a  pipeline  company,  as those  companies  favor                                                               
rolled-in  rates  and  expansion.    He  said  that  although  an                                                               
integrated approach  may appear to lessen  the project's economic                                                               
benefits  to the  producers, an  integrated approach  may improve                                                               
"bargaining position with the state."                                                                                           
5:03:05 PM                                                                                                                    
DR. SCOTT  referred to  slide 15  which represents  the financial                                                               
commitment  necessary to  enter  FT contracts  for  either a  $20                                                               
billion or $25 billion pipeline project.   He said that the total                                                               
FT  commitment  costs for  the  producers  could be  around  $3.4                                                               
billion a  year; higher  should the project  costs increase.   He                                                               
indicated that  even using conservative gas  price estimates, and                                                               
assuming  no additional  discoveries, the  likely revenues  would                                                               
exceed the FT payments [as shown in slide 16].                                                                                  
5:04:42 PM                                                                                                                    
REPRESENTATIVE WILSON  asked whether  the peak revenues  from the                                                               
gas pipeline as depicted in slide  16 would plateau if there were                                                               
additional discoveries of gas.                                                                                                  
DR. SCOTT predicted that if  additional gas reserves were to fill                                                               
the pipeline to capacity, the  revenue projections shown on slide                                                               
16 would not  plateau, but would continue to rise.   He explained                                                               
that  the prices  used for  the example  are in  today's dollars,                                                               
which  is why  the prices  continue to  rise.   He described  the                                                               
tariff  as  "not a  real  tariff"  but  a $2.00  "nominal  dollar                                                               
tariff."   Over the course of  15 years, the cost  of the nominal                                                               
tariff is much less than in the beginning, he said.                                                                             
[Co-Chair Johnson returned the gavel to Co-Chair Gatto.]                                                                        
DR.   SCOTT    explained   that   economic    forecasts   predict                                                               
"considerable positive  cash flow"  should the gas  prices exceed                                                               
the "AECO  [Alberta Hub] price  level," which they  are predicted                                                               
to do over 85 percent of the time.                                                                                              
5:06:54 PM                                                                                                                    
CO-CHAIR GATTO  asked about recovery  of exploration costs  if no                                                               
new gas is discovered despite exploration efforts.                                                                              
DR. SCOTT  replied that "they  are out  of pocket" for  the costs                                                               
REPRESENTATIVE SEATON clarified that  the explorers would be "out                                                               
of pocket" for basically 60  percent of the exploration costs due                                                               
to  PPT provisions  which set  a  tax rate  of 22  percent and  a                                                               
capital credit rate of 20 percent.                                                                                              
DR. SCOTT  agreed that the aforementioned  description is exactly                                                               
right under the current PPT.                                                                                                    
5:07:56 PM                                                                                                                    
DR.  SCOTT explained  that  slide  17 sets  forth  the effect  on                                                               
revenue of  raising taxes by 15,  30, or 50 percent  on "day one"                                                               
of the  project.  A tax  increase of 15 percent  would reduce the                                                               
project's NPV by 5.1 percent, a  tax increase of 30 percent would                                                               
decrease NPV  by 10.2 percent, and  a tax increase of  50 percent                                                               
would   decrease  NPV   by  17.1   percent,  results   he  deemed                                                               
"material."  However, he offered  his belief that it is important                                                               
to put  the effect any  tax increases  in context.   He indicated                                                               
that a  $0.50 change  in the  price of  gas may  have more  of an                                                               
effect on the NPV  than a tax increase of 30  percent.  He opined                                                               
that the "big risk" on this  project is price risk.  He responded                                                               
to  an  inquiry  by  noting   that  gas  prices  tend  to  change                                                               
significantly and daily.                                                                                                        
CO-CHAIR GATTO noted  that the scenario discussed  so far assumes                                                               
a tax increase as of "day one."                                                                                                 
5:13:11 PM                                                                                                                    
DR. SCOTT  presented a  prediction based  on the  assumption that                                                               
production taxes would  be increased in the eleventh  year of the                                                               
project.   Under this scenario,  a 15 percent tax  increase would                                                               
decrease NPV  by 2 percent,  which indicates that  set production                                                               
tax rates  for a 10 year  period "makes a material  difference in                                                               
terms  of  exposure  to  fiscal   uncertainty,"  he  said.    Tax                                                               
increases have less  of an effect on NPV after  15 years, since a                                                               
15 percent  tax increase in  the sixteenth year may  decrease NPV                                                               
by only  1 percent, he  said, referring to  slide 20.   He opined                                                               
that  the "value  of fiscal  certainty starts  decaying rapidly,"                                                               
after a project's initial few years of operation.                                                                               
5:15:19 PM                                                                                                                    
CO-CHAIR GATTO  observed that  the first ten  years of  a project                                                               
appear to be the most important in terms of fiscal certainty.                                                                   
DR. SCOTT  agreed that  the early  years of  the project  are the                                                               
most important  period for  which to have  fiscal certainty.   He                                                               
noted "we  are dealing with  compounding" and explained  that one                                                               
needs to  remember that companies  make investments on  the basis                                                               
of discounted value.                                                                                                            
5:16:28 PM                                                                                                                    
DR. SCOTT went on to explain  that internal rates of return (IRR)                                                               
do not "move very much with  tax increases," and that 10 years of                                                               
fiscal certainty  is adequate from an  IRR basis.  He  went on to                                                               
say  that profitability  indexes also  show that  the project  is                                                               
economically  attractive.   In  response  to  an observation,  he                                                               
explained that  a 30-year  project life forecast  is all  that is                                                               
needed  to  get a  good  understanding  of the  pipeline  project                                                               
5:20:11 PM                                                                                                                    
DR. SCOTT responded  to a request to clarify  his prior testimony                                                               
regarding the relationship of FT  commitments to possible federal                                                               
loan  guarantee  provisions.     He  said  that  the  authorizing                                                               
language  for  the loan  guarantees  in  the Alaska  Natural  Gas                                                               
Pipeline Act  of 2004 (ANGPA)  states that "the Secretary  of the                                                               
Department of Energy ... may impose  ... no condition on the loan                                                               
guarantee beyond  what the project  proponent imposes on  ... the                                                               
shippers."   He said that means  if a project proponent  does not                                                               
obtain  FT guarantees  from  the shipper,  the  Secretary of  the                                                               
Department  of Energy  cannot  place "that  as  a requirement  of                                                               
receiving  a federal  loan  guarantee."   He  explained that  the                                                               
potential cost  to taxpayers of  the federal loan  guarantees for                                                               
the Alaska  pipeline project was  analyzed by  federal economists                                                               
with the  assumption that there would  be no FT commitments.   He                                                               
reminded   the  committee   that  TAPS   was  built   without  FT                                                               
commitments,  although he  noted that  the economics  surrounding                                                               
the construction of TAPS were different.                                                                                        
5:22:41 PM                                                                                                                    
REPRESENTATIVE SEATON  set forth  a hypothetical  assumption that                                                               
there are  FT commitments for  the first  five to seven  years of                                                               
the pipeline.   In that  situation, he asked whether  the federal                                                               
loan guarantee would still apply to the other 80 percent.                                                                       
DR. SCOTT agreed that the  aforementioned description is correct.                                                               
The federal loan  guarantee would apply to all  the project debt,                                                               
including debt  service that extends  beyond the terms of  any FT                                                               
commitments, he explained.                                                                                                      
REPRESENTATIVE  SEATON asked  whether  it is  possible to  reduce                                                               
risk to  shippers by asking  "for an  open season of  seven years                                                               
... so then  people could bid on whether they  want seven or they                                                               
want to guarantee themselves more time on that pipeline."                                                                       
DR. SCOTT replied that such  a scenario is possible, but unlikely                                                               
because  such a  short  FT commitment  period  by an  independent                                                               
pipeline company is due  to "hold up" risk, he said.   He went on                                                               
to  explain  that  the  federal  government  will  guarantee  the                                                               
construction debt, but  that the pipeline company  will require a                                                               
return  on  equity,  which  is  not  guaranteed  by  the  federal                                                               
government.  He  said that FT commitments for 15  years have been                                                               
used  for  pipelines  in  the   Lower  48,  but  opined  that  FT                                                               
commitments for the Alaska project would  more likely be 15 to 20                                                               
years.   He said that  a shipper does  face some reserve  risk as                                                               
production  will decrease  after 14  or  so years.   However,  he                                                               
opined that shippers are best  positioned to "wear that risk," so                                                               
it makes more  business sense for the shippers to  take a 20 year                                                               
FT commitment while  the pipeline builder takes more  of the cost                                                               
overrun risk  as it can better  manage costs.  He  explained that                                                               
in commercial  negotiations, companies  prefer to bear  the risks                                                               
they have the ability to manage.                                                                                                
5:28:12 PM                                                                                                                    
CO-CHAIR JOHNSON  asked if a change  in the debt to  equity ratio                                                               
would allow for a shorter FT commitment.                                                                                        
DR. SCOTT replied that  he did not think so.   He said FERC never                                                               
permits  pipelines to  base rates  on  100 percent  equity.   The                                                               
situation is  different from a  residential mortgage,  where debt                                                               
is retired.   In pipeline projects, the  debt retirement schedule                                                               
is  not  necessarily at  all  the  same  as the  debt  retirement                                                               
schedule that  rates are  based on.   FERC  will not  allow rates                                                               
based  on 100  percent  equity -  that is  "outside  the zone  of                                                               
reasonableness," he said.  He  stated that the lowest debt ratios                                                               
are  usually around  30  to 35  percent debt,  and  that debt  is                                                               
maintained throughout the life of the project.                                                                                  
5:30:08 PM                                                                                                                    
CO-CHAIR JOHNSON asked  for further information on  the effect of                                                               
differing debt  to equity ratios  on the FT commitment  terms and                                                               
on the  approaches available  to provide  an acceptable  level of                                                               
fiscal certainty.                                                                                                               
DR. SCOTT answered that the debt  to equity ratio will not effect                                                               
the appropriate period for FT  commitments.  These two issues are                                                               
"not linked," he opined.                                                                                                        
5:31:57 PM                                                                                                                    
REPRESENTATIVE  WILSON  asked  if  negotiated  rates  are  "solid                                                               
deals," not subject to later adjustment by FERC.                                                                                
DR. SCOTT replied that is  correct.  The contracts for negotiated                                                               
rates are  finalized at open  season and are known  as "precedent                                                               
agreements" as there are often  conditions that must be satisfied                                                               
before  the  shipper must  commit  to  the  contract terms.    He                                                               
offered his belief  that for this project one  of the "conditions                                                               
precedent" will be  that the cost estimates be  within the bounds                                                               
estimated at the time of the open season.                                                                                       
REPRESENTATIVE WILSON asked if the  shippers can "back out" under                                                               
certain situations.                                                                                                             
DR.  SCOTT agreed  that  the  shippers could  "back  out" if  the                                                               
contract  had  a  clause  that  allowed  them  to  under  certain                                                               
circumstances, such  as a cost  increase of a  certain magnitude.                                                               
He said that  for large, complex projects, it is  not unusual for                                                               
parties to  enter agreements  which require  the shipper  to take                                                               
certain   actions  as   a  "condition   precedent"  to   contract                                                               
5:36:32 PM                                                                                                                    
REPRESENTATIVE WILSON noted that  previous producer testimony had                                                               
expressed  opposition  to  use  of  rolled-in  rates,  while  the                                                               
independent pipeline companies did not  seem to oppose them.  She                                                               
asked for some further explanation of this issue.                                                                               
DR.  SCOTT  explained  that rolled-in  rates  are  "unequivocally                                                               
good" for  a shipper interested  in exploring for  additional gas                                                               
supplies.   For  a shipper  that  is not  an explorer,  rolled-in                                                               
rates are "potentially  a problem" because rates  can rise, which                                                               
is harmful to  shippers.  A pipeline owner who  is also a shipper                                                               
does "not care" what the  rate is, assuming there are appropriate                                                               
distribution   rules  in   its   limited  liability   partnership                                                               
arrangement.   The  "rate is  immaterial because  you are  paying                                                               
yourself,"  he said.   A  pipeline owner  who is  also a  shipper                                                               
therefore  does not  support rolled-in  rates  because "they  can                                                               
only hurt ..."   Therefore, an independent  pipeline company that                                                               
does not plan on owning  the pipeline may support rolled-in rates                                                               
as they  can be less  costly than  incremental rates.   He opined                                                               
that  incremental rates  can  be so  much  higher than  rolled-in                                                               
rates  that it  may affect  the ability  to expand  the pipeline.                                                               
For example, if expansion was  done through compression, the rate                                                               
increase  under incremental  rates could  be around  $1.00, while                                                               
the rate increase under rolled-in rates could be around $0.15.                                                                  
5:40:23 PM                                                                                                                    
REPRESENTATIVE  WILSON  suggested  that  the 15  percent  cap  on                                                               
rolled-in  rates in  AGIA is  designed to  protect the  producers                                                               
somewhat and still provide some incentive to explorers.                                                                         
DR.  SCOTT   characterized  the  aforementioned   description  as                                                               
exactly right.                                                                                                                  
REPRESENTATIVE WILSON asked whether  the 15 percent limitation on                                                               
rate increases  [AS 43.90.130(7)] is  reasonable and fair  to the                                                               
5:41:21 PM                                                                                                                    
DR.  SCOTT  responded  that  "fairness  is  in  the  eye  of  the                                                               
beholder."    He explained  that  the  15 percent  provision  was                                                               
developed after  considering issues described  in slides 1  and 2                                                               
titled respectively, "Effects of  Government Subsidies on Rates,"                                                               
and  "Summary   of  Government  Subsidies   on  Rates,"   from  a                                                               
presentation  on  "Government  contributions  to  rates"  to  the                                                               
Senate  Judiciary  Committee, 4/16/07.    He  explained that  the                                                               
various federal  and state subsidies  granted the  Alaska project                                                               
reduce the  pipeline tariff by  $0.25.  On  a tariff of  $2.00, a                                                               
$0.25 reduction is  about 12 and one-half  percent, he explained.                                                               
He noted  that the owners of  the GTP will receive  an additional                                                               
15 percent federal investment tax  credit.  He suggested that one                                                               
way  to  view the  15  percent  cap in  AGIA  is  to assure  that                                                               
government subsidies  are shared by  all shippers in  the system,                                                               
and are  not "enjoyed only by  the initial shippers."   A further                                                               
consideration that  supports the  15 percent  cap is  the state's                                                               
interest  in   assuring  future   pipeline  expansions   are  not                                                               
"artificially  capped,"  he  explained.   He  opined  that  a  15                                                               
percent  cap  is   likely  to  get  the   pipeline  through  full                                                               
compression and perhaps  through a first looping  on the project.                                                               
After the first  looping, he suggested that rates  may decline or                                                               
at least  hold steady.   He said  there is  uncertainty regarding                                                               
the  effect of  expansion  on rates  as it  depends  on when  the                                                               
expansion occurs and the costs thereof.                                                                                         
5:46:14 PM                                                                                                                    
REPRESENTATIVE WILSON noted that  the producers can negotiate for                                                               
certain rates prior to the project.   She asked why the producers                                                               
claim that AGIA does not allow them to negotiate with FERC.                                                                     
DR. SCOTT  opined that  the producers  object to  provisions that                                                               
require  the  pipeline company  not  negotiate  rates that  would                                                               
preclude it from rolling in expansion  costs up to the 15 percent                                                               
cap.   He  suggested  that  if the  producers  own the  pipeline,                                                               
business  considerations would  favor that  they negotiate  rates                                                               
with themselves  which would prevent  expansion costs  from being                                                               
rolled-in  to them  as shippers.   He  offered that  this matters                                                               
because  if  there   is  a  subsequent  expansion,   it  will  be                                                               
"exceptionally  difficult"  for  FERC  to  order  rolled-in  rate                                                               
treatment of  expansion costs because  there are "no  shippers to                                                               
spread it over."   As a political matter, the  ability of FERC to                                                               
roll-in  such expansion  costs would  be affected,  he said.   He                                                               
noted  that a  compression expansion  of one  billion cubic  feet                                                               
(Bcf)  would   cost  approximately  $1  billion   in  compression                                                               
5:48:32 PM                                                                                                                    
DR. SCOTT responded  to a concern regarding the focus  of the DNR                                                               
and the Department of Revenue (DOR)  by explaining that it is not                                                               
the case  that DNR  is engaged  solely in  regulatory activities.                                                               
The Division  of Oil  and Gas has  a crucial  commercial function                                                               
since it  is bound  by contractual  lease relationships  with oil                                                               
and gas  explorers.   In comparison,  the DOR acts  in more  of a                                                               
sovereign capacity.   He opined that  DNR and the lessees  can be                                                               
considered equals  under the  bounds of contract  law.   The DNR,                                                               
through  the  Division  of  Oil  and  Gas,  tends  to  have  more                                                               
expertise  on  matters of  geology,  pipeline  tariffs, and  rate                                                               
5:52:07 PM                                                                                                                    
REPRESENTATIVE  ROSES said  that  the  presentation really  added                                                               
some  clarity to  issues of  flexibility.   He opined  that those                                                               
"who were hollering the most"  about flexibility appear to be the                                                               
parties with the greatest control  over both sides of the pricing                                                               
structure.   Additionally, he noted  that until the  ownership of                                                               
the pipeline is clear, the parties  may want to wait to negotiate                                                               
the rate structure.                                                                                                             
CO-CHAIR JOHNSON stated  he was intrigued by  the suggestion that                                                               
a 15 percent federal subsidy applies  to the rates on the project                                                               
as  it seems  to lessen  any conclusion  that the  pipeline owner                                                               
subsidizes shippers up to the 15 percent.                                                                                       
5:53:51 PM                                                                                                                    
DR. SCOTT  said there is  some confusion regarding  the economics                                                               
of  what  a  subsidy  actually  is.    Initial  shippers  do  not                                                               
necessarily subsidize later shippers as  long as all shippers are                                                               
at  least paying  the "marginal  cost," he  explained.   He noted                                                               
that in business expansions, very  often costs rise and all users                                                               
pay  the same  increased costs.    The only  way expansion  costs                                                               
could be  a subsidy is  if an initial  shipper believes it  has a                                                               
property right to a  rate, and if there is a  property right to a                                                               
rate, "what  we're talking  about is  not subsidy,  we're talking                                                               
about theft," he opined.                                                                                                        
5:56:57 PM                                                                                                                    
REPRESENTATIVE  SEATON asked  for further  discussion of  whether                                                               
the 15  percent limitation could  be characterized as  a subsidy.                                                               
He suggested that all AGIA  establishes is the state's preference                                                               
for  rolled-in rates  and  that FERC  will  ultimately decide  if                                                               
there is a subsidy.                                                                                                             
5:58:18 PM                                                                                                                    
DR. SCOTT  replied that an  independent pipeline owner  will want                                                               
to expand its  business by expanding the pipe.   He said it would                                                               
be in their interest to roll-in  rates so as to decrease the cost                                                               
to new  entrants.  He  offered that  the pipeline company  has no                                                               
commercial interest  in assessing whether something  is a subsidy                                                               
or not.   Under  AGIA the  pipeline company  is required  only to                                                               
propose  rates,  while  FERC  "disposes"  of  rate  issues.    He                                                               
explained that the  state's approach does not  infringe on FERC's                                                               
jurisdiction; rather  it helps assure  that the  pipeline company                                                               
"acts  like  a  pipeline  company" regardless  of  who  owns  the                                                               
[HB 177 was held over.]                                                                                                         

Document Name Date/Time Subjects