Legislature(1995 - 1996)
05/11/1995 09:30 PM Senate FIN
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* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
HOUSE BILL NO. 207
"An Act relating to adjustments to royalty reserved to
the state to encourage otherwise uneconomic production of
oil and gas; relating to the depositing of royalties and
royalty sale proceeds in the Alaska permanent fund; and
providing for an effective date."
Senator Rieger MOVED to adopt CS Work Draft, version "X",
dated 5/11/95 by Chenoweth/Finley. No objection having been
heard it was ADOPTED. Senator Rieger testified to the
basics of the "X" version, compared to the Resources
substitute. He stated that the focus of this version is on
the economics of the field. The most important feature is
on page 3, line 15-16, which speaks to a mechanism for
adjusting royalty percentages based on price or value of the
hydrocarbons produced. He read, "the mechanism must provide
for an increase in royalty percentage resulting from an
increase in price from the base assumptions that, at a
minimum, fully compensates for any decreases in royalty
percentage resulting from a decrease in price..." He stated
that this was an effort to set forth the nature of the
royalty modification, and that there would be an upside for
the state to compensate for the downside risk the state
assumes. Another change addresses the findings which did
not speak to the financial aspects, and are no longer
mandated in this bill. The focus is more on the financial
impact of a royalty modification on the state. A
significant change, one which Senator Rieger stated that the
administration wants to change back, is in the amendment
offered earlier to the committee. He stated that he could
not see how a pool or field that had never been developed
could clearly and convincingly be shown to be uneconomic.
He therefore offered an amendment for deletion. It is
currently in the work draft CS, but supports the
administration's wishes. The last significant change from
the Resources CS is the information provided for the
justification of a royalty modification which could not be
provided for legislators. He stated that the bill does
retain the sunset and the governor's sign off. He
recommended that Mr. Shively speak to the committee on the
administration's amendments.
John Shively, Commissioner, Dept. of Natural Resources was
invited to join the committee. He said that he would go
through the amendments and explain each one. Starting on
page 2, line 3, technical amendment; line 8 and 9,
recommended removal of the sunset date; line 15 (iii)
reinsert, "oil or gas production from the field or pool
would not otherwise be economically feasible;".
He said that is the standard by which to judge the royalty
reductions.
Co-chair Frank inquired if the proposed insert (iii), was
intentionally or inadvertently left out. Senator Rieger
stated that in the first amendment offered to the committee,
he had recommended taking the (iii) language out, because he
could not see how a field would be economically feasible in
speaking of a future undeveloped field. However, he
supports the administration in replacing it in the bill if
that is how they want it to read.
Co-chair Halford asked if there is a point where the State
of Alaska should say that our oil is worth $.50/bbl or
$1.00/bbl or some figure that the state should never go
below? Mr. Shively responded that there most likely is, but
he felt that it depended on a variety of circumstances. He
stated that there were three situations: marginal fields yet
to be developed; shut-in fields, and fields that might be
abandoned; and in the later two cases, there may be good
argument to going down to a very small amount of money in
order to keep certain facilities operating or jobs going.
In terms of a marginal field that was just starting to
develop, there would be a higher rate, which is what has
been done in this bill. There is a higher floor rate for a
marginal field, than for the shut-in or abandoned fields.
The legislation does set that minimum. Discussion was had by
regarding the bottom price per barrel. It was mentioned
that at times there had been discussion in setting a floor
in the value and working off of that. Co-chair Halford
stated that it could work in the opposite direction
regarding variability and taking risk from the industry,
which are the arguments against doing it, but at some point
the state should say there has to be some return or, no
activity.
Mr. Shively advanced to page 3, line 7: after the word
"price", delete the rest of the line; lines 8-15, he stated
that the language is more reasonable and intent language
than actual law. If it remains in actual law, there are a
few concerns on line 10, "fully compensates". The term is
subject to difficulty in the interpretation. Line 14, the
term, "negative risks". He asked Senator Rieger to explain
his intent, as it may be helpful. Senator Rieger explained
that it was language that the drafters came back with. He
stated that his word was "downside" and the drafters came
back with "negative risks". Mr. Shively stated that on line
18, he recommended eliminating the words, "ultimate
recovery", and replacing them with the words, "production
rate or volume". The term ultimate recovery would seem to
be that we would go back at the end of the field and assess
backwards on the oil or lessees, which is something that was
not intended. It would make this section difficult to use.
Most of the economics, if this is the way to assess, would
be on production rate (monthly or daily base production) or
the actual total volume.
Senator Sharp asked if the rate of production could be
manipulated for a more favorable rate? Mr. Shively
responded that it could be. He gave a formula example with
an average monthly production rate, and it went above a
certain figure, which would grant an extra royalty. The cap
could be managed. There is consideration in accounting for
the cap, plus the total volume. There has been adequate
testimony regarding a new field, generally the total volume
is unknown. This is why both variables must be considered.
The total volume cannot be ultimately manipulated, but the
production could be managed. Co-chair Frank asked for a
definition of volume. Mr. Shively stated that it was
production over the life of the field. To determine the
economics variable, the state would use the amount that the
lessees have figured the field is worth, such as a base of
100 million barrels of unrecoverable oil. Anything over and
above the 100 million barrels would be at an increased
royalty rate. He stated that another way to figure the
economics, would be to examine the daily or monthly rate.
There is no way to achieve the figures up front, the
analysis is based on certain economics. One, is the volume
that is expected from the field. Co-chair Frank expressed
his concerns. Mr. Shively stated that often once the
development of the field starts, it becomes clear that there
will be estimate changes. Co-chair Frank emphasized that he
started out with the notion that if there were going to be
variables, production would logically be one of them.
However, he is now placing more emphasis on price
expectation, and not so much on the production over the life
of the field. In the case of field production, the return
comes later; in the case of production, there is an
opportunity for increases or decreases based on what the
lessee would like to do. Mr. Shively responded that is why
Senator Rieger's amendment mandates that price be used, with
an option of using volume in adjustment.
Mr. Shively continued through with the changes in the
document and stated that the change made on page 5, line 31,
Section 9, is an improvement. He stated that the last
issue, is that of the governor's signature. The department
recommends that the governor not sign. Currently, the law
allows the commissioner to sign royalty reductions.
Co-chair Halford stated that the previous Finance Committee
Substitute removed the prohibition on legislators being able
to review the information on which the decision was made.
However, the language that is moved up into the other
section, says, "the confidential data may be disclosed by
the commissioner to legislators." He inquired if there was
a problem in changing the word from "may" to "shall". Co-
chair Frank MOVED to remove "may" and insert "shall" on page
4, line 17. No objections being heard, it was ADOPTED.
Senator Zharoff inquired as to the price modifications, how
cumbersome is it going to be to make adjustments as prices
go up and down? Co-chair Frank suggested a fixed royalty.
Mr. Shively stated that royalty adjustments are done in
other places, and there are much more complicated scenarios
such as: net profit leases; a direct sliding scale based on
a time period; or step royalty (price agreement). Market
baskets differ from company to company, but this is what is
used as a price and adjust accordingly.
In response to the committee, Mr. Shively noted that there
was no reference made in the legislation to "net profits
leases". When asked what bidding method was used, he
responded that there were no precise leases. If related to
straight base royalty, which varies in the state from 12-
1/2% to 20%, there are some leases which have a net profit
aspect and a base royalty. Under this legislation, there
could be negotiation on the base royalty, but not the net
profit portion. He emphasized that the royalty is not used
as a bid variable. It is possible, but it has never been
used. In terms of net profit leases, there are 45. There
has not been a sale involving a net profit with a big
variable for some time. That was a concept that came out of
the late 70's and early 80's, when everyone thought that the
price of oil today would be about $75/bbl which would have
solved a lot of problems that we have been facing in the
last few days. It has been suggested for use by some of the
remote fields.
Mr. Shively noted that a complete analysis has not been done
and the tax rates seem high. Information relating to the
competitiveness of Alaska, some of which came from a report
by Richard Feinberg, who has been a major critic of this
legislation, indicates that North America, and Alaska in
particular, has real problems in being competitive in the
world market as it relates to marginal fields.
Senator Phillips MOVED to adopt his amendment. He stated
that this amendment would give the legislative oversight. He
stated that he feels uncomfortable with a limited number of
people approving or disapproving royalty contracts. It is a
business proposition between the state and the companies.
The companies have stated that they would have to go back to
their board of directors for approval, and it is not just
the chairman that makes the decision. In the state's case,
the legislators are the board of directors for 600,000
residents in Alaska. He stressed that there is an
obligation to represent the share holders of Alaska. The
amendment was presented to the Senate Resources Committee.
In speaking to the amendment, Co-chair Halford referred to
another law which is not included in this bill. He inquired
if that law is the same law that the State operates under
when royalty contracts are approved? Senator Leman
responded that this was a proposal that was offered in a
work draft to the Senate Resource Committee. It was not
adopted. The interest is to create a compressed schedule
for legislative approval or disapproval. The concern was
offered by some, that if the legislature is not in session
it would cause delays. This will add 20 days on to the
legislative process.
Mr. Shively read from the "L" version, page 7, subsection
(D). "transmit a copy of the final findings and
determination prepared under (B) or (C) of this paragraph to
the lessee or lessees making application for the royalty
increase, decrease, or other adjustment:" Discussion was
had on Senator Phillip's Amendment #1.
End Tape #73, Side 1
Begin Tape #73, Side 2
Co-chair Halford asked the wishes of the committee. By a
show of hands the Amendment #1 FAILED. Those in favor were
Senators Frank, Phillips and Halford; those opposed,
Senators Rieger, Zharoff and Sharp.
Amendment #3 was discussed. It was noted that whatever the
reduction, the apportionment shall be (until the revenue
actually declines) below the amount that would have
otherwise gone to the permanent fund. The apportionment of
the royalty shall protect the permanent fund share. Senator
Sharp MOVED to adopt amendment #3.
Senator Zharoff asked for additional explanation. Co-chair
Halford stated that if there is a royalty reduction, the
apportionment of royalty between the permanent fund and the
general fund shall be apportioned in such a way as to hold
the permanent fund harmless as much as possible. For
example, if the royalty goes below the 50% share provisions
on some leases, then the PF would see a reduction anyway.
Senator Rieger stated that he understood the intent of the
language, but wondered if it was constitutional? He stated
that it was dedicating revenues that are not dedicated by
the constitution. Co-chair Halford said that the
constitution only requires 25% dedication. The statute on
leases is 78%, which increases the amount going to the PF to
50% statutorily. The PF is a constitutionally dedicated
fund. Co-chair Frank stated that if there is a royalty
reduction, the general fund will not receive funds since the
PF will maintain its share. Under the leases, the PF gets
50% of the royalty revenue. With a 50% royalty reduction,
there will not be a royalty from the development of a new
field. He stated that in the hypothetical case given
earlier, there would be a 3% severance tax. There are few,
if any, fields providing severance tax, hence, the amendment
means there will be no general fund revenues when a marginal
field is developed. Co-chair Frank noted that it would
allow for marginal fields that would not otherwise be in
production at all. If it is good for the state, it would be
good for the PF. It is a bill worth supporting because it
will bring in net revenues to the treasury it will also
bring in revenues to the PF that would otherwise not come
in. Senator Zharoff stated that he liked the intent of the
amendment, but could not support it.
No further debate on the amendment was offered and by a show
of hands the amendment FAILED. In support of the amendment
were Co-chair Halford, along with Senators Phillips and
Sharp. Opposed were Co-chair Frank, along with Senator
Rieger and Zharoff.
Senator Rieger MOVED Amendment #4, a technical amendment.
No objections being heard, it was ADOPTED by unanimous
consent.
Senator Rieger MOVED Amendment #5, offered by the
administration. placing back into the bill the words,
"economically feasible determination". Co-chair Halford
suggested that this implies that the only floor, is the
absolute floor in the bill. If economically feasible is the
determination of any tax policy, then all that needs to be
done to prove the point, is to be uneconomically feasible.
Mr. Shively was asked his understanding of this amendment.
He stated that there is better direction with this amendment
inserted in terms of getting to the kinds of mechanism that
Senator Frank mentions in his other changes. He stated the
purpose of the legislation is to test the feasibility of the
field, otherwise, the royalty would be left alone. The
language has been debated, in the final analysis, it
strengthens the purpose of the legislation.
Senator Rieger expressed the difficulty in defining
marginal. This is the administration's bill. He supports
the language. However, he asked how the administration
determines if a field is economically feasible.
Mr. Shively said that as he understands it, there will be
an analysis on the rate of return of investment. There will
be a determination on fair rate of investment, which is
debatable. If the determination is made that it is under
the fair rate, then it would not be feasible to develop
without the royalty reduction. The reason for making the
changes is, if the assumptions based on the rate of return
change, particularly with price and volume, then there
should be an upward adjustment.
Senator Rieger stated with that approach, it might be that
with a royalty modification, not a downward adjustment, the
expected rate of return does not change. The threshold
return that the company requires goes down. Taking a number
of 14% rate of return, may be adequate, when there is a risk
sharing arrangement, but not acceptable rate of return to
induce an investment if there is too much downside. He
noted that it was not absolutely clear that there has to be
a downward adjustment as the base case of a modification.
Mr. Shively responded that this is a way that some companies
do business. This is not the intent of this legislation,
though it is a concept worthy of further review. He
stressed that this legislation is not meant to solve every
possible potential situation. The Oil and Gas Policy
Council will be analyzing other approaches as incentives
over the next year.
Co-chair Frank pointed to the rate of return. He read an
analysis from the Dept. of Natural Resources: "A reasonable
rate of return that is independent of the particular company
financing involved should be adopted to avoid possible
manipulation of an in-house economics simply for royalty
reduction purposes." He asked what the policy would be on
that statement. He brought out that it was in the Conoco
findings, dated 12/28/90.
Mr. Shively stated that it did come from Conoco, included in
current law, which has been determined necessary to be place
into this legislation. Some of the changes and amendments
being considered is designed to give more flexibility. Co-
chair Frank restated that the department is saying, "that
under current law, the state cannot analyze a company's rate
of return and analyze two difference companies and give one
a royalty reduction." In the previous memo from the
department, is states that there should be a consistent rate
of return; nor should hurdle rates be considered.
Mr. Shively stated that when that occurred, Conoco already
had lost their investment costs. In this situation we will
be looking at fields that may have different kinds of risks.
Risks are what people look at when analyzing hurdle rate.
Location, and size of capital investment may go into the
risk analysis. If the department does not have the capacity
to a determination, there would be outside experts hired.
Co-chair Frank asked if the department should be striving
for consistency in terms of analyzing? If rate of return is
the variable for determination, should there be a policy
covering this area of concern? Mr. Shively responded that a
rate of return is a major issue. There should be
consistency. Once there is experience, then the accuracy
will be better. He pointed out that there are other risk
factors. He also suggested that all companies do not look
at investments in the same way. This legislation has
language making it flexible to address the various
situations. Co-chair Frank stated that the department should
have a policy with consistent rate of return.
Co-chair Halford asked the question, for adoption of
Amendment #5. By a show of hands the amendment FAILED.
Senators Zharoff and Rieger voted for the amendment. Co-
chairs Halford and Frank, along with Senators Sharp and
Phillips voted against the amendment.
Senator Rieger MOVED to adopt a version of the drafted
Amendment #6 which deletes on line 7, page 3, after the word
"price", "or value of the hydrocarbons produced". Senator
Zharoff OBJECTED. No further debate, and by a show of hands,
the amendment was ADOPTED. In referring to the remains of
the Amendment #6, he asked to have defined the terms "fully
compensates" and "negative risks". Senator Rieger stated
that Anne Finley, the drafter in legal services used the
term "negative risks",to mean the downside potential be
equal to the upside potential." The term, "fully
compensates" means equal. Following the explanation and by
a show of hands, Amendment #6 FAILED. Senator Zharoff voted
for the amendment. Co-chair Halford, along with Senators
Phillips, Rieger and Sharp were opposed.
Senator Rieger stated that the language in Amendment #7 is
permissive, but that the language was acceptable. He MOVED
for the adoption of Amendment #7. Co-chair Frank asked to
delete section (ii) on page 3, line 16, keeping the focus on
the price. He said it is the one known element. If the
price goes down, there would be relief. If the price goes
up, it would be obvious. There would not be an opportunity
to make changes in production rates driven by royalty
effects.
Senator Sharp asked if this section only applies to the
original application for adjustment. Senator Rieger
responded that the entire modification would be structured
up front. It might be that on the ultimate recovery
questions, there remain unknowns until later. How it is
made to work, he does not know. The advantage of using only
price for recovery, whether it is current recovery or total
recovery is understandable. This is only an option.
Mr. Shively stated that it is permissible. The department
says that the volume is a variable that will always go up.
This gives the state the opportunity to collect on the
upside, which is always better. Collecting can be done in a
variety of ways: it could be based on a daily, monthly, or
annual production; or above a certain total amount. Any
alternative would be part of the negotiation. It would be in
addition to any adjustment as a result of price. The
department wants the paragraph in question, to stay in.
Co-chair Frank expressed concern regarding the amendment
because, it could be, that the volume of oil is going to be
greater than the company says it is going to be when they
make application. He was fearful that the state could be put
off for royalties to a later date, if ever.
Mr. Shively said that if it is confined to production rate,
the company can manage that rate. Therefore, they never
have to go above it. He cited a company in Norway that
managed under the volume to keep the royalty down. It is a
potential problem. If, on the other hand, there is pay on
volume, it might give more incentive to produce earlier.
Combined to rate, it gives them a great incentive to stay
under that rate.
Senator Sharp expressed concern over production rates being
manipulated. He stressed the possibility of never seeing
the upside. Co-chair Frank said he is convinced that the
focus should be on the price. He noted that what is heard,
is the volatility of price being risky. Mr. Shively
responded that they can delineate before the investment is
made. Co-chair Frank stressed that if the emphasis were on
the price, there would be risk sharing, which would
eliminate the manipulation of the production rate or the
ultimate recovery. Mr. Shively responded that in dealing
with estimated volume and estimated rates, it is cause for
disagreement for the lessees. When dealing with what is
down the hole, one is dealing with different geological
theories. One cannot make the analysis without the volume.
If one is using it to make the initial analysis and it is
ignored, and there is a considerable amount of oil, which
there can be, then the state has lost an economic
opportunity. Even if this happens 10, 15, 20 years down the
line.
Co-chair Frank stated that it is an inherent problem
crafting law to make it work in the way it is intended. He
stated he was not in disagreement, but he is also looking
for a vehicle that will give them confidence.
Co-chair Halford stated that in the section on information,
"It shall be disclosed to legislators, legislative audit,
legislative finance, employees of their divisions, or
contractors of the auditor of finance division who is
engaged to evaluate it." Mr. Shively pointed out that on
page 4, line 24, Section 7, it states, "may require the
lessee or lessees making application for the royalty
modification to pay for the services of an independent
contractor, qualified to evaluate hydrocarbon development,
production, transportation, and economics, who is selected
by the commissioner to assist the commissioner in evaluating
the application and financial and technical data; selection
of an independent contractor under this paragraph is not
subject to AS 36.30;"
Co-chair Frank stated that the royalty reduction that BP
submitted on the Badami Project was turned down. Was that
solely based on price, or did it have a production or field
volume element to it? Mr. Shively stated that it was solely
based on price. Co-chair Frank asked if it was turned down
because there was not enough upside? Mr. Shively responded
that it was withdrawn, not turned down. The state did not
have the authority to grant it. It is in the marginal field
category in terms of volume. Co-chair Frank asked if the
methodology in a "price only" sliding scale was appropriate?
Mr. Shively introduced Kevin Banks, Economist for the
Division of Oil and Gas. Mr. Banks stated that in the
Badami case, price would not have been a sufficient variable
upon which to base a royalty percentage. He stated that it
is entirely possible, without changing the total recovery in
a field. In response to increases in prices, that the
production rates could be increased in the field by drilling
wells more quickly and stimulating the oil field, so that
these production rates increase. The fact is, that revenue
is, price times the production, at any given period of time.
It has a dramatic effect on the economics of the field if
one can begin to pull out oil much faster and sooner. The
state would want to be protected to take advantage of those
types of situations where that may arise. It is possible to
produce more oil from a field. He cited the example of the
Gulf War, when prices rose dramatically, but in Prudhoe Bay,
production rose to over 200,000 barrels a day because of
rapid stimulation in the field to take advantage of those
high prices.
Co-chair Frank offered an Amendment to Amendment #7. On
line 17, delete, "as", insert, "which must meet the
conditions...". Senator Rieger asked Ms. Finley about the
language. She stated that it does not do harm and even
without the language that is what it says. The
administration expressed no objection to the amended
amendment. The amendment was MOVED and ADOPTED.
Co-chair Halford asked if there were objections to adopting
the amended version of Amendment #7? No further objections
being heard, amendment #7 was ADOPTED.
Senator Zharoff MOVED to adopt Amendment #8, which is the
sunset provision. By a show of hands the amendment failed.
Senator Zharoff voted for adoption. Co-chairs Halford,
Frank, along with Senators Rieger, Sharp and Phillips were
opposed.
Senator Zharoff offered a verbal amendment to amend the date
on Amendment #8 to the year 2015. Those in favor: Senator
Zharoff; Those opposed: Co-chairs Halford and Frank,
Senators Rieger, Sharp, and Phillips. The amendment FAILED.
Senator Zharoff amended Amendment #8 to a new date of 2010.
Those in favor: Senator Zharoff; Those opposed: Co-chairs
Halford and Frank, along with Senators Rieger, Sharp and
Phillips. The amendment FAILED.
Senator Zharoff amended Amendment #8 to a new date of 2005.
Those in favor: Senator Zharoff; Those opposed: Co-chairs
Halford and Frank, along with Senators Rieger, Sharp and
Phillips. The amendment FAILED.
Senator Zharoff WITHDREW Amendment #9.
Co-chair Halford asked for a definition of a field or a
pool. Mr. Shively responded that there is not an exact
definition. A pool may be a different horizon or different
area of oil that may underlay one or more leases. He cited
an example of the Kuparuk field that is being developed and
West Sak, a pool above it. This language allows at looking
at the two pools separately opposed to all one field. Co-
chair Halford asked if they can be producing from the same
hole. Ken Boyd, Director, Division of Oil & Gas, responded
that they can come from the same hole, but more often, they
do not. Co-chair Halford asked if the administration needs
the term, "or pool" in the legislation. Mr. Shively
responded that it does give more flexibility. It has been
debated in the House Oil and Gas Committee and the House
Resources Committee, discussed in some detail in Senate
Resources. All those committees were comfortable with the
provision.
Senator Leman stated that Resources deleted the phrase, "or
a portion of a pool" because it was decided not to name
individual wells in a field or a pool. Co-chair Frank asked
how many producing pools there are. Mr. Boyd responded that
there are a number of pools within a field.
Co-chair Halford asked the wishes of the committee. Senator
Rieger MOVED to adopt SCSCSHB 207 (FIN) with individual
recommendations and accompanying fiscal notes. SCSCSHB 207
(FIN) was REPORTED OUT of committee with no recommendations
and the following fiscal notes: Dept of Revenue (APFC),
zero; Dept of Natural Resources, $105.8; and Dept of Revenue
(Revenue Operations) Indeterminate amount.
ADJOURNMENT
The meeting was adjourned at approximately 11:30 p.m.
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