Legislature(2005 - 2006)BUTROVICH 205
05/04/2005 03:30 PM RESOURCES
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CSHB 71(FIN)am-OIL& GAS EXPLORATION CREDIT & LEASE TERMS CHAIR WAGONER announced CSHB 71 (FIN) am to be up for consideration and that he had asked Ms. Robson in the last meeting to provide more information for the record. BONNIE ROBSON, oil and gas attorney and consultant to the Legislative Budget and Audit Committee on gas pipeline issues, said she wanted to cover six different points with regard to HB 71. 4:15:05 PM First, and very importantly, I want to talk about what we didn't hear on Monday. Second, I would like to correct some incorrect statements or impressions left on Monday. Third, I heard concern over what is the right standard for 'reasonable profitability' on Monday and I think we should discuss that as well. Fourth, there was some dispute about how the duty would be enforced, how the duty to develop and market gas when 'reasonably profitable' would be enforced. Fifth, I think strategically, we need to talk about the time for invoking the duty and what that means for you today. And, sixth, discuss some options available to the committee at this point in time. First, what did we not hear on Monday. If you think back a couple of weeks ago, Spencer Hosie testified before a combined committee, LB&A and this committee and he testified that there was in oil and gas leases an obligation to develop and market oil and gas when reasonably profitable to do so. He was before you on behalf of the Administration and you did not hear from lessees at that time. He was emphatic that there is, in fact, a duty or an obligation to develop and market gas when reasonably profitable to do so. On Monday, you heard from the other side. You heard from lessees, you heard from industry representatives. And I did not hear anyone deny that the duty exists. I think I listened carefully. Nobody denied the obligation was there; nobody suggested that lessees can warehouse leases long-term without having an obligation to develop and market. They did dispute how you would go about enforcing that duty and what would be the standard for measuring 'reasonable profit,' but nobody disputed that the obligation was there. The second thing that you did not hear on Monday is no one disputed that seven years was a reasonable time- clock for getting the gas to market once there had been a determination that it would be reasonably profitable to do so. As we mentioned on Monday, particularly for the State of Alaska and for the other project participants, time is money. It's a lot of money. At current gas prices, every year delay of this pipeline project costs the state and its municipalities on the order of $2 billion - rough order of magnitude $150 million per month for a year delay in this project. This bill, HB 71, includes a seven-year time clock once there has been a determination that a project would be reasonably profitable to get that gas developed and to market and nobody disputed that on Monday - that seven years was a reasonable timeframe. Next I'd like to move on to correct some misimpressions, I think, created on Monday and I don't mean to suggest that these misimpressions were intentional. I think sometimes the person at the table did not have a full familiarity with some of the oil and gas leasing history of this state and that might be the source of some misimpressions. But, as I said, there was no dispute about whether the obligation, the duty to develop and market exists when reasonably profitable and that exists currently under leases and unit agreements. It's important to know the origins of the state's leases and unit agreements. There was some suggestion that perhaps these were contracts of adhesion. I don't believe that's so. With regard to the state's oil and gas lease form, it used to be in regulations and I think all of you know that for anything to be adopted as a regulation, it must go through a public and industry comment period. So, that lease form was developed through a public process and initially put into regulations. It's no longer in regulations, but that's its origin, so there was public comment. 4:18:43 PM SENATOR ELTON asked what a contract of adhesion is. MS. ROBSON explained: There are times when because of uneven bargaining power between two parties to a contract, one party might actually be relieved of its obligations under the contract - because it was a contract of adhesion, you didn't have any choice. Here, because we're talking about the State of Alaska and the largest international petroleum companies, so there isn't the disequilibrium in bargaining power. But there was some concern these were 'take it or leave it' contracts and an implication that maybe that should bear on whether the duty to develop and market should be enforced and how. SENATOR ELTON thanked her for the clarification. MS. ROBSON continued: So, the lease form adopted through a public process and then if we turn and think about how the state's oil and gas leases are put out to bid, it's through a competitive bid process. If you think about the competitive bidding process, typically there's one bid variable price, often the bonus bid. You can try for two bid variables; that complicates things. Usually any contract by competitive bid - all the terms of the contract are spelled out and there's one bid variable - something like prices. So, I don't think that this body wants to think of every competitive bid in the oil and gas industry and in the United State of America as a contract of adhesion or a 'take it or leave it' contract. That's simply the process that's used in the competitive process. That's how our state's oil and gas leases are by and large distributed. 4:20:24 PM SENATOR SEEKINS argued that the process still fits the definition of a contract of adhesion. MS. ROBSON disagreed and said that contracts of adhesion happen most often where you have two parties of unequal bargaining strength. SENATOR SEEKINS said it's generally applied to situations where one party would have no meaningful chance to negotiate the terms of a contract. MS. ROBSON responded: "Actually that's not correct. Specifically with regard to the obligation we're talking about here in the oil and gas lease forms there's some language and we didn't cover it Monday and I think it's important that we talk about it today. In paragraph 20 entitled "Diligence" it reads: 4:22:11 PM 'Diligence - Lessees shall exercise reasonable diligence in producing and shall abide by and conform to regulations of lessor related to the matters covered by this paragraph in effect on the effective date hereof or herein after in effect if not inconsistent with any specific provision of this lease.' There is elsewhere in the lease a provision that generally only the regulations in effect at the date the lease was issued governed the operations under the lease, but this specific paragraph with regard to diligence and the obligation to diligently produce oil and gas allows the lessor to proceed to adopt regulations thereafter covering this subject matter - regulations such as how you define 'reasonable profitability.' 4:23:06 PM SENATOR SEEKINS asked if there is an integration clause in lease. MS. ROBSON replied that that such a clause would be conditioned by the specific language on diligence in paragraph 20. 4:23:56 PM MS. ROBSON said with regard to unit agreements: I think with unit agreements, particularly for Prudhoe Bay and the Pt. Thompson unit, are instrumental to the enforcement of the duty in this instance. The unit agreements were negotiated and there are reams of paper now in archives that were generated as part of negotiating the specific terms of the unit agreements for Prudhoe Bay and Pt. Thompson. So, in any case, you had the state sitting down with the lessees at Prudhoe Bay and Pt. Thompson and negotiating those terms including the language in those unit agreements that allows the Department of Natural Resource from time to time to alter or modify the quantity and rate of production from the unit area. So, you do have terms in both the leases and the unit agreements specific to this obligation that gives to the State of Alaska, as lessor, to the DNR, the ability to set obligations regarding production and to alter and modify the quantity and rate of production. Another area, I think on Monday, where there was some incorrect impressions left is what are the consequences of this obligation, the duty to develop and market gas when reasonably profitable to do so. There was a picture painted that this legislation was intended to force lessees to pay $20 billion for new investment or lose their interest at Prudhoe Bay. And that's a dramatic statement. I believe it's an overstatement. If we look at the consequences of the obligation, there at least three different ways that you can comply with the obligation to develop and market Prudhoe Bay and Pt. Thompson gas when reasonably profitable to do so. First of all, you can sell the gas in the field and you can leave it to somebody else to spend their capital to build the new gas treatment plant at Prudhoe Bay for gas processing and to build a pipeline. So, if there is an offer to purchase gas at Prudhoe Bay and Pt. Thompson, that offer includes a reasonable profit to the lessees of those units. Then they can comply with their obligations under the leases and the unit agreements simply by selling the gas. That's a low risk operation, particularly at Prudhoe Bay where they're producing over 8 bcf per day right now and they are paying to put in back in the ground. If somebody is there offering to pay to take that gas and put it through their own new gas treatment plant and their own pipeline and the price offered includes a reasonable profit, then that is one method of compliance. The second method of compliance is if somebody else is willing to spend their capital to build this pipeline, the lessees could ship their gas on the pipeline and then they would be in the position to capture the high side. When gas prices go high, they would be there - of course having the obligation to pay for the pipeline transportation. That's a second method of compliance. A third method - they could choose to build a new gas treatment plant and the pipeline themselves. So three different ways to comply with the obligation after there's been a determination that there's a reasonable profit to be made from developing and marketing North Slope gas. 4:27:59 PM If the lessees decide not to purchase gas when a reasonable offer is made and decide not to ship their gas on somebody else's pipeline when another party offers to build that pipeline and decide not to build a pipeline, all when there's been a determination that it would be reasonably profitable to do so, so they will not be in compliance with their lease. They will be in breach. And the remedy - I think it's an overstatement to say they're at serious risk for losing all of their interest at Prudhoe Bay. More probably, what I see happening is certainly under HB 71 with the seven-year time clock, if there was a determination that there was a reasonable profit to be made, seven years came and went and they were not marketing their gas, they may be liable to the State of Alaska for royalties as if they had developed and marketed their gas. Other possible remedies - at Prudhoe Bay potentially severing the oil interests from the gas interests leaving the oil interests with the current lessees, possibly leaving some of the gas interest because some of that gas is marketed as NGLs blended in with crude and for local use. But having some of the gas interests severed and returned to the state. 4:29:02 PM Also, at Pt. Thompson is a particular case. You have to realize some of those leases are more than 40 years old and Pt. Thompson is a world-class field. It has not been developed. There's not even the first development well there now and if the lessees have the opportunity after a determination that it would be reasonably profitable to market that gas, they have the opportunity to sell it to a third party or ship it on somebody else's pipeline or build the pipeline themselves and they don't take it, it may be appropriate for the state to seek the remedy of return of those leases so that the state could relet those leases to a party who would make it a priority to get that gas to market. 4:29:52 PM There was concern expressed from several different sides on Monday about whether the language written into HB 71 provided the right standard for reasonable profitability and if you'll recall there was a dual part standard for the pipeline piece of it, for the regulated piece. Built into the statute was a rate of return equal to or higher than FERC would allow. For the unregulated production operations, the rate of return talked about was a 10-year simple average of the return on capital employed for oil and gas companies, discretioned with DNR as to what would be the group of oil and gas companies used, but our example used the four largest international petroleum companies and the three largest Alaska companies. And right now if you look at the previous 10-year average, you get to a 14 percent return on capital employed that is return on all forms of capital - debt and equity. So that if this pipeline project is financed 80 percent debt and 20 percent equity as is envisioned with the federal loan guarantee, that the return on equity could be as high as 46 percent under the language in this bill. And there was some question about whether that's a reasonable standard. I tell you quite frankly I would have some concerns about that, but for some information that unfortunately I'm not in a position to share with you today, because of the confidentiality requirements. But the important point today is that there is not a single standard or only one standard for what could be reasonable. There are a number of possibilities of what could be used as a standard for reasonable profit. There have been suggestions, in fact, from consultants we are using with regard to gas pipeline issues that the cost of capital - different from the rate of return on capital employed - but the cost of capital could be one measure. You could also look at the return on equity as another measure and we did hear from industry that perhaps it would be appropriate to look to venture capital. There was some discussion about venture capital earning in the low 20 percents. The thing to think about there is that venture capital is 100 percent equity. There is no borrowing; there is no cheap capital in the form of debt when you're talking about venture capital. So, actually the suggestion from AOGA or the discussion about 20s, low 20s rate of return indicative of what is appropriate for venture capital and maybe for this project, could be a lower rate than what could be allowed under this statute. This statute, as I mentioned, could go as high as a 46 percent return on equity. Compare that to your low 20s percent return on equity return on venture capital that was discussed here on Monday. I think the important point to recognize here today is that there's not going to be agreement within this room by all parties on what the appropriate standard is for measuring reasonable profitability and that may be an issue that if you don't chose to resolve today could be looked at in the Interim; it could be looked at next session. It is an important issue not only for this bill, but it's also an important issue as you begin to think about gas pipeline issues under the Stranded Gas Act and any proposal that may come to you. 4:33:42 PM There was some industry suggestion on Monday that the free market should be the standard - that basically you should leave it to the lessees to decide what is the rate of return appropriate. Again, that means in effect there is no duty to develop and market when reasonably profitable. If you leave a lessees obligation to the lessee to decide and enforce, it is effectively no obligation at all. 4:34:19 PM Another question that came up and was discussed on Monday was just how is the duty enforced - the duty to develop and market when reasonably profitable. To think the lessees came in here and urged in the first instance it should be the court system making the determination whereas there was discussion of this bill providing for DNR to make the initial determination. And there is a reason for that difference of perspective. The lessees, I think, would see certain benefits in having the court system make the initial determination. It forces DNR or the Administration to be the one to file suit and it is not easy or undertaken lightly in this state for the Administration to sue big oil. It's an advantage if industry forces the state to be the one to take the matter to the courthouse. The second advantage industry may see in leaving the trial court as the one to make the initial determination is that if there is no DNR decision preceding going to court, then there is no deference accorded the DNR decision. And the third thing is that it may provide an opportunity for lessees to withhold information until such time as you get into court. 4:36:32 PM As we discussed before, we think under the status quo that, in fact, the decision is first to be made by DNR whether you're looking at the leases or the unit agreements. Earlier today we talked about the language in the lease agreements - in the paragraph 20 specific to diligence - saying that the Administration, the Department of Natural Resources, had the ability to adopt regulations on the subject matters covered in the paragraph on diligence after the adoption of the lease and the lessees would be bound by that. So, that the Administration could, in fact, adopt standards on reasonable profitability in accordance with preexisting lease terms and make a determination as to whether those standards had been met. Same thing with the unit agreements where after hard negotiations, the lessees gave DNR the ability to alter or modify from time to time the rate of production from the unit areas. The advantages, of course, from the Administration and the State of Alaska's perspective of having DNR being the initial decision-maker is that if industry doesn't like the decision issued by DNR, they have to take the matter to court. Also, DNR's decision would be entitled to some level of deference in the court system as to some issues and finally, there would be the ability and, in fact, the incentive for industry to provide information to DNR when it is making its decision pre-court and so information actually gets exchanged at an earlier point in time and informs DNR's decision-making. In any case, HB 71 did not do anything to alter the status quo as to who is the primary decision-maker, the first decision-maker on this duty. There is no language in there that is intended to shift. So, if the debate remains open, if you're unpersuaded that DNR is to be the initial decision-maker, the legislation did not intend to alter the current situation and, if in fact, the trial courts are to be the initial decision-maker, that would not be changed by HB 71. 4:38:10 PM Two more points - strategically what is the best time for invoking the duty to develop and market when reasonably profitable to do so? This is important to you today because it may frame the time period within which you want to act on this matter. And I think on Monday you heard some people say, 'Not now, because of Stranded Gas Act negotiations. Don't upset the balance of those negotiations. Worry about this later.' And you also heard some people say, 'Now would be a good time.' People who know what's going on in those negotiations thought it would be an appropriate time, but let's look practically at how the duty would be invoked and enforced and whether it matters whether you act now or next session or at all. Of course, Prudhoe Bay is the lynch pin for getting this gas to market. And so if we look at the annual plans of development for the main reservoir at Prudhoe Bay and what is the time frame for DNR raising any issue about whether that gas should be developed and marketed because it's reasonably profitable, the lessees at Prudhoe Bay will not be obligated to file their next proposed plan of development until March 30, 2006 and DNR will have until June 30 of next year to act on their proposed plan of development. And so whether you act on this matter today or next year, that will not necessarily change how DNR would go about enforcing the obligation that already exists in the leases and unit agreements - because a new plan of development isn't to be filed with DNR until the end of March. And as I believe was pointed out by at least one of the senators on Monday, it looks like the obligation, the duty, is already there and so maybe you never need to act on this matter. But certainly it is not time critical and I don't mean to suggest that at the end of this session. 4:40:23 PM Pt. Thompson - a little bit different. The next proposed plan of development has to be filed July 1 of this year and DNR will have until the end of September to act on that and decide whether or not they are in compliance with that. DNR may or may not choose to raise the issue of the duty to develop and market with regard to Pt. Thompson in this year's plan of development. Again, Pt. Thompson is important to the gas pipeline, but Prudhoe gas is the number one issue there. Also, Pt. Thompson, you have a situation, as I mentioned before, where you've had leases - some held for decades - and there's been no development or production there. So, DNR may choose to take it up this year. That would certainly be their prerogative if that obligation already exists. 4:41:22 PM In closing, I would like to talk about what options I see available to this committee today. I see one of my jobs is to provide you with different options on ways to proceed and certainly there are four that are immediately apparent. First, you could act on the legislation as is or with some revisions to the standard on what constitutes 'reasonably profitable.' And if you think about it, what you do have then in HB 71 is a compliment of exploration incentive credits in which the state undertakes some of the risk of exploration. It agrees to effectively cover the cost of up to 40 percent of the cost of new exploratory wells. So, it makes exploration less risky and yet the new sections 1 and 2 of this bill say when that exploration is successful, when you have a reservoir that would be reasonably profitable to develop, we are affirming our belief in your obligation to go ahead and develop that gas. A second alternative would be drop the reasonably profitable standard from the proposed legislation, keep the exploration incentive credits and keep the seven-year clock. There was no dispute raised on Monday about the seven-year clock, so that would be another alternative. How would the seven-year clock then work without this definition of reasonably profitable included? Well, the way it would work is if DNR in the course of enforcing the preexisting obligation to develop and market gas found that there was, in fact, an obligation to do so at this point in time, you would be providing guidance that you expected to see that gas to market in a maximum of seven years. The third alternative would be to separate the language on exploration incentive credits and the reasonably profitable legislation including the seven- year clock into separate bills with the exploration incentive credits being acted on this year and the reasonably profitable sections 1 and 2 considered next year. A fourth alternative would be again to separate the exploration incentive credits from the reasonably profitable legislation, act on the EIC's exploration incentive credits this year and simply recognize that there already is an existing duty and obligation to develop gas when reasonably profitable to do so and leave it to the administration to enforce it under the pre-existing standards without any further definition and no time clock, but as DNR or the Administration saw appropriate at the time they saw appropriate. With that, I'll conclude my remarks. 4:44:23 PM SENATOR SEEKINS asked if data from an exploratory well is made freely available to the state to be able to consider the commercial applicability of that field. MS. ROBSON replied that it depends on whether or not the well is on state acreage. There are some requirements with regard to oil and gas wells drilled on state acreage about data that must be provided to the state. There are different rules that apply when it is not on state acreage - subject to state oil and gas lease. SENATOR SEEKINS said he heard there may be some Security Commission regulations on what kind of data can be released and when. 4:45:44 PM MS. ROBSON replied: There are rules with regard to the requirement that well data be provided to the Department of Natural Resources when the well is on state leased lands and some of that data, I believe, is released after two years, but, again, I am not the best person to answer that question. She offered to follow up on this question. 4:47:08 PM SENATOR ELTON reflected that Spencer Hosie asserted a right that was reaffirmed through the adoption of the amendment on the floor. He asked if the amendment ere taken out and HB 71 passes without it, has the Legislature clouded the state's assertion of that right. MS. ROBSON replied: There may be a variety of ways in which you could act with regard to HB 71 and I didn't mean to suggest how it is that you would go about separating the exploration credits from the sections 1 and 2 on reasonable profit. SENATOR ELTON asked if one of those mitigators could be a letter of intent saying that removal of the amendment does not mean the state can't assert the rights. MS. ROBSON replied that Representative Samuels would know more about that subject than she does. 4:48:31 PM SENATOR GUESS asked if HB 71 is saying the standard will be a simple 10-year average and that's the only standard that the commissioner of DNR can apply regarding reasonability or is it just one standard of a number of standards that may be applied. MS. ROBSON replied that the bill requires that the 10-year average be applied. There would be discretion as to what oil and gas companies were used in the sample group of companies, but the 10-year simple average of return on capital employed is, at this stage, non discretionary. That could certainly be changed. SENATOR GUESS asked if that is the only standard that can be used. MS. ROBSON answered: There is some language in section 1 on findings, subpart 13, that talks about there may be a number of comparisons that would be appropriate to make - to the cost of capital, to the cost of equity, to return on capital employed or to return on equity. And so, the findings language indicates that there may be a variety of potentially reasonable standards. The section 2 language, as it currently reads, does not give discretion in terms of choosing a different standard. 4:50:54 PM REPRESENTATIVE RALPH SAMUELS said he wanted to give a brief snapshot of the thinking that went into the amendment to HB 71. I'm not an attorney and I won't apologize for that either. So, I know that you've heard from plenty of industry lawyers and I know that you've heard from Ms. Robson twice.... I was in and out of meetings on Monday and I tried to listen in to some of the testimony and I realize full well what the reaction was going to be going into this. I did catch part of one presentation and I wholeheartedly agreed with a lot of what was said. Ken Conrad testified and he's an executive with BP and I have met him several times over the past year and I have a lot of respect for Mr. Konrad. He is articulate, he knows the oil and gas industry better than I will ever know the oil and gas industry and he has some very good points. One of the main thrusts...was who is going pay if the state's numbers are wrong and we have now forced investors to do something which they know is wrong and they're going to lose money on. Who is going to make it right? He was a little over the top on the un-American comments and this and that, but all in all, that's an extremely valid point. Who would pay if our numbers were wrong? And philosophically speaking, the point of the amendment and to get the debate going is the fact that it cuts both ways. Who is going to pay if the numbers are right and the project is not developed? The jobs that are lost for Alaskans. A lot people testified are the people that want the jobs - the jobs that are lost. The money to the state. So, they're both extremely valid points and the point of the amendment was to make sure that both points are up for debate before we adjourn. I hope in my soul that we come back here some time this fall and we have a vote. And I think that to push something of this magnitude off, if you listen to the Hosie testimony, whether you agreed with it or you do not agree with it, if it is left hanging out there, the water will get muddy at the end when we can least afford to have muddy water on this entire project. I think that all of us as members, all elected people in this building right now, 61 of us, including Frank Murkowski, who's been doing this a whole lot longer than all of us combined, will never have a bigger choice to make than this gas pipeline - 30, 40 years worth of things, grandchildren - a legacy. We're fortunate to be serving at this time, but along with that honor of serving right now comes the responsibility to know everything that you can about every possible aspect of this project - duties, rights and responsibilities, both of industry and of the state. If we're scared to discuss it, then I think that come fall it's going to be problematic. And that was the point behind amendment 1 - knowing full well what the lawyers were going to say and the fact that the water was going to get muddy now and I honestly believe that it was better now and I felt it was a duty to do better now than it was going to be to do it later. That being said, Mr. Chairman, I also wholeheartedly agree with the original concept behind HB 71. I think exploration tax credits - quite frankly they work. We look at the Nenana Basin; we look at the Alaska Peninsula where I grew up and those folks have come around to think that it is probably a good thing to try to open the door a little bit. So, with that, as you and I have discussed previously, Mr. Chairman, I wholeheartedly agree with the [indisc.]. I've got a copy of the CS for 286 right here. To take the tax credits, the rather non- controversial part of this bill - it had - on the House side I believe 30 or 35 votes supporting it. It was pretty uncontroversial. To move those forward under a different vehicle and not move forward with HB 71, I think, was in the best interest of the Legislature and the state at this time. So, that was kind of the thinking behind it. 4:56:08 PM And I'd like to add just a couple of remarks here that I'm pretty troubled by. Those of us in the public life, you end up getting a pretty thick skin and you get it pretty quick or you don't last. It's as simple as that. But I am troubled by some of the personal comments that have been made about Amendment 1 towards myself. And not a lot, but I wanted to go on the record that there are very few people in this building, and most of them are probably sitting in this room right behind me, that know more about a gas line than I do as far as the process goes that are not professionals at this. And I would not have done this had I not thought it was in the best interest of moving the gas line forward. So, with that I don't know how appropriate that comment is, but I did want to get it on the record that I thought that some of the comments made were clearly inappropriate and I've got as thick a skin as any of the rest of you do. So.... I appreciate you having this hearing. 4:57:34 PM SENATOR SEEKINS asked if he had ever been able to sneak anything through in the middle of the night in this building. REPRESENTATIVE SAMUELS replied no and pointed out that he hearings were being held right now. We have six or eight days left. We wanted to make sure we had some hearings on this subject so that that Hosie testimony is not just hanging out there and waiting until the fall. The sharks are circling around this project. It will get attacked no matter what deal is cut. No matter who it is cut with, it is going to get rocks thrown at it. CHAIR WAGONER agreed that this is a work in progress. He thanked Representative Samuels for his testimony and announced an at ease.