Legislature(2011 - 2012)BUTROVICH 205

02/21/2012 03:30 PM RESOURCES

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03:35:26 PM Start
03:36:30 PM SB192
03:37:00 PM Analysis of Royalty Modification (focus on Economic Analysis) Presentation by Department of Natural Resources
04:51:43 PM SB176
04:57:27 PM HB144
05:10:49 PM HB185
05:29:58 PM Adjourn
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
Heard & Held
Analysis of Royalty Modification (Focus on
Economic Analysis)
Presentation by Department of Natural Resources
<Invited Testimony Only on DNR Presentation>
Moved CSHB 144(RES) Out of Committee
Heard & Held
<Public Testimony on HB 144 and HB 185>
Bills Previously Heard/Scheduled
Moved CSSB 176(RES) Out of Committee
            SB 192-OIL AND GAS PRODUCTION TAX RATES                                                                         
  PRESENTATION BY DEPARTMENT OF NATURAL RESOURCES: ANALYSIS OF                                                              
       ROYALTY MODIFICATION (FOCUS ON ECONOMIC ANALYSIS)                                                                    
3:36:30 PM                                                                                                                    
CO-CHAIR PASKVAN announced the consideration  of SB 192. He asked                                                               
DNR  Commissioner Sullivan  to provide  introductory comments  to                                                               
the   presentation   of   the  economic   analysis   of   royalty                                                               
^Analysis of  Royalty Modification  (Focus on  Economic Analysis)                                                           
Presentation by Department of Natural Resources                                                                             
3:37:00 PM                                                                                                                    
DAN  SULLIVAN,  Commissioner,  Department  of  Natural  Resources                                                               
(DNR), said  he had  asked permission to  provide an  overview of                                                               
things  he is  doing  in some  of the  areas  this committee  was                                                               
interested in. He  said an overview is important  because it will                                                               
put  into context  some  of  the more  detailed  issues that  Mr.                                                               
Barron  and his  team will  soon be  testifying on  about royalty                                                               
issues and  plans of  development. He  complimented his  team for                                                               
their work  today and emphasized  that the goal  of DNR is  to be                                                               
responsive,  respectful  and  informative   with  regard  to  the                                                               
legislature as it grapples with  some of the most critical issues                                                               
facing the state.                                                                                                               
3:38:43 PM                                                                                                                    
COMMISSIONER  SULLIVAN said  this committee  shares an  important                                                               
strategic goal  with the DNR  and the Parnell  administration: to                                                               
increase  the numbers  of companies  and investors  in Alaska  in                                                               
terms of  hydrocarbon exploration, development and  production in                                                               
both Cook Inlet  and the North Slope. All kinds  of companies are                                                               
needed to  do that from  the super majors, the  legacy producers,                                                               
to  the small  and  nimble  companies focusing  on  all kinds  of                                                               
resource development plays whether  it's new large fields, legacy                                                               
fields,  smaller  conventional  pools of  oil  or  unconventional                                                               
plays  such as  shale, heavy  or viscous  oil. He  said the  USGS                                                               
would have  estimates of North Slope  unconventional hydrocarbons                                                               
coming out soon.                                                                                                                
Given the  importance of  the issue,  the commissioner  said over                                                               
the  last  year  that  DNR has  taken  unprecedented  actions  to                                                               
"relentlessly get out  and tell the Alaska story to  all types of                                                               
companies" in the  U.S. and overseas. They have  been focusing on                                                               
four   things:  Alaska's   amazing   resource  base,   investment                                                               
incentives,  tax  reform, and  lease  terms.  The department  had                                                               
follow up meetings with its technical lead by Mr. Barron.                                                                       
3:41:52 PM                                                                                                                    
While  the department  is out  making the  case for  Alaska, they                                                               
gain  intelligence on  what these  companies think  about Alaska.                                                               
Literally  all of  them see  Alaska's  resource base  as a  world                                                               
class structure  on the  North Slope. Some  of the  more negative                                                               
feedback  was about  the cost  of doing  business in  Alaska from                                                               
drilling  wells,  remoteness, infrastructure,  short  exploration                                                               
season to high tax rates. He  acknowledged all the new players on                                                               
the  North Slope  and  in Cook  Inlet and  he  vowed to  continue                                                               
focusing on telling the story.                                                                                                  
COMMISSIONER  SULLIVAN  said once  they  get  here he  wanted  to                                                               
advance responsible  development policies  that help  spur action                                                               
and Mr. Barron  had done a good  job of that over  the past year.                                                               
In  general, that  means using  a business-like  in dialogues  to                                                               
establish  commitments and  benchmarks for  development and  then                                                               
working  hard to  hold lessees  to these  commitments and  having                                                               
consequences when they are not met.  He said the state is aligned                                                               
with these  companies in  a lot  of areas -  for example  the CD5                                                               
issues, some  of the federal OCS  issues and EIS issues  at Point                                                               
Other times  they are not  aligned and that  is when they  try to                                                               
guard the state's interest and  work constructively. For example,                                                               
the commissioner said he revised  the lease terms with regards to                                                               
the very  significant North Slope  lease sale. Some have  been as                                                               
short  as  5 years,  which  is  kind  of  tough given  the  short                                                               
exploration   seasons   and   the   different   challenges   with                                                               
exploration on the North Slope, and  as long as 10 years. He also                                                               
raised the rent rate from $10 (for  the first 7 years) to $250 an                                                               
acre  for  years  8,  9  and 10  if  adequate  work  hadn't  been                                                               
performed to  encourage exploration and  production, particularly                                                               
on the  North Slope, or  give up  the lease. He  also accelerated                                                               
work commitments in last spring's  lease sale in Cook Inlet where                                                               
he knew hydrocarbons were present.                                                                                              
3:45:30 PM                                                                                                                    
SENATOR STEVENS joined the committee.                                                                                           
3:46:27 PM                                                                                                                    
COMMISSIONER SULLIVAN said  the second area he had  worked on was                                                               
unit applications  and that last  year several  applications came                                                               
in to  unitize large areas of  North Slope acreage, and  with Mr.                                                               
Barron's  help,  they dramatically  decreased  the  size of  what                                                               
would be accepted in terms  of unitized acreage and required firm                                                               
and aggressive  work commitments. The acreage  they didn't accept                                                               
to  unitize  just  went  back  out for  lease.  Several  tens  of                                                               
thousands of acres were denied  unit status in the December lease                                                               
sale and  were put back  out to  lease. One unit  application was                                                               
denied outright,  because the  previous work  commitments weren't                                                               
met and all of that acreage went back out to lease.                                                                             
3:48:23 PM                                                                                                                    
COMMISSIONER  SULLIVAN said  they have  been trying  to cooperate                                                               
with the  federal government to accelerated  responsible resource                                                               
development by  testifying in  front of  Congress and  by meeting                                                               
with senior  federal officials  in Washington,  D.C., on  a whole                                                               
variety of issues.  For instance DNR played a  very critical role                                                               
in  developing  a  white  paper  that was  sent  to  the  federal                                                               
administration resulting in  a CD5 reversal. He said  all of this                                                               
relates to the broader strategic  goal of his five-part 1 million                                                               
barrels a day within 10 years strategy.                                                                                         
3:50:10 PM                                                                                                                    
BILL BARRON,  Director, Division  of Oil  and Gas,  Department of                                                               
Natural Resources (DNR), testified  on several aspects of royalty                                                               
modification.  Basically, he  said,  royalty  is the  sovereign's                                                               
share  regardless of  the  activity  of the  developer;  it is  a                                                               
driver of  the Permanent  Fund and  of the  General Fund.  In the                                                               
last several years,  royalty has gained the state  $2-3 billion a                                                               
CO-CHAIR   PASKVAN  said   in  this   context,  royalty   is  the                                                               
representation of Alaska's ownership interest in the resource.                                                                  
MR. BARRON said that was absolutely correct.                                                                                    
CO-CHAIR PASKVAN said  the term "royalty" might be  used in other                                                               
jurisdictions  and  then  it  may  be  applicable  to  a  private                                                               
ownership  as compared  to state  ownership in  Alaska. Now  they                                                               
were looking  at the potential  for a company to  receive royalty                                                               
modification based upon an economic analysis.                                                                                   
3:52:27 PM                                                                                                                    
MR.  BARRON replied  that  was correct.  He  said the  unmodified                                                               
royalty rates  throughout the  state are  12-16 2/3  percent. The                                                               
elevated  royalty (16  2/3 percent)  are primarily  in the  North                                                               
Slope and portions of the  Beaufort, because those areas are very                                                               
well known hydrocarbon producing areas.                                                                                         
He  explained  that the  royalty  modification  statute is  long-                                                               
standing but a very much unused  opportunity in the state. It was                                                               
amended in  1995 and  basically gave the  DNR the  opportunity to                                                               
look at three classifications of  areas: the cost of development,                                                               
the volume of  the oil or gas  in the field and the  price of the                                                               
product,  itself. New  fields and  pools were  added, the  reason                                                               
being that the  commissioner at the time identified a  lot of new                                                               
discoveries and new developments that  were smaller. It was again                                                               
amended in  2003 and designed  to allow more public  interest and                                                               
participation in  the process. Part  of that was to  push Liberty                                                               
in Badami.                                                                                                                      
MR. BARRON said  in 1995, product price  was $15-18/barrel; today                                                               
it's  $124/barrel. In  2003, the  first uptick  in product  price                                                               
happened at $25-30/barrel.  What was going on in  the industry at                                                               
those two  times? In 1995,  Milne Point was shut-in,  because the                                                               
oil price  low. There  had only  been one new  unit on  the North                                                               
Slope and that was North  Star. Overall world-wide production was                                                               
declining primarily due to low  oil prices. In 2003, TAPS dropped                                                               
below  1 million  barrels  a day  for the  first  time and  there                                                               
seemed to  be a  bit of  a surge on  North Slope  unit approvals,                                                               
probably tied  to lease  terms that were  coming due.  Oil prices                                                               
were  beginning  to climb,  but  there  hadn't  been any  use  of                                                               
royalty modification by the industry.                                                                                           
3:56:05 PM                                                                                                                    
MR. BARRON  said companies have  three opportunities to  bring in                                                               
applications for  royalty modification and the  division believes                                                               
that  it should  be the  last thing  touched in  any negotiations                                                               
with companies in terms of revenue to the state.                                                                                
3:56:39 PM                                                                                                                    
The  first  category  that  a   company  can  apply  for  royalty                                                               
modification  in is  if it  is  a field  or  a pool  that has  no                                                               
previous  production; it  has to  be  reasonably well  delineated                                                               
(DNR's  jurisdiction), and  it  has to  be a  field  that in  the                                                               
company's opinion would  not otherwise be economic if  it did not                                                               
receive  royalty  modification. If  it  is  granted through  this                                                               
process, the royalty can't be reduced below 5 percent.                                                                          
CO-CHAIR PASKVAN  commented that  means that the  commissioner as                                                               
part  of this  process can  reduce the  royalty by  more than  50                                                               
MR. BARRON replied that was correct.                                                                                            
3:57:51 PM                                                                                                                    
SENATOR  FRENCH  asked   if  a  company  says  a   field  is  not                                                               
economically feasible, how the division makes its decision.                                                                     
MR.  BARRON asked  him  to  hold that  question  until after  the                                                               
presentation walked through that very  point, because is the real                                                               
heart of what he was going to talk about.                                                                                       
SENATOR FRENCH responded that he would wait.                                                                                    
MR.  BARRON continued  that the  second  opportunity for  royalty                                                               
modification is  when a  field is  just about at  the end  of its                                                               
life. Again, it  is the whole premise of uneconomic,  and then it                                                               
can't go below 3 percent.                                                                                                       
3:59:18 PM                                                                                                                    
He said  the last opportunity  to request royalty relief  is when                                                               
the  field  is  shut-in  and   a  company  wants  to  reestablish                                                               
CO-CHAIR PASKVAN asked  what the liability for  production tax is                                                               
if one is making an application for royalty modification.                                                                       
MR. BARRONS replied that as  part of the application process, the                                                               
department runs  the economics on  whatever tax fiscal  system is                                                               
in place at the time. Royalty  modification is not designed to be                                                               
applicable at  a project  level (pool), but  rather to  an entire                                                               
field. He said  the DNR can hire a consultant,  if they deemed it                                                               
appropriate  (at the  cost of  the  applicant) to  make sure  the                                                               
department's work  is transparent  and for verification.  He said                                                               
the  relief mechanism  is usually  an adjustment  based on  price                                                               
change of  the oil  and gas;  it can be  based on  other relevant                                                               
factors  including the  production rate,  the ultimate  recovery,                                                               
development and operating costs.                                                                                                
4:02:20 PM                                                                                                                    
So  edging in  toward Senator  French's question  about just  the                                                               
application review process; the  department doesn't solicit these                                                               
applications.  The  companies  come forward  asking  for  royalty                                                               
modification. Part  of the  stipulation is  that it  is incumbent                                                               
upon  them  to  submit  a significant  amount  of  technical  and                                                               
financial  data to  prove to  the  department that  the field  is                                                               
uneconomic. All of  this information is held  in confidence; that                                                               
is a very important part of this statute.                                                                                       
MR. BARRON said that the  department does not blindly accept this                                                               
information; it  goes through an  incredibly rigorous  process of                                                               
"stochastic  modeling" and  looking  at things  like net  present                                                               
values, rates of return, break  even analysis, operating costs of                                                               
the area and if capital costs  are reasonable.  They come up with                                                               
their own assessment  of whether or not a  prudent investor would                                                               
carry the  project forward.  Sunk costs (costs  in the  past) are                                                               
typically   excluded,  because   the  department   evaluates  the                                                               
forward-looking set of economics.                                                                                               
4:05:07 PM                                                                                                                    
CO-CHAIR PASKVAN  asked him  to define  "forward-looking" company                                                               
more fully.                                                                                                                     
MR.  BARRON answered  that "forward-looking"  means that  you are                                                               
looking forward and not including anything  in the past. A lot of                                                               
times companies  do two sets  of economics; one  is point-forward                                                               
economics to  see if  their investments  from today  forward make                                                               
sense, and at  the same time they will run  "full field" or "full                                                               
history" economics  for internal purposes (that  includes all the                                                               
sunk  costs).  The  reason  sunk   costs  are  excluded  in  this                                                               
assessment is because  they are looking at costs  that impact net                                                               
present value.  Once the  department is  done with  its modeling,                                                               
Mr. Barron  said, they  issue a preliminary  finding as  a public                                                               
notice and  then there  is a 30-day  public comment  period. They                                                               
evaluate the public  comments and respond to them  and then issue                                                               
a final finding.                                                                                                                
4:06:38 PM                                                                                                                    
MR. BARRON next talked about  the decision parameters in terms of                                                               
economics.  He said  they primarily  use  the "expected  monetary                                                               
value  (EMV),"   a  stochastic   (statistical)  term   used  when                                                               
different  distributions  of  different  variables  are  used  to                                                               
determine the expected value of  a project. For a simple example,                                                               
if  you have  a decision  tree with  two branches;  one is  at 90                                                               
percent probability and one is at  10 percent (both adding to 100                                                               
percent). The 90  percent probability has a value of  $10; the 10                                                               
percent may  have a value  of $100. Your expected  monetary value                                                               
is .9 times $10 and .1 times $100, added together.                                                                              
4:07:42 PM                                                                                                                    
CO-CHAIR PASKVAN  said he was  describing a Monte  Carlo analysis                                                               
that looks at multiple factors to arrive at EMV.                                                                                
MR.  BARRON  said yes.  The  key  parameters  they look  at  are:                                                               
product  price,  potential  reserves and  production  rates,  the                                                               
capital costs  and the operating  costs. The  key is that  all of                                                               
these have uncertainty.                                                                                                         
CO-CHAIR  PASKVAN referred  to the  Nikaitchuq royalty  case from                                                               
October  30,  2006,  that  said  "granting  royalty  modification                                                               
should influence the  behavior of the applicant."  What does that                                                               
mean when performing their economic analysis?                                                                                   
MR.  BARRON  replied in  that  document,  the behavior  they  are                                                               
trying  to influence  is the  decision of  the company  to either                                                               
proceed with the  development of the field or not.  If they grant                                                               
royalty  modification  and the  company  moves  forward with  the                                                               
field, that is the change  of decision. Otherwise the field would                                                               
not be developed.                                                                                                               
4:09:34 PM                                                                                                                    
SENATOR WIELECHOWSKI  asked when a  company takes out a  lease in                                                               
the State of Alaska, at what  point in time are they obligated to                                                               
develop it or can they just sit on it forever.                                                                                  
MR. BARRON  replied when a company  takes out a lease,  they have                                                               
been granted  the exclusive  right to hold  that acreage  for the                                                               
term  of the  lease.  There  is no  requirement  for  them to  do                                                               
anything during  the primary lease term;  they can sit on  it. At                                                               
the end  of the life of  that term, the state  takes the property                                                               
back  and  it  can  be  put  back  into  a  lease  sale.  As  the                                                               
commissioner  mentioned,  that  is   one  thing  they  were  very                                                               
cognizant of  in the  current lease sale  and modified  the lease                                                               
terms to  increase the opportunity  of development  by increasing                                                               
the cost after year 7 to $250 an  acre instead of $10. There is a                                                               
choice: you can hold the land  but it will cost you a significant                                                               
SENATOR  WIELECHOWSKI asked  if it  is  the best  policy for  the                                                               
state to  lease land  that is wildly  economic and  let companies                                                               
sit on that land for seven or eight years and not develop it.                                                                   
4:11:58 PM                                                                                                                    
MR. BARRON replied  that in a primary lease term  the land may or                                                               
may not  be known to be  productive. The heart of  the lease sale                                                               
is to  offer state land  to companies to do  adequate exploration                                                               
and to  then take that  exploration and  knowledge and, if  it is                                                               
something that  can be  developed, to  move into  the development                                                               
SENATOR  WIELECHOWSKI asked  if  he knew  of other  jurisdictions                                                               
that  try to  encourage  exploration by  different means  through                                                               
their lease terms.                                                                                                              
MR. BARRON  replied that many jurisdictions,  internationally and                                                               
domestically,  have many  different ways  of trying  to encourage                                                               
companies to do adequate exploration and development.                                                                           
SENATOR WIELECHOWSKI  asked if  they have no  obligation to  do a                                                               
single  thing  to develop  or  do  a  single seismic  test  under                                                               
current Alaska law.                                                                                                             
MR.  BARRON answered  that was  correct under  the primary  lease                                                               
CO-CHAIR PASKVAN asked him to define "primary lease term."                                                                      
4:14:00 PM                                                                                                                    
MR. BARRON said  the primary lease term in the  case of the North                                                               
Slope is for 10 years. If  a company is deemed the highest bidder                                                               
in  a lease  sale,  they  are granted  the  right  for a  10-year                                                               
timeframe.  During that  timeframe, the  state's objective  is to                                                               
have them  do as much  exploration work as possible  to establish                                                               
the productive  potential of the  land. Once they have  deemed it                                                               
to  be  commercial  hydrocarbons,   they  ask  the  division  for                                                               
unitization, which  is when they  establish work  commitments and                                                               
financing   criteria  during   their  first   primary  phase   of                                                               
unitization.  That's typically  a  five-year  timeframe. This  is                                                               
where the  department has made modifications  in its negotiations                                                               
with companies  this year  to drive  that discussion  forward. In                                                               
the first year  or two, they have an obligation  to the state and                                                               
if they aren't  performed (i.e. drill a well), you  will lose the                                                               
bond  and the  acreage. Once  that field  is in  production, that                                                               
production holds the lease.                                                                                                     
SENATOR  WIELECHOWSKI  asked  if  Kuparuk  is  producing  150,000                                                               
barrels a  day and  the producer  said they  were going  to lower                                                               
production to 1,000 barrels a day  until they get tax breaks, was                                                               
he saying the state couldn't take action.                                                                                       
MR. BARRON  replied he thought  that would be correct;  that land                                                               
is held by  production. Companies have an  opportunity to discuss                                                               
on  an  annual  basis  their  plans  of  development  (tomorrow's                                                               
presentation),  but  in theory  and  practice  once a  lease  has                                                               
production on it, it is held by that production.                                                                                
4:16:29 PM                                                                                                                    
SENATOR  STEDMAN asked  if he  knew  of any  cases when  industry                                                               
turned down the  volume for reasons that  weren't mechanically or                                                               
constraint driven on a productive lease.                                                                                        
MR. BARRON answered not that he was aware of.                                                                                   
SENATOR WIELECHOWSKI asked  what kind of internal  rate of return                                                               
he  would expect  for  a  project to  be  deemed  economic for  a                                                               
MR.  BARRON replied  that DNR's  keeps  its economic  assessments                                                               
very  internal  in  royalty modification  cases.  That  is  done,                                                               
because they  don't want  to encourage the  industry to  work its                                                               
numbers  in   a  way  that   would  slant  them   toward  royalty                                                               
modification.  He  said  the department  looks  at  each  project                                                               
differently  so  that  the  parameters   they  use  for  one  are                                                               
different  than   the  parameters  for  another,   because  their                                                               
reserves are  different, the product profiles  are different, the                                                               
escalation curves  may be  different and  all of  their operating                                                               
conditions could be different. Each  one has its own hurdle rate.                                                               
They are trying  to find at what  point in time, if  they were to                                                               
give  royalty  modification,  what  it would  be  to  change  the                                                               
behavior of  that company to  go from  a nonproducing asset  to a                                                               
producing asset.                                                                                                                
CO-CHAIR  PASKVAN asked  if a  duty to  produce is  part of  that                                                               
prudent producer obligation.                                                                                                    
4:20:07 PM                                                                                                                    
MR.  BARRON said  that was  an  interesting question  and he  was                                                               
trying to understand the difference  between the two concepts. He                                                               
didn't think  any sovereign had the  right to force a  company to                                                               
produce uneconomic assets.  So, while company may  be prudent and                                                               
may have a  duty to produce, the question would  be at what point                                                               
in  time any  sovereign  has  the right  to  force  a company  to                                                               
produce an uneconomic asset.                                                                                                    
CO-CHAIR  PASKVAN said  he assumed  that when  he does  the Monte                                                               
Carlo simulation  on granting  royalty relief,  he would  look at                                                               
net present  value and internal  rate of  return. If he  comes to                                                               
the  determination that  a prudent  investor  would develop  this                                                               
field  based   upon  the  department's  modeling,   doesn't  that                                                               
determination also create a duty to produce?                                                                                    
4:22:00 PM                                                                                                                    
MR.   BARRON  responded   that  thinking   through  the   royalty                                                               
modification context,  when the division does  its assessment and                                                               
deems  that a  prudent investor  or operator  would move  forward                                                               
with   the   development   without  royalty   modification,   the                                                               
application is  denied. The first  threshold of an  assessment is                                                               
that it's not  on production. At that junction, they  then have a                                                               
choice to make:  if they choose not to develop  the field after a                                                               
period of  time, that  land is relinquished  and returned  to the                                                               
In the case of the other  two aspects of royalty modification, if                                                               
the field is already on line  and it is essentially either almost                                                               
dead  or is  dead, that  is the  state's opportunity  to increase                                                               
production  by  modifying the  royalty.  It's  not reasonable  to                                                               
think a company is purposely  withholding production. It's not in                                                               
their  best interest  or  that of  their  shareholders' and  it's                                                               
against the concept of capitalism and entrepreneurship.                                                                         
SENATOR WIELECHOWSKI asked if OPEC had ever withheld production.                                                                
MR.  BARRON  replied  that  is  market  manipulation  and  market                                                               
control;  and   whether  anyone  in  the   state  is  withholding                                                               
production is not the crux  of this committee's question. OPEC is                                                               
a  cartel; it  is  not an  individual company  that  is based  on                                                               
capitalism; they are  trying to control an entire  market and not                                                               
produce  economically the  reserves of  the field  that they  are                                                               
operator on.                                                                                                                    
4:24:47 PM                                                                                                                    
CO-CHAIR PASKVAN said a decade  ago the division director said in                                                               
a  document  dated  January  3,  2002  that  this  state  had  an                                                               
MR. BARRON  responded by urging them  to think back a  little bit                                                               
about  what that  meant.  In  terms of  operations  on the  North                                                               
Slope, clearly  there are  three primary  players; there  are two                                                               
new players  and there  is an  opportunity to  have at  least one                                                               
more this  year two more  after that.  At the time  that document                                                               
was presented,  there were issues  on access, cost  structure and                                                               
available resources for new entries  into the market to break in.                                                               
The context  was a little  bit different  and the thrust  of that                                                               
dialogue probably  had nothing to  do with  royalty modification.                                                               
It had to do with if  there was a need for additional competition                                                               
on  the North  Slope, and  the DNR  and the  DOG have  made great                                                               
strides in  the last  several years  to increase  the competitive                                                               
nature on the Slope.                                                                                                            
CO-CHAIR PASKVAN said  he had talked about  his in-house economic                                                               
models for  performing the analysis for  royalty modification and                                                               
he  assumed  that  he  believed   it's  reasonably  accurate  and                                                               
MR. BARRON agreed yes.                                                                                                          
CO-CHAIR PASKVAN asked  if the DOG used that model  to assess the                                                               
homogenized oil industry  in Alaska, for example  taking FY13 and                                                               
using the parameters the department  knows about the oil industry                                                               
to determine  net present  value, internal  rates of  returns and                                                               
those types of Monte Carlo analyses.                                                                                            
4:28:11 PM                                                                                                                    
MR. BARRON  replied no,  not to  his knowledge.  That would  be a                                                               
huge undertaking and be exceptionally  complicated for one field,                                                               
to say nothing of how much more  complicated it would be to do it                                                               
for the  whole state of  Alaska. The next slide  showed numerical                                                               
distributions  of various  variables; the  first one  was product                                                               
price  and  was basically  a  normal  distribution of  production                                                               
rates and  production, operating  costs and capital  costs, which                                                               
in  this presentation  are demonstrated  as triangular,  and they                                                               
all have  high end  and low  end truncations.  Each one  of those                                                               
could  be looked  at  a  little bit  differently.  In some  areas                                                               
operating costs can  be used as a uniform  distribution (the same                                                               
throughout  time).   A  Monte  Carlo   run  uses  all   of  these                                                               
distributions;  and  including  a   production  decline  is  very                                                               
complicated if  you want to  take it to a  well level or  a field                                                               
level.  "Doing it  on a  statewide basis  would be  an incredible                                                               
4:36:08 PM                                                                                                                    
SENATOR WIELECHOWSKI said they have  heard talk that if they pass                                                               
an oil  tax reduction there will  be an investment of  $5 billion                                                               
over five  years and  it will  generate 90,000  barrels of  oil a                                                               
day.  Some of  them in  the building  also ran  some numbers  and                                                               
concluded that the  state would pick up 60 percent  of the costs,                                                               
so it  would actually be an  investment of $2 billion  by the oil                                                               
industry.  That would  generate a  net present  value of  over $3                                                               
billion  and an  internal rate  of  return of  about 92  percent.                                                               
"Does that sound like an economic project to you under ACES?"                                                                   
MR. BARRON answered yes.                                                                                                        
SENATOR WIELECHOWSKI asked  if he thought that  project should go                                                               
forward under ACES and the terms of the leases.                                                                                 
MR. BARRON  responded that part  of the answer is  the discussion                                                               
of what it  is being compared to relative to  the company and its                                                               
desire to advance its commerciality.  The DOG doesn't necessarily                                                               
look  at that.  In terms  of royalty  modification, if  a project                                                               
came  to  them  and had  a  92  percent  rate  of return  in  its                                                               
application, he guessed it would probably be rejected.                                                                          
SENATOR  WIELECHOWSKI  asked  if  something was  wrong  with  the                                                               
system, assuming the  numbers are correct, that  there are fields                                                               
out there that can generate a  net present value under ACES of $3                                                               
billion  at a  rate of  92 percent  ROR, and  they are  not being                                                               
MR. BARRON replied that he  would welcome the opportunity to look                                                               
at the  facts and figures  he was  discussing. He didn't  know of                                                               
any field that is not currently producing with those economics.                                                                 
4:33:08 PM                                                                                                                    
SENATOR  FRENCH  asked what  sorts  of  improvements he  sees  in                                                               
taking  royalty from  12  percent  down 5  percent  (if that's  a                                                               
typical case).                                                                                                                  
MR. BARRON answered that involves  a field-by-field assessment of                                                               
how  big the  resource  plays in  it and  the  longevity of  that                                                               
field. The  current product price and  what it's going to  do may                                                               
actually  have  a greater  swing  than  the royalty  modification                                                               
itself.  What  you think  the  escalations  or de-escalations  on                                                               
operating costs and  capital costs are, what  the company's plans                                                               
are over the next 10, 20 or 30  years in terms of what they think                                                               
is required for  capitalization. These are the  kinds of in-depth                                                               
discussions the department  has with these companies  in terms of                                                               
overall long-term field development.                                                                                            
SENATOR  FRENCH said  many of  their questions  come back  to the                                                               
current  ACES debate  and the  fact that  the state  has suddenly                                                               
gone from  one exploration well last  year to a much  more robust                                                               
exploration season  this year  and maybe next,  and now  they are                                                               
hearing questions about whether they  will develop. It seems like                                                               
this  is exactly  what royalty  modification  is for  and he  was                                                               
trying to a  get a feel for how big  a lever royalty modification                                                               
MR. BARRON asked Mr. Banks to field that question.                                                                              
4:35:37 PM                                                                                                                    
KEVIN BANKS, Petroleum  Market Analyst, Division of  Oil and Gas,                                                               
Department of  Natural Resources  (DNR), explained  that Director                                                               
Barron's   caveats  about   responding  to   the  question   were                                                               
important,  because every  project  is so  different. Looking  at                                                               
Pioneer's application in the Oooguruk  Unit, their royalty relief                                                               
(12.5  to  5  percent)  moved  the IRR  dial  only  a  couple  of                                                               
percentage points at relatively higher  prices (for the time). At                                                               
a  $60 price,  the IRR  change was  about 1.5  percent; at  lower                                                               
prices it  was a little  bit more. The royalty  relief mechanism,                                                               
because a fairly  small slice of the pie is  being changed, has a                                                               
somewhat moderated effect on the economics.                                                                                     
4:37:10 PM                                                                                                                    
SENATOR  WIELECHOWSKI asked  if  he was  aware  of any  projects,                                                               
fields or  developments under current  lease that  are uneconomic                                                               
under the current tax structure.                                                                                                
MR.  BARRON answered  that the  Pioneer project  may fall  within                                                               
that category, because it has  been granted royalty modification.                                                               
The Eni  or any project  even though it has  royalty modification                                                               
probably is  not in that  category because  it takes effect  at a                                                               
$40-$43 basement.  Some fields in  Cook Inlet possibly,  but they                                                               
are  under  a  completely  different royalty  and  tax  code  and                                                               
probably shouldn't be  part of the dialogue at  this juncture. He                                                               
didn't know of  any uneconomic fields that  were uneconomic under                                                               
the current  tax structure,  because no one  has come  forward to                                                               
apply for royalty modifications.                                                                                                
SENATOR  WIELECHOWSKI asked  if the  administration had  done any                                                               
analysis  of  fields   to  see  whether  they   are  economic  or                                                               
uneconomic under the current tax structure.                                                                                     
MR. BARRON  replied that he  was not  aware of any  activity like                                                               
that being done or not being done.                                                                                              
4:39:09 PM                                                                                                                    
MR.  BARRON  reviewed  a  short   list  of  royalty  modification                                                               
applications that had come in:                                                                                                  
-BP at Milne Point in 1995 - that was denied.                                                                                   
-Unocal for  10 platforms in  Cook Inlet  1997 - did  not pursue,                                                               
but it wouldn't  have fallen into any of the  buckets, because 10                                                               
platforms was beyond the scope of any specific field or pool.                                                                   
-Phillips' application  for Tyonek  Deep in  Cook Inlet  in 1999,                                                               
but  it  was  withdrawn  voluntarily. It  might  have  qualified,                                                               
because  the  Deep  unit  had   never  been  produced  from  that                                                               
-Pioneer for  Oooguruk in 2005 -  it was granted and  royalty was                                                               
reduced to 5 percent until their NPSL lease has payout.                                                                         
CO-CHAIR PASKVAN asked him to define NPSL payout.                                                                               
MR.  BARRON answered  that means  "net profit  share lease,"  the                                                               
lease  term for  payout. There's  one lease  within the  Oooguruk                                                               
field that is  an NPSL lease and when that  lease has payout, the                                                               
reduction  goes away;  the state  has audit  rights on  Pioneer's                                                               
books to make sure the payout has taken place.                                                                                  
-Kerr-McGee came forward in 2006  with the Nikaitchuq and Kakivik                                                               
Units and  the application was  denied. After looking at  it very                                                               
seriously,  the  department  felt  it could  have  moved  forward                                                               
without royalty relief.                                                                                                         
-Chevron  came forward  with Ivan  River  and Stump  Lake in  the                                                               
Kenai area in 2007 and it was withdrawn.                                                                                        
-Eni came forward  with the Nikaitchuq Unit again in  2007 - this                                                               
was approved  based on a  different assessment and  analysis that                                                               
had the  most to do with  the trigger point of  product price and                                                               
volume. If the  field falls below 4,000 barrels a  day within the                                                               
first 120  months, they  get their  royalty modification.  If the                                                               
product price drops below $42.64,  they get royalty modification.                                                               
He said  Eni's production to date  is around 7,000 barrels  a day                                                               
and they do  not enjoy royalty modification,  because neither one                                                               
of the two triggers have been satisfied.                                                                                        
4:43:54 PM                                                                                                                    
He said two  modifications have been granted since  1995 and only                                                               
one is  being used.  The division  is very  careful to  not grant                                                               
reduction to  a field  forever; at  some point  the state  has to                                                               
recapture its sovereign share.                                                                                                  
CO-CHAIR PASKVAN  asked if he  assumed that all  other operations                                                               
are currently economically profitable.                                                                                          
MR. BARRON replied  that one could make that  assumption and that                                                               
conclusion,  but  it's important  to  understand  that the  three                                                               
categories  of applications  fall  within  very discreet  bounds;                                                               
that a field  has never been on production and  the other two are                                                               
at the very end  of field life or when a field  has been shut in.                                                               
While   they  could   assume  that   all  fields   are  currently                                                               
economically viable, none  of them are at the end  of the life of                                                               
the  field  and   don't  qualify  to  make   an  application  for                                                               
SENATOR WIELECHOWSKI asked if he  saw any benefit to changing the                                                               
law  to allow  for royalty  relief  in the  case of  a heavy  oil                                                               
project,   for  example,   within  Prudhoe   Bay  that   is  very                                                               
MR.  BARRON  replied  that  they  would  have  to  be  incredibly                                                               
cautious about  structuring something like that.  Heavy oil might                                                               
be  a good  example of  royalty modification  by a  participating                                                               
area (PA). It  would be very difficult to  structure the language                                                               
if  someone  were  to  put  gas  injection  in  the  crest  of  a                                                               
structure. The  question would be  how to assess  what production                                                               
to apply  royalty relief to;  that production would also  have to                                                               
be audited for accuracy in a greater field.                                                                                     
CO-CHAIR PASKVAN said  one of the Nikaitchuq  applications had an                                                               
analysis that indicated  at $60 a barrel that  the operator would                                                               
experience "very large profits." Is that accurate?                                                                              
MR. BARRON deferred to Mr. Banks.                                                                                               
4:48:19 PM                                                                                                                    
MR. BANKS  said that was  in reference to the  Kerr-McGee project                                                               
that was  eventually denied.  He recalled  that that  project was                                                               
quite  a bit  different than  the  one proposed  by Eni  somewhat                                                               
later. A couple  of factors formed the conclusions  for the Kerr-                                                               
McGee application. One  had to do with the  taxpayer situation at                                                               
the  time. Kerr-McGee  was  owned by  Anadarko  and had  existing                                                               
production going  on; so  their PPT  tax situation  was different                                                               
than Eni's  simply because there  was an existing tax  upon which                                                               
credits and deductions could be  taken (that weren't available to                                                               
Eni in the same way). The other important factor for the Kerr-                                                                  
McGee  project was  the prices  at the  time were  relatively low                                                               
($40-$50)  and the  costs they  had predicted  in the  go-forward                                                               
economics  were   substantially  less  than  what   Eni  proposed                                                               
somewhat  later.  So at  just  a  slight  increase in  price  the                                                               
project  would  be  profitable  and the  downside  risk  for  the                                                               
project  was  rather small  as  well.  The two  conclusions  were                                                               
combined in evaluating this project.                                                                                            
[SB 192 was held in committee.]                                                                                                 

Document Name Date/Time Subjects
Nikaitchuq_Final_Finding_2008.pdf SRES 2/21/2012 3:30:00 PM
SB 192
Nikaitchuq_Final_Finding_2006.pdf SRES 2/21/2012 3:30:00 PM
SB 192
SRES_DNR-DOG_Royalty_Mod_slides_2_21_12.pdf SRES 2/21/2012 3:30:00 PM
SB 192