Legislature(2003 - 2004)
10/13/2004 09:35 AM House BUD
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* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
ALASKA STATE LEGISLATURE
JOINT MEETING
JOINT COMMITTEE ON LEGISLATIVE BUDGET AND AUDIT
SENATE RESOURCES STANDING COMMITTEE
October 13, 2004
9:35 a.m.
MEMBERS PRESENT
LEGISLATIVE BUDGET AND AUDIT
Representative Ralph Samuels, Chair
Representative Mike Chenault
Representative Reggie Joule, alternate
Senator Gene Therriault, Vice Chair
Senator Ben Stevens
Senator Con Bunde
Senator Lyman Hoffman
SENATE RESOURCES
Senator Tom Wagoner, Vice Chair
Senator Ben Stevens
Senator Kim Elton
MEMBERS ABSENT
LEGISLATIVE BUDGET AND AUDIT
Representative Mike Hawker
Representative Vic Kohring
Representative Beth Kerttula
Senator Gary Wilken
SENATE RESOURCES
Senator Fred Dyson
Senator Ralph Seekins
Senator Georgianna Lincoln
OTHER LEGISLATORS PRESENT
Representative Nancy Dahlstrom
Representative Hugh Fate (via teleconference)
Representative Carl Gatto
Representative Pete Kott
Representative Lesil McGuire
Representative Norman Rokeberg
Representative Bill Stoltze
Representative Ethan Berkowitz
Representative Eric Croft
Representative Les Gara
Representative David Guttenberg (via teleconference)
Senator Gary Stevens
Senator Hollis French
Senator Gretchen Guess
COMMITTEE CALENDAR
^OVERSIGHT ON ALASKA NATURAL GAS PIPELINE ISSUES
PREVIOUS COMMITTEE ACTION
No previous action to record
WITNESS REGISTER
Presentations by:
GOVERNOR FRANK MURKOWSKI
State of Alaska
DR. PEDRO VAN MEURS
Van Meurs & Associates
JAMES ZIGLAR, Managing Director/Chief Business Strategist
Municipal Securities Group
UBS Financial Services Inc.
CHARLES DAVIS, Managing Director
UBS Investment Bank
UBS Financial Services Inc.
ROBERT DOHERTY, Managing Director & Co-Head National
Infrastructure Group
UBS Financial Services Inc.
JAMES SCOTT, Managing Director
UBS Financial Services Inc.
JOE FORRESTER, Managing Director
UBS Financial Services Inc.
PHILIP KOROT, Senior Vice President
Lehman Brothers
ROBERT MILIUS, Senior Vice President
Lehman Brothers
ACTION NARRATIVE
TAPE 04-29, SIDE A [BUD TAPE]
Number 001
CHAIR RALPH SAMUELS called the joint meeting of the Joint
Committee on Legislative Budget and Audit and the Senate
Resources Standing Committee to order at 9:35 a.m.
Representatives Samuels, Chenault, and Joule, and Senators
Therriault, Ben Stevens, Bunde, Hoffman, Wagoner, Elton, and
Gara Stevens were present at the call to order. Also in
attendance were Representatives Dahlstrom, Fate (via
teleconference), Gatto, Kott, McGuire, Rokeberg, Stoltze,
Berkowitz, Croft, Gara, Guttenberg (via teleconference), and
Senators Gary Stevens, French, and Guess.
CHAIR SAMUELS acknowledged that there has been much concern with
regard to the timing of this hearing. He explained that he set
the date for this meeting and invited the Administration, at the
behest of both the Joint Committee on Legislative Budget and
Audit and the Senate Resources Standing Committee, to come
forward with an update on the natural gas pipeline. He
emphasized that the point of this hearing, knowing the political
downside of it, is to not put it off for two months. Chair
Samuels said, "So, I've worked very well, I think, with both
Senators and Representatives, with Democrats and Republicans to
try to keep politics out of this issue because it is way too
important - no matter what happens on the 2nd of November - for
all of us to make sure that this project has the best chance of
going forward and shame on all of us if we do anything to stop
the project."
Number 011
GOVERNOR FRANK MURKOWSKI, State of Alaska, paraphrased from the
following written remarks:
Good morning and thank you for the opportunity to
discuss with you an issue of significant importance to
the future of our state.
I would like to thank the Legislative Budget and Audit
Committee for the professional way it has performed
its task of overseeing the Stranded Gas Act
negotiations. I appreciate the fact that the issue
has not been politicized but devoted solely to what is
in the best interest of Alaska.
While my Administration and the Legislature share many
common goals and responsibilities ---- none will have
more jobs impact on the future of Alaska than the
commercialization of our vast North Slope natural gas
resources.
Success in this venture will require nothing less than
the very best each and every one of us has to offer.
We saw an example of this over the weekend when in an
unprecedented action our Congressional Delegation
managed to obtain the Federal fiscal and enabling
legislation necessary for this project to go forward.
So now it is up to us to fulfill the roles set out for
us in the Stranded Gas Act by negotiating the state
fiscal terms necessary to allow the project to go
forward.
Our Administration has worked very hard on this issue.
So far this year the Departments of Natural Resources
and Revenue have spent more that 15,000 employee hours
and over $1.9 million for contractor services; the
Department of Law has expended $295,700 for inside
counsel and an additional $597,200 for contract legal
services.
GOVERNOR MURKOWSKI interjected [The following state is not part
of his written remarks]:
Now, the good news is that 75 percent of this is
reimbursable by the applicants.
Before going any further I want to make two things
perfectly clear:
One ---- I am "not" here this morning to announce any
preference for one gas project over another.
And two ---- active negotiations and discussions are
continuing with "all" parties engaged in gas
commercialization efforts.
These include the:
Alaska Natural Gas Development Authority;
Port Authority;
Producers Group (Conoco/Phillips, British
Petroleum, Exxon);
TransCanada;
Enbridge;
and MidAmerican
Only two groups, TransCanada and the Producers, have
submitted a Stranded Gas Act application and signed a
reimbursement agreement with the State and thus are
entitled to formally negotiate with the State.
In addition, the Alaska Natural Gas Development
Authority and the Alaska Gasline Port Authority
continue to work on their own plans for an All Alaska
gasline.
The issue I want to discuss with you today cuts across
all of these commercialization efforts.
Number 069
Since becoming Governor 22 months ago, I have hammered
home one constant and recurring theme ----- Alaska
needs to move now on construction of a gas pipeline.
Delay will seriously erode our chances at getting the
line built. Imported liquefied natural gas is our
chief competitor, and our nation would be better off
with a stable, domestic supply of natural gas, instead
of relying on overseas supplies.
I strongly believe that any position negotiated by the
state must reward early construction, and penalize
delay. Our goal is an in-service date of 2012.
It is with these thoughts in mind that I come before
you today.
One of the very first legislative efforts I undertook
as Governor was to work with Representative Bud Fate,
many of you here today and the rest of the Legislature
in reauthorizing and expanding the Alaska Stranded Gas
Development Act.
This act clearly articulates roles and
responsibilities for both the Governor and the
Legislature.
The Act requires my Administration to bring you a
proposed contract and, following legislative and
public input, the Legislature will either approve or
disapprove that proposal.
It is important to point out that the crafters of the
legislation did not provide the legislature with the
authority to modify any of the elements of the
proposal.
Given the complexity and scope of a Stranded Gas
Development Act contract ---- this provision is
appropriate. And it places a grave responsibility on
our Administration to advance the best possible
proposal to you for your consideration.
However, given the Act's all or nothing approach if
you disapprove the contract because of a fundamental
disagreement over a major component ---- it could well
be months before an alternative is brought back to you
for your further consideration.
Therefore, I want to discuss with you today a
fundamental concept that will underpin the proposal,
which my Administration intended to present to you
during the Legislative session.
I cannot discuss the details of confidential
negotiations with the two applicants which have
qualified to enter into negotiations with the State
under the Stranded Gas Act - the Producers and
TransCanada - but I can tell you that a critical
element of a successful negotiation will involve the
State taking an equity position and significant level
of project risk.
And with that equity position and project risk comes
the associated awards.
I have made no secret of the fact that I believe
Alaska should take an equity participation in the
gasline project ----
We may have missed the boat when the Trans-
Alaska Pipeline was built ---- For example, had
we been owners we would have been much better
positioned to obtain more revenue for Alaska even
though we would have taken a significant risk.
And we have stood on the sidelines for nearly 30
years watching a lot of revenue flow to those who
were willing to take the risk.
We "did" take the safer tax and royalty route back
then and it "did" provide us with great benefit ----
but I think all of us have pondered from time-to-time
what would have happened if we had taken some equity
in the pipeline ---- perhaps equal to our 12 1/2
percent royalty share.
Now the time has come to address this issue again as
we put together the gas line structure.
Number 124
Whether we are talking about an independently operated
gas line or a producer built and operated gas line, it
has become clear to me that the most likely path for
starting construction soon will require the State to
take an ownership position in the project and bear a
certain amount of shippers' risk.
This equity interest could, for example, involve
offsets in respect to taxes, royalties, or other
obligations.
It could mean a bigger share of revenues for the
State, but more importantly it may be the only path
forward that gets a pipeline project underway.
The details of the overall package for a gas line
project will be necessary for your final
consideration.
As prescribed in the Stranded Gas Development Act, we
"will" have all of those details incorporated into the
proposal presented to you for your consideration.
But at this stage, I want to say you are to be
complimented for holding these hearings and for
otherwise working to educate yourselves on the subject
of equity participation and risk taking. You have an
excellent two days of presentations scheduled.
The more dialogue we can have in the ensuing months
about the concepts of equity participation and risk
sharing the easier it will be for the legislature to
analyze our final proposal.
I also do not want our Administration's team to spend
months negotiating a contract with equity and
shippers' risk incorporated into the document only to
have you tell me later that this concept is a complete
non-starter.
Given the appropriate caveats, are you willing, or
perhaps more importantly, do you believe Alaskans are
willing to consider sharing in the risk and rewards
from partial ownership?
Are we willing to "risk" downside potential in return
for the upside potential and the certainty that
construction on the project will begin sooner?
I personally think the potential risk is worth the
reward.
And there are three reasons why I hold this position.
First, I believe that the gas markets in the Lower 48
are strong and will remain strong for decades to come
---- gas is the favored fuel for heating and
electrical generation.
America's hunger for electricity is growing and this
is expected to hold true for decades to come.
Second, through state's participation and assumption
of risk ---- we make the project both "safer" and more
"competitive" for the other participants. We may get
a gas line project started this way and no other way.
And that is important if our gas is going to compete
with increased LNG imports.
Sharing investment cost lowers risk for other
participants and provides for a high rate of return
which is necessary in view of other worldwide
opportunities for investment in energy projects.
All of this provides additional incentive for
participation in the gasline project.
And third, I want generations of Alaskans to share in
the upside of this project ---- remember that once the
gasline goes into service it is going to operate for
many decades ---- that is a generation worth of
benefit to all of us here today both on the monetary
return to the State and the availability of gas to
Alaskans.
Number 184
Sovereign equity participation in energy projects is
common in the world today ---- Governmental assumption
of risk is a regular consideration in many oil and gas
contracts.
Our principal consultant in the state's gas pipeline
commercialization efforts, Pedro van Meurs, will be
following me with a detailed discussion of what equity
and shipper risk means.
We have world class experience available to us through
the testimony of Dr. van Meurs ---- He has global
experience in governmental risk taking. As you know
he represents only governments, not energy companies.
I would again like to make it very clear that this
equity issue cuts across "all" of the proposals being
considered ---- each and every one of the
commercialization efforts could contain components
that are a departure from the traditional taxation and
royalty position held by the state.
Let me close by saying that time is "not" on our side.
The window of opportunity for the commercialization of
Alaska gas will not stay open indefinitely ---- We
cannot afford a lot of false starts in our ongoing
negotiating efforts. Again our goal is an in-service
date of 2012.
The detail, complexity, and scope of these discussions
is mind boggling ---- at the end of the day if
Alaska's interests are to be protected to the maximum
extent possible, every element of the contract must be
intricately woven together.
As Governor I accept the responsibility in making a
strong recommendation that Alaska consider taking a
significant equity and shippers' risk positions.
I invite your input as well on this major policy
decision.
Number 241
DR. PEDRO VAN MEURS, Van Meurs & Associates, informed the
committees that he has been involved in negotiations on the
government side for many projects and bidding rounds. In fact,
he related that he has probably been involved with 20 successful
projects and bidding rounds in the world. In the case of
Alaska, Dr. van Meurs opined that this project can be a
successful venture, although it will require new thinking. He
began by discussing the risk-reward balance and referred to a
graph in his testimony that illustrates how risk and reward work
around the world. The graph illustrates that the more risk
there is, the more profit [investors] want. Therefore, if a
government is willing to accept more risk, [there is the
potential] for more government revenues. "Governments can gain
revenues, if there is less risk," he specified. Dr. van Meurs
turned to the risk-reward balance in relation to stranded gas
and related that usually there aren't enough profits with
stranded gas. Therefore, he posed the question of how one would
turn a stranded gas project that isn't profitable into one that
is profitable. Many suggest that the [state] has to give up all
its royalties, taxes, et cetera [in order to be profitable].
Although some nations did the aforementioned, it is much smarter
to change the risk. The graph illustrates that by lowering risk
a project can be done with less profitability. Therefore,
legislatures shouldn't always be focused on the reward rather
the legislature must determine how it can alter the risk balance
such that the project becomes economic. Many nations, he
related, have been very successful when using the graph "Risk
and Reward Balance for Stranded Gas" because they understand the
risk-reward balance.
DR. VAN MEURS explained that governments affect the risk-reward
balance in the following two ways: equity participation and
production/risk sharing agreements. Sometimes the purpose of
equity participation or risk sharing is to create additional
revenues for the state, which is illustrated in the first graph
entitled "Risk and Reward Balance." However, sometimes the
objective is to make a stranded gas project profitable by
lowering the risk, which is illustrated in the second graph
entitled "Risk and Reward Balance for Stranded Gas." The two
instruments that are [most often] employed throughout the world
are production/risk sharing agreements and joint ventures.
Number 350
DR. VAN MEURS related that typically there are three types of
joint ventures: a joint corporation with shareholders; a joint
operating agreement; and limited liability companies (LLC) or
limited partnerships. He explained that in a joint corporation
there are shareholders and the assets are owned by the company
and decisions are made by the board. Furthermore, capital is
contributed to share capital. He highlighted an important
concept, which is that individual shareholders can't opt out of
the venture. It's also important to realize that a single
corporation is a single taxable entity, and therefore when a
joint corporate structure is created it becomes a new taxable
entity. For that reason, oil companies often enter,
particularly in the upstream, into joint operating agreements.
Joint operating agreements are a different form of joint
venturing. The [major] difference is that in joint operating
agreements, the parties remain independent. Therefore, the
parties pay their own tax and own a proportionate share of the
assets. Furthermore, the decisions are made by working interest
owners in a committee. He indicated that one familiar with the
oil industry in Alaska is probably very familiar with joint
operating agreements.
DR. VAN MEURS turned to LLCs, which he characterized as
something in between [a joint corporation and a joint operating
agreement]. He explained that with LLCs, the parties are
independent members. He further explained that the assets are
owned by the LLC and the decisions are made by a management
committee. However, the parties remain independent for tax
purposes. The aforementioned makes the LLC concept attractive
if one wants to invest in pipelines. "An Alaska state company,
if it's an integral part of the state, wouldn't pay federal
income tax; so it would be very satisfying if we could earn
return on the profit and not pay federal income tax," he pointed
out.
Number 408
DR. VAN MEURS moved on to the international experience with
joint ventures and addressed why some nations have been
successful while others have not. The notion of joint ventures
started in 1960 with Egypt and an Italian state company. Both
of the parties decided that the normal royalty and tax, which
together was 50 percent in Egypt, wasn't a fair reward. Egypt
wanted more, which led to the decision to do a 50:50 joint
venture. However, the question became what to do if one side
votes for something and the other votes against. The
aforementioned led to the decision for each party to give 1
percent to a Swiss banker who would solve any gridlock. At that
time Dr. van Meurs was an advisor, much like Bonnie Robson to
the Alaska State Legislature, in the Netherlands. The
Netherlands was discussing the possibility of equity
participation. He explained that in 1959, the Netherlands
discovered the largest gas field discovered in Europe. The
government of the Netherlands realized that the only way it
could gain advantage, since it couldn't change the royalties and
the taxes, was to negotiate a very substantial equity
participation. However, the government of the Netherlands also
realized that all the gas would negatively effect its coal
mines, which led to placing Dutch State Coal Mines in charge of
the pipeline distribution system. The Netherlands example is
one of the most successful gas field stories in the world.
DR. VAN MEURS continued with an example of a joint venture in
Venezuela, which has stranded oil. Venezuela has probably one
of the largest oil reserves in the world with 200 billion
barrels of stranded oil in the Orinoco Delta and River Valley.
No one wanted to develop that stranded oil because the royalties
and taxes were too high and too difficult. Therefore, Venezuela
decided to make a deal with 1 percent royalty and 50 percent
participation. The aforementioned has resulted in 500,000
barrels a day of heavy oil production and companies such as
ExxonMobil Corporation and ConocoPhillips are spending money on
the stranded oil. With the high oil prices, Venezuela had
announced that it will increase the royalties to what it
should've been.
Number 516
DR. VAN MEURS addressed Russia, which he characterized as an
important competitor of Alaska. Although Russia went through a
number of joint ventures, what's most interesting are its
production sharing agreements. He explained that in 1992 Russia
realized that it was an enormous political risk because it had
no legal system and no laws. However, Russia also realized that
its oil resources were the key to its future and thus Russia is
doing very well with its oil exports today. Russia was
successful with production sharing agreements. He explained
that Russia agreed to [pay] for a share of the production so
that there's full fiscal stability on a contractual basis, and
therefore the country's instability isn't a worry. The
aforementioned has led to ExxonMobil Corporation doing the
Sakhalin project. Dr. van Meurs related that Russia has the
largest gas reserves in the Bering Sea, which he predicted will
be one of the largest liquefied natural gas (LNG) projects in
the world. The reason the aforementioned project is going
forward is because of the production sharing agreement.
DR. VAN MEURS turned to Brunei in the 1970s, which was faced
with a huge gas resource it couldn't market. Brunei determined
that in order to have an LNG project, it had to think
differently, and therefore Brunei launched a 50:50 joint venture
with Shell Western E&P Inc. ("Shell"). Brunei's 50:50 joint
venture with Shell has been one of the most successful projects
in the world and Brunei is the richest country in Asia because
of this project. The same happened in Oman, which capped all
royalties and taxes because it is "completely at the end of the
trail as far as LNG." Oman also provided 50 percent
participation. Now, Oman is exporting gas to the Far East in
large volumes. Qatar is perhaps one of the most successful
nations in the world for marketing gas, he remarked. Qatar is
sitting on approximately 700 trillion cubic feet (tcf) of gas,
which is about 20 North Slopes. Qatar realized it needed to
find a way to market its gas.
TAPE 04-29, SIDE B
DR. VAN MEURS related that ExxonMobil Corporation did a highly
unusual deal in which it agreed to participate with Qatar
sharing an enormous percentage of the risk. [Qatar] agreed to
invest 70 percent of the project with no royalties, just
corporate income tax. Today, Qatar is a successful exporter of
LNG all over the world. Qatar is ExxonMobil Corporation's
largest LNG area. He noted that ConocoPhillips just did a deal
with Qatar as well. Dr. van Meurs opined that Alaska's
competitors understand the risk-reward balance.
Number 654
DR. VAN MEURS highlighted that Norway has a long history of
joint ventures. Today, Norway is the richest country in the
European area. In fact, Norway is so rich that it doesn't want
to join the European common market. He explained that Norway's
successful petroleum policy was initially based on 50 percent
equity participation and a sharing style profit sharing tax. He
pointed out that BP and ExxonMobil Corporation are investing in
the first LNG project in Norway. The aforementioned project
isn't that profitable with perhaps only a 15 percent rate of
return, and therefore the question is why those companies are
going to Norway rather than Alaska, where a similar rate of
return could be achieved. The reason those companies are going
to Norway is the difference in the risk.
DR. VAN MEURS then turned to Malaysia and China, which decided
to be involved in both equity participation and production
sharing. Although Malaysia had no production of anything in
1970, it is now one of the largest gas exporters in Asia.
Furthermore, Malaysia's national oil company that didn't exist
30 years ago is now one of the leading companies in the world.
He then turned to Colombia, a country that faces much political
unrest, and pointed out that it has been very successful in
attracting investment with risk-sharing contracts. In fact,
Colombia discovered so much gas with the oil that it was able to
distribute gas throughout the country. Colombia is a wonderful
example of how gas can be used to stimulate a local economy.
DR. VAN MEURS highlighted two of his clients, Trinidad and
Tobago, for which he helped change their petroleum legislation.
These two countries were sitting on these large gas resources
without a market. Both Trinidad and Tobago decided to go for
production sharing, take a share of the gas and use it as a
basis for LNG projects. Dr. van Meurs noted that Trinidad and
Tobago are competitors of Alaska. Both countries are exporting
LNG to the East Coast of the US and other European nations.
Another country that has successfully used production sharing is
Indonesia. Actually, a part of Indonesia, East Timor, became
independent. ConocoPhillips Alaska, Inc. is present in [East
Timor] and investing in a large LNG project to export gas to
Asia. Again, the project has a low rate of return. He
reiterated that the reason ConocoPhillips Alaska, Inc. is in
Indonesia rather than Alaska is because of risk sharing. All
countries that have developed their gas with risk sharing or
production sharing are taking their gas in-kind, which can mean
a lot of different things. Taking gas in-kind completely alters
the risk balance of the contract and stabilizes the
relationship, and therefore a contract can be signed for 30-40
years. The aforementioned is why 40 countries in the world use
the formula to attract investment.
Number 733
DR. VAN MEURS moved on to the situation in Alaska and the issue
of risk of which there are two kinds in a pipeline. There is
the shipper's risk. He explained that the shipper commits to
the capacity in the line similar to renting space in a building.
The pipeline owner constructs and owns the building. Therefore,
if the pipeline owner can obtain a long contract, building the
pipeline wouldn't be difficult and the risk would lay in the
shipper's contract. He posed an example in which there is a $14
million pipeline project for a pipeline that runs from Prudhoe
Bay/Point Thomson to British Columbia/Alberta border and there
is a tariff of $1.20 MmBtu [million British thermal units].
Suppose the pipeline company wants a 15-year contract for 22
tcf, which amounts to a $28 billion contract. In such a
situation, the main risk is committing to a $28 billion
contract, which is the shippers' risk. The guaranteed income of
the $28 billion contract provides the pipeline owner the ability
to invest the required $14 billion to build the line.
Therefore, the oil companies can either spend the $14 billion to
construct the pipeline or commit to a $28 billion contract and
allow someone else to build the line.
DR. VAN MEURS addressed Alaska's issues. He explained that he
hoped he has demonstrated that all of Alaska's competitors are
doing quite well, while Alaska is not yet out of the "starting
gate." Therefore, he suggested that Alaskans need to learn how
to move from one "bar of risk" to another. The aforementioned
is so important for Alaska because the project in Alaska is one
with immense risks, quite unlike any other project in the world.
The main risks in the Alaska Gas Project are the huge size of
the project; the gas price risk; cost overrun risk; and
regulatory risk. He then referred to a graph entitled, "Capital
Expenditures related to current large world oil and gas projects
(blue) compared to Alaska (red)". This graph shows the 40
largest projects in the world that are currently in progress and
compared it with Alaska's project, which is three times larger
than any other project in the world. The large size of the
Alaska project is a risk itself. If the project fails, the
results for a company would be horrible. Therefore, there is no
room for failure with a project that is three times larger than
any other project being undertaken.
DR. VAN MEURS then directed attention to a graph entitled "IRR
[Individual Rate of Return] comparison with Top Ten projects",
which illustrates that the huge up-front capital requirements of
the Alaska project result in a low rate of return compared to
competing projects. "There's nothing Alaska can do about the
rate of return of this project," he said. However, the rewards
of the Alaska project are [potentially] huge. He turned to the
pie chart entitled, "North American Gas Market: Even at $3.50
per MmBtu in Chicago it represents a $221 billion opportunity
(nominal)". The pie chart illustrates how the $221 billion
opportunity would be distributed and highlights why, even with
only a $3.50 MmBtu in Chicago, it's so important for the Alaska
project to come to fruition. Dr. van Meurs opined, "A huge
project with a huge risk and a huge benefit, a very ... strange
and difficult combination." He then turned attention to a graph
entitled, "NPV@10% comparison with Top 10 projects", which
illustrates that if the price is low and the cost overruns are
high, the project is dead. The aforementioned is referred to as
a big downside risk. He stated that the downside risk is large
while the upside is very high provided that there is fiscal
stability.
Number 843
DR. VAN MEURS reviewed the challenges of the Alaska project: an
extraordinarily large project, a low rate of return, huge
downside risk, and North America's complex regulatory framework.
He related that he was the lead negotiator for Bolivia on the
Bolivia Brazil pipeline. The regulatory framework took 15
minutes on that project. The complexities of the regulatory
framework for Alaska's project make the project even worse.
Therefore, unique solutions are required in order to get
Alaska's project under way. In order to make Alaska's project
economic it's imperative to lower the risk, he reiterated. Dr.
van Meurs reminded the committees that at the April 7, 2004,
joint caucus he suggested the following strategy. First, a
stranded gas agreement must be developed. Second, a risk
sharing package between the state and the producers must be
developed. Third and above all else, there must be a federal
energy bill. The latter, the federal energy bill, was
accomplished. The Alaska congressional delegation educated the
entire Congress of the need to change the risk in order for
Alaska's project to proceed. "The federal legislation that was
passed is a classic example of a superb risk-reduction package,"
he remarked. He explained that the federal legislation includes
enabling provisions for a significantly reduced regulatory risk,
which is essential when competing with countries that have no
regulatory risk at all. The federal legislation also includes
federal loan guarantees, which reduce the financing risk. The
aforementioned is essential with a pipeline of this size. The
federal legislation also contains attractive tax provisions,
which reduce the downside risk and keep the EOR [enhanced oil
recovery] going in the North Slope, including gas. "There is no
question in my mind that the passing of this federal energy bill
is a gigantic step forward because this was the classic risk
reduction package, now the onus is on Alaska," he opined.
DR. VAN MEURS related that [the administration] is negotiating
stranded gas agreements, which are essential for this project.
A robust stranded gas agreement with appropriate fiscal
stability is necessary so that Alaska can compete with other
production sharing contracts that offer sometimes 30-50 years of
fiscal stability. Furthermore, it's necessary that there be a
competitive fiscal regime. "The last piece in the puzzle is a
risk sharing contract," he stated. Without changing the risks,
there will be no project because all of Alaska's competitors are
changing the risk.
Number 944
DR. VAN MEURS pointed out that there are two ways for Alaska to
change the risk: equity participation; production sharing by
taking gas in-kind. There is also the ability to change the
risk with a combination of the two, which is what China and
Malaysia did successfully. Dr. van Meurs opined that if the
risk is changed, the Alaska project will come about. However,
many are concerned that Congress didn't pass the tax credit that
would provide the downside price protection. "Personally, I
have never been positive about this tax package," he said. As
Alan Greenspan, Chairman, Board of Governors, Federal Reserve
System, has related, the tax credit doesn't align the parties.
Furthermore, there is no incentive to save costs nor obtain the
best price. Moreover, companies in a particular price band no
longer have an incentive to do a good job. He opined that the
interests of the US and Alaska would be misaligned [with the tax
credit]. "Corporate welfare is not a good method to align
interests," he emphasized. Still, the downside price risk
remains.
DR. VAN MEURS concluded:
In Alaska we can create a risk sharing package that is
in the interest of the state and will properly align
the interests of the investors and the state, and
will, to a significant degree, deal with the downside
price risk. That's the solution. The downside price
risk formula through equity participation and through
taking your gas in-kind, that will solve the downside
price risk. How will ... it solve the downside price
risk if we're going for gas in-kind? ... If the state
takes its gas in-kind and the price in Chicago is
$1.00 MmBtu, what is the value of this gas in-kind?
Negative. So, taking your gas in-kind means sharing
the downside price risk. That is a much smarter
formula than the tax credit. Why, because if the
price is high, Alaska gets the benefit. So, that is
why I believe the fact that the downside price risk
was not dealt with in the US Congress is not a
disaster. On the contrary, we can use that to our
advantage to create a sensible price risk sharing
formula that will be to the benefit of Alaska and the
producers.
Number 025
SENATOR BUNDE related that Dr. van Meurs seemed to interchange
the terms reducing risk and sharing risk, which Senator Bunde
viewed as very different. Senator Bunde pointed out that if the
state shares the risk, it doesn't necessarily reduce the total
risk. Perhaps it even increases the risk, he suggested.
Senator Bunde asked if [in the use of the aforementioned two
terms] Dr. van Meurs is really referring to reducing the risk
for the commercial entity rather than reducing the total risk.
DR. VAN MEURS said that Senator Bunde is correct. Risk sharing
between the state and the investors means that the risk to the
investors is lowered.
SENATOR BUNDE remarked that it's important for the public to
realize that if the state becomes involved, the total risk isn't
changed. Senator Bunde requested that Dr. van Meurs discuss the
politics of the state being involved in such a project and the
risk of cost overruns. He reminded the committees that the
Trans-Alaska Pipeline was a large economic opportunity for
Alaska labor. Similarly, one of the things being touted to the
public with the gas line is that there will be well paying jobs.
Therefore, he suggested that for some Alaskans the notion of
cost overruns would be positive because it could mean a higher
paying job or a job that lasts longer. With the aforementioned
logic, there is great pressure on the legislature to keep the
good jobs going, which could increase the risk of cost overruns.
DR. VAN MEURS agreed that the cost overrun risk is immense on
this project. In fact, a 20-30 percent cost overrun could kill
this project, he said. He noted that some have suggested that
without reducing the estimated cost by 10 percent, the project
may not be economic. The cost overrun risk is a central issue.
If the state participates, then the state participates in the
cost overrun risk. He acknowledged that there would be pressure
to maximize Alaska hire and jobs. In fact, the legislature has
already said that even if it's more costly, it prefers the
southern route. However, there is a balance between excessive,
unjustified, uncommercial, and uncompetitive costs on a pipeline
and the overall broad interest of Alaska. The legislature is
charged with finding that balance, he said. By the state
participating in the process, the aforementioned becomes more
accessible because the state is on the inside of taking the cost
overrun risk. Furthermore, the state being a partner in the
project provides the ability for the state to have a more
objective feel of the economic interest of the state.
Number 135
REPRESENTATIVE BERKOWITZ asked if the administration has a
preference regarding a producer-owned pipeline. He also asked
if there is any impact on the risk analysis if there is a
producer-owned pipeline. Representative Berkowitz expressed
interest in whether any of the examples or the risk sharing and
production sharing ventures discussed were producer-owned
pipelines. If so, he inquired as to the agreements that protect
[the country].
DR. VAN MEURS clarified that the Alaska government is
negotiating in good faith with two parties, and therefore he
opined that it's inappropriate to say whether there's a
preference at this point. With regard to risk sharing, he
turned to Thailand for whom he was an economic advisor in the
early 1980s when a large gas field was discovered in the middle
of the Gulf of Thailand. Consequently, Dr. van Meurs was
charged with helping the government define a new fiscal system
for gas. However, there was no market for the gas. The
Thailand government said it would build the entire line, taking
the entire risk. At that time, Thailand built the longest
offshore pipeline in the world in order to get the project
going. Today, Thailand is one of the most successful gas
producers and has introduced gas to the petrochemical industry
across the entire Eastern seaboard. He also related examples in
which the producers built the line, such as Vietnam. Each
project, he pointed out, has its own formula, benefits, and
characteristics.
REPRESENTATIVE BERKOWITZ clarified his question. Of the 17
examples in which there is risk sharing, do the producers own a
majority of the pipeline in any of those situations, he asked.
DR. VAN MEURS said that he hasn't done such analysis, but went
through the countries. He related that in Russia the producers
own a line [as is the case] in Brunei. However, in Oman the
state created a special company. In Qatar the situation is one
in which 30 percent of the pipeline is owned by the producers
and 70 percent by the state. Norway is a very mixed picture.
In Malaysia and China sometimes the [pipeline is owned] by the
producers and sometimes independents. He reminded the
committees that in Colombia the entire gas distribution system
was done by an independent pipeline company that was separate
from the producers. The LNG project in Trinidad and Tobago was
entirely done by the producers. Indonesia has many different
projects. Bangladesh, in some areas, is a monopoly. In Egypt
and Yemen the producers have successfully participated [in a
pipeline]. Dr. van Meurs reiterated that there is no automatic
formula. What is most beneficial to the project and the host
nation is what should happen, he opined.
Number 274
REPRESENTATIVE ROKEBERG related his understanding that Dr. van
Meurs seemed to have a preference for the distinction between
the shippers' risk reward versus the pipeline owners' risk
reward.
TAPE 04-30, SIDE A
REPRESENTATIVE ROKEBERG further related his understanding that
the federal loan guarantee helps lower or underpin the risk as
to the pipeline construction. Therefore, Representative
Rokeberg asked if Dr. van Meurs has a preference regarding
whether the state should be in the shipping model or the
pipeline model in terms of equity participation.
DR. VAN MEURS answered that if the state wants to help this
project in terms of equity participation, then the discussion is
regarding the shippers' risk and possibly in the context of
taking gas in-kind. He noted that other solutions are still
being reviewed. However, if the discussion is about risk
sharing, then it's about shippers' risk. He acknowledged that
there is also the pipeline risk. Dr. van Meurs recalled that
Jeff Brown, Managing Director, Merrill Lynch, pointed out to the
committees that under the appropriate circumstances, the state
could participate with debt financing packages and entirely
finance the venture. The 80 percent federal loan guarantees,
from the state's perspective, removes an enormous risk if the
state wants to participate. The aforementioned is why the
package passed in Congress has an enormous impact on the
economics of Alaska's project because a significant amount of
risk on 80 percent of the state's debt would be removed.
REPRESENTATIVE ROKEBERG surmised then that Dr. van Meurs is
suggesting that the state should investigate both equity
participation in the pipeline as well as production sharing
activities that would be consistent with the state's royalty in-
kind abilities under the current statute. Therefore, he
understood Dr. van Meurs to be recommending review of equity
participation and production sharing rather the singular albeit
safer option because the singular option may not result in
lowering the risks enough to provide an incentive.
DR. VAN MEURS confirmed that many options are still being
reviewed and serious negotiations have been started with two
parties. One of the options is precisely what Representative
Rokeberg has described, that is taking shipper equity risk plus
gas in-kind risk. The aforementioned is the strongest risk
reduction formula, if that can be turned into the interest of
the state. Dr. van Meurs said that at this point he isn't in
the position of recommending anything.
REPRESENTATIVE ROKEBERG surmised from Dr. van Meurs' testimony
that he preferred the LLC combination. He asked whether the
fact that this project will pass through two different countries
with two different business structures will cause any conflict.
If so, how would such be overcome, he asked.
DR. VAN MEURS confirmed that it's imperative that the US and
Canada sides of this project are understood. With respect to
the LLC model, Dr. van Meurs highlighted that it's interesting
in the realm of Alaska's project because it would be good to
obtain income tax free. Whether that can be attained has yet to
be seen. On the Canadian side with Alaska participation, Canada
wouldn't allow Alaska to pass through tax free and thus the
formula would be different. From an organizational point of
view, the limited partnership (LP) would be similar in structure
to the LLC. Therefore, if the decision is for an LLC on the US
side, then it would be logical to think of an LP on the Canadian
side. However, he clarified that he didn't want to advocate at
this time that there necessarily has to be an LP on the Canadian
side because there are other possible combinations. He said
that LLCs and LPs are almost different names for the same
concept.
Number 080
SENATOR ELTON posed an assumption that if a portion or all of
Alaska's royalty gas is taken in-kind, it would impose a duty on
the state to market that gas in the domestic marketplace. The
aforementioned doesn't seem like a typical governmental
function, and therefore Senator Elton inquired as to how other
governmental entities have accomplished such a private sector
duty.
DR. VAN MEURS clarified that the in-kind concept could be taken
broader and the state could even take some of its taxes in-kind.
To the question, Dr. van Meurs agreed that if the state does
take the gas in-kind, it does assume the responsibility to
market that gas. However, some governments make arrangements
such that the producers market the gas for a fee. Assuming the
marketing is costly and the state assumes the marketing costs,
it's a benefit for the investors who wouldn't have to assume the
marketing costs and risks. Dr. van Meurs related that countries
have made various arrangements with regard to who pays for
marketing. He emphasized that this is important in Alaska
because if the state is in control of the gas and the marketer
of the gas, the state can take a different approach than would
the companies in regard to marketing the gas in the state.
There may be very significant benefits from the state being able
to promote the benefits to a broader group of Alaskans by
controlling a considerable share of the gas and the marketing
obligation.
SENATOR ELTON related his assumption that if the state reduces
the risk for shippers and producers, then the state would have
to have a fairly good idea regarding whether it would work.
Furthermore, the state would have to have a fairly good idea how
much gas might be diverted in the state. He asked if Dr. van
Meurs is suggesting that the state will have a good notion of
what the gas needs will be and are in the state. Senator Elton
opined that if in fact the state is to take advantage of selling
gas in state, it would be important to know how much gas is
going down the pipeline.
DR. VAN MEURS agreed, adding that the in-state use of gas is a
high-risk proposition for certain markets in the state. "Here
again, Alaskans could increasingly become masters in their own
home, ... if they looked at these opportunities ... risks and
make an informed judgment and say, 'For the benefit of the state
we're going to do X, Y, and X.'," he remarked. However, whether
that would be recommended depends upon the details.
Number 147
REPRESENTATIVE GARA turned to the royalty in-kind issue, and
asked if the potential royalty in-kind proposals only take the
downside risk or is there also an upside reward. Representative
Gara related his understanding that if the state does royalty
in-value and gas is $1.00, the state wouldn't receive any tax
revenue but wouldn't lose anything either. If the state does
royalty in-value and gas is at $5.00, the state would receive a
large amount of tax revenue. However, if the state chooses to
go with royalty in-kind, the downside risk is that the state
would lose money when it tried to sell the gas, while the upside
doesn't seem to be any greater than if the state chose to go
with royalty in-value. Therefore, Representative Gara asked if
there has been review of royalty in-kind proposals that also
provide the state with greater upside reward in order to offset
the downside risk or does the royalty in-kind proposal only
allow the downside risk without an additional upside reward.
DR. VAN MEURS said that Representative Gara's analysis/views are
completely correct in that if the state takes its gas in-kind
and there is the assumption that there is no negative royalty,
then taking the royalty in-kind is riskier than taking the
royalty in-value. The aforementioned is why these negotiations
are so important.
REPRESENTATIVE GARA inquired as to Dr. van Meurs' thoughts on
the equity share risk. The recently passed federal loan
guarantees have a finite amount and the companies have, at
times, said that they would be insane to put in an investment
without a loan guarantee. If the proposal is for an equity
share, in which the state owns part of the pipeline, it seems
that the state should also share in part of the federal loan
guarantee.
DR. VAN MEURS again said that Representative Gara's analysis is
correct. What happened in Congress creates an entirely new
dimension of state participation because if the state [owns part
of the pipeline], the state should receive a share of the
benefit.
Number 195
SENATOR GUESS surmised then that the royalty in-kind is riskier,
but asked if there is a greater reward in choosing royalty in-
kind over royalty in-value.
DR. VAN MEURS clarified that his response to Representative Gara
was based on Representative Gara's assumption that the state
would receive the same price for the royalty in-kind gas.
However, the royalty provisions of the state actually have
beneficial clauses permitting the state to obtain some higher
principle, which would be lost if the state chooses to go with
the royalty in-kind. Consequently, care must be taken in that
decision.
REPRESENTATIVE BERKOWITZ recalled Governor Murkowski's point
that Dr. van Meurs only represents governments, not energy
companies, and inquired as to why.
DR. VAN MEURS answered that one can't negotiate for a government
unless that government has complete confidence in the fact that
the individual is fighting for that government. If one
negotiates for one side of the matter in one situation and on
the other side in another situation, the confidence in that
individual is gone. Dr. van Meurs related that his business
depends on that confidence, and noted that he has had a
successful business for 30 years.
Number 221
REPRESENTATIVE FATE asked if Dr. van Meurs considered treating
the liquid components of the wet gas that Alaska, in Point
Thomson and Prudhoe Bay, has in the same manner as it would in
the negotiations on the gas itself.
DR. VAN MEURS specified that there are two aspects to the liquid
components. In the case of Point Thomson, the Point Thomson
project involves liquids that would pass through the Trans-
Alaska Pipeline System (TAPS) as well as gas. He clarified that
[the state] isn't negotiating on the liquids part, and therefore
[the negotiations] are concentrated on the gas part. Although
the gas that would come out of Alaska isn't very rich, the
liquids would remain in the gas. Therefore, the question
regarding what to do with the liquids in the gas is important.
Every feasible option is being reviewed to determine whether the
liquids in the gas can bring some benefit to the state.
"Obviously, if the liquids are part of the gas stream, then we
have to ensure for the state that the state gets the best
possible benefit out of the value of those liquids," he said.
However, the precise formulas are still under discussion at this
point.
REPRESENTATIVE CROFT noted his agreement with Dr. van Meurs that
the federal legislation is a huge step forward for the state.
He asked if the accelerated depreciation provisions, which he
recalled only started in 2014, in the federal legislation match
the governor's in-service date of 2012. He expressed concern
with regard to having access in and out of the line for Alaska
businesses and independent producers, especially when there are
120 days to enter into the regulatory scheme with Federal Energy
Regulatory Commission (FERC).
DR. VAN MEURS highlighted that accelerated depreciation is of
tremendous benefit with risk reduction. However, the entire
interaction of the dates mentioned is being reviewed. With
regard to access, Dr. van Meurs characterized it as a crucial
concern and a top priority for Alaska. This line isn't being
built just to transport gas from Point Thomson and Prudhoe Bay,
it's being built because there is at least 50 tcf of gas in the
North Slope. The desire is to have the pipeline full for 50
years, if possible. The aforementioned should be the focus and
vision. He mentioned that the Congressional energy legislation
includes very helpful provisions on access, and therefore the
details of the access agreement need to be reviewed. In further
response to Representative Croft, Dr. van Meurs said that it was
his understanding that there is a 120-day window for FERC to
write access regulations after the passage of the energy
legislation. He added that [the state] will be very
aggressively involved in the process.
Number 293
SENATOR THERRIAULT asked if Dr. van Meurs has had time to review
the energy legislation and determine a dollar value of that
package to Alaska's project.
DR. VAN MEURS replied no, but added that there have been
intensive economic models and estimates of the benefits.
CHAIR SAMUELS informed the committees that the administration is
looking for input for the legislature regarding whether
[members] are willing to take a risk, in general terms. He
charged the members with determining how to obtain constituent
input.
The committees were in recess from 11:40 a.m. to 1:37 p.m.
Number 342
JAMES ZIGLAR, Managing Director/Chief Business Strategist,
Municipal Securities Group, UBS Financial Services Inc., turned
attention to the packet of information provided by UBS. Tab 1
includes the resumes of all of the people from different parts
of UBS who have helped analyze Alaska's project. Mr. Ziglar
highlighted the federal loan guarantee, the accelerated
depreciation with certain aspects of the pipeline, the
accelerated permitting and processing, including judicial review
of lawsuits, as well as the application for the enhanced oil
recovery [EOR] tax credit to the gas treatment plants are all
positive developments encompassed in the recently passed federal
energy legislation. Mr. Ziglar related the hope that he could
shed some light on some of the possible unique solutions eluded
to by Dr. van Meurs. Mr. Ziglar informed the committees that he
and his associates would provide testimony on the following
topics:
An overview of UBS.
The natural gas market, particularly the growth in LNG
and its potential implications for this pipeline
project and why action is required.
The project itself and the potential risks and rewards
for the state as a participant in the project.
Financing, credit options, and business models, in
particular a hypothetical situation in which the state
could participate as an equity partner in a meaningful
way while mitigating some of the risks.
Summary and conclusions.
MR. ZIGLAR informed the committees that in 2000 Paine Weber was
acquired by UBS AG and together with other firms, it became part
of the largest private bank in the world and one of the best
capitalized firms in the world. He turned attention to pages 3
and 5, which specify some of the rankings that UBS has in a
variety of areas. "We tend to think that we are now the premier
investment banking firm in the world," he related. Mr. Ziglar
highlighted that UBS is ranked first in the municipal bond
business, which includes tax exempt and taxable bond issues.
For at least the past 20 years, UBS has been involved as either
an underwriter or a financial adviser in over 50 percent of all
the bond issues performed in Alaska. "The breadth and depth of
our structuring experience, particularly in the municipal and
corporate area, I think, cannot be overstated when it comes to
putting together a transaction of this magnitude,' he opined.
Furthermore, on the corporate investment banking side energy is
one of UBS's strongest calling cards as illustrated by the fact
that UBS has managed the largest energy deals performed in the
corporate market over the last few years. Moreover, UBS is a
dominant player in the energy marketing, trading, and hedging
business all over the world. Pages 7-8 outline UBS's activities
in the aforementioned area. Mr. Ziglar opined that UBS brings
to Alaska the ability to assist the state in managing its
assets, risks, and financings in all their dimensions.
Number 493
CHARLES DAVIS, Managing Director, UBS Investment Bank, UBS
Financial Services Inc., informed the committees that for the
last 20 years he has spent most of his time working with natural
gas pipeline companies and integrated energy merchant companies
all over the world. He said he would discuss the competitive
environment for natural gas around the world and how it impacts
the feasibility of a pipeline from Alaska down to Alberta,
Canada. Mr. Davis opined that there's a significant first-mover
advantage as it relates to competition between the LNG market
and Alaska's project because once the project is underway, the
costs become "sunk." When one compares the competitive dynamic
of a pipeline from Alaska into Canada, the cost competition will
be reviewed on a variable basis as opposed to a full-cost basis.
He informed the committees that the global LNG liquefaction
capacity is expected to increase from about 6.6 tcf in 2003 to
9.4 tcf in 2007. The aforementioned is important because
somewhere between 75 percent and two-thirds of the costs
associated with LNG are located upstream of the re-gas
terminals. Therefore, once the producers and the countries
develop the liquefaction trains and ships, re-gas becomes
relatively inexpensive. He also informed the committees that US
LNG imports are expected to increase to more than 2.2 tcf by
2010, which will amount to about 8-10 percent of US natural gas
consumption.
MR. DAVIS opined that natural gas is probably one of the most
underutilized natural resources in the world. As of 2003,
natural gas reserves are estimated at 5,500 tcf, which is about
60 times the natural gas that was used last year. Furthermore,
the 12 countries that currently export LNG hold only about 25
percent of the world's natural gas reserves, which means that
there's a lot of gas that isn't being utilized. The
aforementioned can be a large competitive threat. He informed
the committees that the three countries holding about 33 percent
of the world natural gas reserves are currently building
liquefaction facilities. Although those [facilities] are very
localized, the LNG is coming and will be a significant economic
threat. He also informed the committees that the economic
crossover point for transporting LNG via tanker versus via a
pipeline has decreased to a distance of about 1,250 miles for an
offshore pipeline to about 2,300 miles for an onshore pipeline.
The difference is because offshore pipelines are more expensive
to build than onshore pipelines.
MR. DAVIS turned attention to page 11 of the UBS packet, which
illustrates that the LNG trade is very localized. The LNG trade
can be broken up into the North American trade; the West African
trade; the Mediterranean trade; and the Pacific trade. However,
there are three geographic regions for LNG export: the Pacific
Basin; the Atlantic Basin; and the Middle East. He noted that
the thicker the line representing the LNG trade gets the more
LNG exports it's meant to represent. The Pacific Basin accounts
for approximately 50 percent of all LNG exports. However, UBS
believes there will be significant investments in the Middle
East and West Africa that will take advantage of significant gas
reserves that aren't there today. Furthermore, it's estimated
that there will be a 25 percent increase in the number of LNG
tankers that will come on line by 2007. Therefore, once the
infrastructure is built, the economics of the project become
variable rather than fixed.
MR. DAVIS moved on to the import side of gas, which he
characterized as a regional market. In the Pacific Basin and
Asia, LNG exports account for about 100 percent of the natural
gas utilized in those countries. Gas in that region competes
with other fuels as opposed to competing with other gas.
However, in Europe and the United States, LNG is really a
supplement for existing natural gas supplies and thus is more of
a gas to other commodities competition. Also important to know
is that the price of LNG is declining because of better
technology. The costs have went from "2.50 m" to breakeven for
full cycle to "4.00".
TAPE 04-30, SIDE B
MR. DAVIS continued on to the outlook for the US with regard to
natural gas and LNG. He informed the committees that in 2002,
the US used about 60 bcf of gas a day and that's expected to
grow to about 72 bcf in 2010 and to about 86 bcf in 2025.
However, domestic production in the US and Canada is flat to
declining depending on the [region]. Domestic production in the
US in 2002 was about 52 bcf with expectations of increases to 56
bcf in 2010 and 65 bcf in 2025. Therefore, the US is about 10
bcf shy a day today, which will grow to 15-16 bcf by 2010 and to
20 bcf a day by 2025. The aforementioned illustrates that
there's a large "hole" to fill, which he characterized as a
positive sign for Alaska's project. He reminded the committees
that these LNG projects can be brought on in small discrete
chunks and the relative cost for the re-gas on the LNG is much
less significant than on a large pipeline. Mr. Davis related
UBS's belief that LNG will account for about 40 percent of the
US natural gas imports by 2010, which is a large increase.
MR. DAVIS informed the committees that LNG has been in the US
for about 30 years in the form of liquefaction capacity and re-
gas capacity. There are only four terminals in the US today.
Most importantly, he related that there are over 200 proposals
to build LNG terminals in the US, of which there are probably a
couple of dozen serious proposals. Each new terminal will be
able to import about 1 bcf of gas a day. Mr. Davis drew
attention to page 16 of the UBS packet and opined that pricing
is going to be significant with this project. Today the pricing
model for LNG or gas around the world is very regional. In
markets where LNG and natural gas compete head-to-head, such as
in the US, it's typically priced off of an index of gas.
However, in Asia, where LNG is only competing with other fuels,
it's priced off a basket of fuels. As more liquefaction
facilities are built and more cargos of LNG move across the
world, a more worldwide commodity price for LNG is developed
such that there are spot cargos going into different terminals
and taking an arbitrage of different markets. The
aforementioned will make that market much more competitive and
allow people to hedge going forward in the LNG market.
MR. DAVIS summarized by highlighting that time is of the essence
because competition from the LNG market poses a serious
challenge to the feasibility of this project. As more LNG
projects are built in the Lower 48, pricing visibility on gas
will become more uncertain. Mr. Davis reiterated his earlier
testimony that there is a first-mover advantage because once
this project is announced and underway, he opined that it will
deter several of the LNG projects from being built in the US.
"We believe the state ... needs to continue to adopt its
proactive attitude in developing this project and develop
alternative business models that provide for optimal risk
sharing among all the constituencies here," he opined.
Number 706
ROBERT DOHERTY, Managing Director & Co-Head National
Infrastructure Group, Municipal Investment Banking, UBS
Financial Services Inc., directed attention to Tab C regarding
what is involved in building a pipeline and how the state can
utilize its competitive advantages to have a profitable project
that's good for the state. [With the passage of the
Congressional energy legislation], incredible progress has been
made with regard to the federal credit guarantees and a
significant amount of risk is taken off the table. Mr. Doherty
related that UBS believes there are three critical factors in
terms of developing a strategy to get a pipeline completed. One
factor is motivating all the participants. Another factor is
assessing and mitigating the risk to the state. The third
factor is utilizing alternative models in order to customize a
solution that will motivate [participants] and minimize risks.
These factors are discussed on page 18 of the UBS packet.
MR. DOHERTY stated that designing a strategy to motivate all the
participants to commit to the project is the critical strategy
that the state needs to implement in the near term. In order to
accomplish the aforementioned, the state must understand and
exploit each of the participants' wants, needs, and desires.
The state must also offer incentives through alternative
business models in order to secure the commitment from the
participants. He noted that part of using participants is using
other people's money first. The aforementioned has to be the
state's number one goal, he remarked. Frankly, the Alaska
delegation accomplished much of that over the course of last
week [with the passage of the energy legislation]. Eighty
percent of the overall project, to a certain extent, is other
people's money. In terms of this first factor the state must
also design a cost-effective transaction from a debt and equity
perspective. He noted that each of the successful projects
mentioned by Dr. van Meurs capitalized on creating a structure
to motivate and incent individual participants to meet their
goals and mitigate their risks. The aforementioned can be
accomplished in Alaska in a cost-effective and reasonable
manner.
MR. DOHERTY turned to the second factor, which is to ensure that
the state's participation level is optimized while its risk
assumption is minimized. Understanding the level at which the
state can participate and the amount of risk the state can
assume is paramount. Achieving the second factor requires
quantifying potential risks and rewards; designing a model to
alter the traditional risk/return profile for a Petro-State such
as Alaska; selecting incentives that most closely align with the
state's interests; and understanding the state's "out of the
project box" risks. He clarified that the "out of the project
box" risks means understanding what happens if the project
doesn't proceed as anticipated and the impact it will have on
other projects in the state as well as other aspects of the
state, such as its credit rating. He moved on to the third
factor, which is to combine aspects of alternative business
models to customize an optimal solution for the state. He
opined that the key is in regard to how the structure is created
to maximize the return with minimal risk.
Number 777
MR. DOHERTY turned to the state's position and what it has at
stake, which is addressed on page 19 of the UBS packet. He
highlighted that Alaska has a massive asset in the ground with a
value today of near zero. As Mr. Davis said, if this project
doesn't proceed relatively soon, it's possible that the
competitive forces from LNG may have that asset remain in the
ground with the same near zero value for the foreseeable future.
Therefore, if the pipeline isn't built, any in-kind gas,
revenues, and incremental tax [revenues] will remain zero. [The
chart on page 19 of the UBS packet] regarding the incremental
tax revenues from the pipeline [illustrates] the way in which
one can view the value of the stranded assets from a tax
perspective. The chart points out the variable revenues. "As
it relates to variable taxes, the value of the assets in the
ground are fairly dependent upon commodity price," he related.
For example, if the market price per MmBtu is $3.00, the
Department of Revenue estimates that the state would collect
about $35 million in royalties, $106 million in severance tax,
and about $340 million in corporate tax. For a sum total of
additional variable revenue, freed stranded assets, in the
amount of about $481 million. The aforementioned doesn't
include the project revenues from the transaction, only the tax
revenues that would be freed from a project. Mr. Doherty
clarified that there are stranded assets in terms of tax
revenues, which are sitting in the ground and will not
materialize unless the pipeline is built as well as additional
project revenues. He noted that there are additional stranded
assets in terms of the economic benefit from an operational
pipeline in terms of jobs. The key is in regard to how much of
the aforementioned incremental revenues the state should commit
to the project in the form of equity. He explained that if the
project isn't built, the revenues don't exist. However, if the
project is built, theoretically the state could commit all of
these variable revenues and be in no worse of a situation.
MR. DOHERTY commented that there needs to be a balance between
aligning the participants' desires and interests. He noted the
confluence of events in terms of high natural gas prices, LNG
competition, and the federal credit guarantee. Although there
are a lot of conflicting interests and motivations, the state
can still establish an incentive mechanism that targets what
people consider to be their risks and mitigate them. He then
turned to the differing incentives of the producers, shippers,
and state. From the producers' perspective, LNG competition
poses the greatest threat to the producers' economics. As more
LNG projects come on-line, the risk [to the producers'
economics] becomes higher and the producers' willingness to
commit will diminish. Furthermore, the commodity price risk is
a significant factor. He emphasized that one of the benefits
and downsides of this project is that it's 4 bcf a day and thus
the commodity risk is "real and large." However, there are ways
to mitigate the aforementioned. One can conclude that an
increase in the supply of natural gas is a benefit and provides
higher potential revenue to the producers. However, injection
of 4 bcf of supply into the US could and probably would move the
price of natural gas as a whole in the US. By definition, the
aforementioned will impact the other natural gas businesses of
those enterprises. Therefore, there are conflicting issues
within the "sponsors' own house". From the shippers' view,
transportation cost is the largest issue. Furthermore,
commodity price risk is a significant factor with the shippers.
If there is a guaranteed shipping contract, it becomes a
significant risk that needs to be mitigated, especially with a 4
bcf project.
Number 849
MR. DOHERTY turned to the state's perspective, the state has a
significant stranded asset. Furthermore, there is a limited
window of opportunity, given the federal credit guarantee and
competition from LNG. Moreover, the participation level and
risk assumption must be fair. With regard to the federal
government's perspective, Mr. Doherty clarified that the UBS
packet was put together [before the passage of the federal
energy legislation], which has resulted in the federal
government assuming all the risk. The federal government's
decision, he opined, is good for the state and the nation as a
whole.
MR. DOHERTY, directing attention to page 21 of the UBS packet,
explained that once the motivations and risks are identified,
how the "risk box" is assessed is the key. He clarified that
UBS views the risk/reward profile as a box and understanding how
that box is shaped will help the state determine how it should
proceed with a particular project. He informed the committees
that there are three areas of risk: type of risk; risk
position; and risk assumption. Mr. Doherty turned to the types
of risk and began by discussing the construction
funding/completion risk. The aforementioned risk was discussed
earlier regarding whether cost overruns would actually be a
benefit for the state. Although cost overruns may provide
benefits for a few, it won't for the state. He related that the
construction funding risk is traditionally taken by a sponsor or
equity participant. With the federal loan guarantee, the
federal government has assumed a portion of that. If the state
was an equity participant, the state would assume part of that
risk as well. Cost overrun risk is traditionally assumed by the
sponsor or an insurance company as it relates to a guaranteed
maximum price, although [the latter] is probably not an option
for this size of a project. He viewed the cost overrun for the
state as a one-time [risk] for the state as an equity
participant. With regard to the permanent takeout risk, Mr.
Doherty informed the committees that [UBS] will discuss the
ability to get around the construction funding loan and enter
into a permanent funding contract. The permanent takeout risk
really lays with the sponsors and the federal government through
the federal loan guarantee as well as the state as an equity
participant. The performance/operational risk would lay with
the sponsor and would be a constant risk.
MR. DOHERTY said that production risk at the wellhead would lay
with the producer, although there is some risk associated with
the state if the state takes in-kind gas. He posed a situation
in which the state, as an equity participant and shipper, has a
contract with the producers and the other sponsors that isn't
tight. In such a situation there is the possibility that if
commodity prices fall to a certain level, it would no longer be
economic to produce the gas out of the ground. "By definition,
the state may not have its in-kind gas," he clarified. If the
state, as an equity participant and shipper, doesn't get the gas
out of the ground, it's a large problem. The details of the
aforementioned should receive a lot of focus. The commodity
price risk is a constant risk for the producer, shipper, and the
state. Capacity gaps are related to how the shipping contracts
are set up, that is can it be renewed when it expires. The
initial shipping contracts/renewal risk traditionally lays with
the sponsor. The state, as an equity participant, would be
classified as a sponsor.
MR. DOHERTY, in response to Chair Samuels, returned to the
permanent takeout financing risk. He noted that one can
structure around permanent takeout financing risk. He also
noted that [the permanent takeout financing risk] would be much
more significant without the ability to utilize a federal credit
guarantee. Traditionally, an entity needs to bear the
construction risk. Once the project is completed, shippers can
come on board, longer-term contracts can be established, and
long-term debt can be issued. Often bondholders aren't willing
to take on construction risk in terms of the long-term
financing. However, once the project is built, the bondholders
will take on a 10- to 15-year investment as it relates to the
debt. In the current environment, the federal loan guarantee
provides the ability to move through some of the construction
risk issues and permanent takeout financing risks.
Number 944
MR. DOHERTY returned to his presentation and informed the
committees that the risks that he mentioned are those that UBS
believes the state should assess and understand in order to
determine which to take. Mr. Doherty stated that the state must
establish a clear loss position and the duration of the risks
must be understood. He questioned, "Do you want to be in the
first-loss position so the first dollar of loss is the State of
Alaska's or do you want to get into a position to have someone
else take the first loss, maybe higher returns, and the state
just pay after that initial loss?" He said there are three ways
in which to view this. There is the first-loss position, which
is similar to a deductible payment. The second-loss position is
when another entity incurs the first "X-million" in losses and
the state takes the rest. The third-loss position is one in
which it's a combination or parity situation.
MR. DOHERTY related the need for the state to establish
liability limits in the case of a catastrophic event, as well as
potential ongoing exposure. In regard to [the state's] "tail
risk", under a normal distribution curve the state would make a
"good chunk of money from the project." However, there is a
small potential that the state may lose money. There is an even
smaller potential that could be catastrophic. From a policy
perspective the state isn't in the position of taking the
catastrophic risk, he opined. With regard to mitigating that
tail risk, the state would have strong and reasonable returns
while protecting the "out of the box" project risks.
Additionally, the state must address the statutory,
constitutional, regulatory, federal, and policy issues.
Number 003
MR. DOHERTY addressed sizing the risk box and the amount of
absolute and relative risk the state is willing to assume. He
explained that the absolute risk would define the [state's] risk
limit while the relative risk relates to ensuring that given the
state's position relative to other players, the state isn't out-
negotiated. Therefore, the state's return, as an equity
participant, is just about as equal or better than the other
equity participants. Mr. Doherty recommended that in sizing the
state's risk box it should use its expected benefits to
establish a base amount of risk assumption. He reiterated the
fact that a stranded asset that remains stranded is worth zero.
Theoretically, all of the [stranded asset] could be pledged and
[the state would] be no worse [off]. The aforementioned is the
state's baseline, he said. Mr. Doherty identified the state's
expected benefits to be the excess or net revenues from the sale
of in-kind gas; the incremental tax revenues; additional
economic benefits in terms of jobs and the related taxes.
MR. DOHERTY added that to size the risk box the state should
evaluate its own level of risk assumption against that of other
participants. The state, he indicated again, should be equal or
better than the other participants. This is accomplished by
determining the total threshold amount of risk as well as the
preferred relative loss position commensurate with expected
benefits. He mentioned that one can absorb a first loss, but
one must be compensated for it. With regard to risk exposure,
the state should analyze the circumstances under which the
losses may occur, the extent of those losses, and the
probabilities of those losses. He likened the aforementioned to
the state's breakeven analysis. Furthermore, the state should
quantify its maximum risk assumption under a catastrophic loss
situation. For instance, he questioned how the state would
protect itself in a situation in which gas prices drop to $1.50.
Mr. Doherty highlighted the need for the state to identify and
mitigate ancillary risks, such as the credit ratings of the
state. The federal credit guarantee goes a long way for 80
percent of the project costs, he opined. He identified other
ancillary risks such as the opportunity cost for other state
programs/projects. He specified, "Ideally, the state should
structure a business model that limits all these risks to the
project box."
Number 081
JAMES SCOTT, Managing Director, UBS Financial Services Inc.,
began his portion of the presentation, which can be found behind
Tab D of the UBS packet. Mr. Scott acknowledged that the
passage of the energy legislation in Congress changes things and
moves [the state] down certain paths. He explained that UBS's
approach began with a traditional pipeline funding model as a
base case against which to compare the state's options. Alaska
is unique geographically as well as economically when compared
to the Lower 48 and other Petro-States. The alternative models
differ depending upon the following dimensions: the level of
state involvement/ownership; risk/reward profile of the state;
the nature of federal loan guarantee/participation; the state's
relationship with other participants; and the capital market
implications.
MR. SCOTT directed attention to page 24 of the UBS packet, which
addresses the traditional pipeline funding method. He explained
that under the traditional pipeline method, the discussion is
about project finance which attempts to limit the financing to
project revenues. Under a traditional project finance
methodology for a pipeline, the sponsors place equity at risk in
the range of 20-40 percent. With an 80 percent federal
guarantee, the sponsors' equity would likely be in the 20
percent range. Mr. Scott highlighted that FERC regulates
tariffs for the pipeline itself with a return on equity in the
amount of about 12 percent. The aforementioned is good for the
equity participants because there would be a regulated rate of
return on the investment. Generally, the project debt is sold
non-recourse to the sponsors and the debt holders look to the
shipping contracts to support that debt. He related that
generally the life of the pipeline is 30 years, the shipping
contracts wouldn't be longer than 15 years. Therefore, the debt
holders take some recontracting/renewal risk. However, that
risk is mitigated with the federal loan guarantee. Mr. Scott
pointed out that the total funding cost is the primary
determinant of the overall tariff. The capital costs, the
return on capital far outweighs the operating costs of a project
such as this. Therefore, lower financing costs result in lower
and more competitive tariffs.
MR. SCOTT moved on to the marginal tariff analysis, which can be
found on page 25 of the UBS packet. This page provides an order
of magnitude with regard to changes in the return equity. The
matrix on page 25 illustrates the order of magnitude of the
change in the tariff to recover capital over the life of the
project. He explained that the matrix assumes the following:
100 percent of the pipeline capacity is utilized; total
throughput of 4 bcf a day, with the state's throughput being 1
bcf a day; total all-in cost of debt of 7.5 percent with a 30-
year amortization period; and total project cost of $20 billion
with the state's share being about $5 billion.
Number 159
MR. SCOTT, in response to Representative Croft, specified that
with the federal loan guarantee, the focus would be on
structures that are 80 percent debt and 20 percent equity. The
more equity in the project, the higher the tariff. He explained
that [in the traditional pipeline funding method] the total cost
of capital, 7.5 percent has been assumed for debt. Therefore,
if 12 percent is assumed on the return on equity component of
capital, the more equity in the total capital structure and the
higher the blended cost of capital overall results. From a cost
standpoint, it would be better to have more debt because it
costs less than equity. However, there's a finite limit on the
aforementioned because the debt holders look to the equity
component to insulate them from loss. In further response to
Representative Croft, Mr. Scott agreed that if one goes too far,
the 7.5 percent debt won't be achieved. He noted that the FERC
return on equity has been 12 percent, but it's subject to
change, which is why the 10 and 14 percent returns on equity
were also listed.
MR. SCOTT continued on to page 26 of the UBS packet, which
relates a hypothetical breakeven analysis for the participants.
The table on the left of page 26 illustrates that in a situation
in which the gas at the wellhead is $1.00 MmBtu with a tariff of
$1.73 MmBtu, the total breakeven price is $2.73 MmBtu. However,
if the commodity price is higher than the breakeven price, the
producer at the wellhead receives a wind fall. On the other
hand, the producer would suffer if the commodity price is less
than the breakeven price. The table on the right of page 26
illustrates the daily and annual aggregations at different spot
market prices. The key question for the state is regarding how
much of the commodity price risk should it assume in order to
advance the project.
Number 228
REPRESENTATIVE GATTO pointed out that the table on the right of
page 26 points out that with a spot market price of $3.00 MmBtu,
the daily economic gain is $1.1 MmBtu. However, a $1.00
increase in the spot market price to $4.00 MmBtu results in a
daily economic gain of [$5.1] MmBtu, which seems to be an
increase by a factor of eight. The annual economic gain
changing the spot market price from $3.00 MmBtu to $4.00 MmBtu
only seems to be barely one-half difference. Those numbers
don't seem correct.
MR. SCOTT said that he would have to check with the individual
who ran those numbers. Mr. Scott continued with his
presentation and related that in the current environment, the
state may need to assume a portion of this risk in order to make
this project viable. He then turned to page 27 of the UBS
packet, which discusses some of the alternative business models
that UBS reviewed in looking to move the project forward. The
alternative business models reviewed are as follows: state
owned/direct support or equity participation; federal credit
support; credit support by the state; "pure investor" support by
the state; no credit support by the state; hybrid financing
options.
TAPE 04-31, SIDE A
MR. SCOTT noted that the 20 percent equity contribution that the
state will contribute can't be covered by the federal loan
guarantee.
Number 002
MR. DAVIS said that he would now discuss a potential business
model that would be well-recognized and well-received by the
financial community. He explained that he would walk through a
project finance structure that outlines equity ownership, flows
of gas, and flows of money. He clarified that there are two
streams of money. One stream of money is from the commodity,
which is the sale of gas. There is also a stream of money that
comes into this model by virtue of a tariff that the shippers
pay. He noted that through both of the aforementioned streams,
the state receives money. He related the financial community's
perspective of a FERC-regulated pipeline in which the shippers
bear all the commodity risk while the owners of the pipeline
bear no commodity risk. He emphasized that it's all about the
contracts. Therefore, the people who ship the gas down the
pipeline are on the hook to pay the tariff regardless of whether
the gas flows or doesn't. If this pipeline is 100 percent
contracted, the only thing the debt holders and the owners of
the pipeline should care about is the contract.
REPRESENTATIVE CROFT asked if it has to be that way. He asked
if there's ever been a profit-sharing [contract].
MR. DAVIS said it's never done that way. In the US, natural gas
pipelines are regulated by FERC. There is a debt/equity
structure and a reasonable rate of return on the equity is
allowed and one is allowed to recover his or her debt and all
the operating expenses. The operating expenses include the
variable and fixed operating expenses, which means a return on
and of capital. Theoretically, if a pipeline is fully
contracted and it doesn't run full out, then [the state] will
earn a fixed return on its money.
REPRESENTATIVE CROFT surmised, "I don't care if my tenants are
making money or not as long as they pay the rent."
MR. DAVIS agreed, but noted that there is a risk that the tenant
could default and the [leaser] would be on the hook for that.
Mr. Davis noted that the Alaska project poses a unique situation
in that it's likely that the owners of the pipeline will be the
shippers, and therefore there would be a perfect alignment of
interest between gas flowing down the pipeline and money being
paid. However, he posed a scenario in which a third-party
company ran the pipeline and related that there might be a risk
that the third-party company had to build this pipeline and only
75 percent of the capacity is contracted. Therefore, 75 percent
of the risk is covered and [the third-party company] would be on
the hook for the remaining 25 percent, which he said it would
try to sell on the spot market. Furthermore, [the third-party
company] would have to obtain a tariff below market because the
shipper realizes that [the third-party company] needs the
shipper more than the shipper needs the [the third-party
company]. Therefore, although the tariff may be $1.75, the
shipper will offer to pay $1.00 tariff. The competitive dynamic
will be such that the [the third-party company] will realize
that $1.00 is better than zero, and therefore the tariff will be
below the market tariff.
REPRESENTATIVE CROFT related his understanding that the vast
majority of pipeline projects are such that the shipper carries
the risk.
MR. DAVIS reiterated that a FERC-regulated pipeline has to
follow certain rules. However, there is no requirement for the
[the third-party company] to contract for the capacity; [the
third-party company] could take 100 percent spot risk, but the
most that can be charged is the maximum rate that he assumed the
state would contract upfront in this deal. Therefore, the
upside is capped and the downside is limited by zero, and
somewhere in between is where the rates will be established. He
reiterated that this is a unique situation in that the equity
holders of the pipeline are also the shippers and producers of
the pipeline, and therefore have the risk up and down the value
chain. Mr. Davis suggested that committee members separate the
returns from the pipeline and the returns from the commodity
because the pipeline will be a fixed charge on which [the state]
will be on the hook and can't get off regardless of whether [the
state] sells or ships gas.
Number 069
REPRESENTATIVE CROFT recalled that the governor was very careful
to say that he and the legislature haven't decided whether it
will be a producer-owned line or not. He opined that the
shippers and owners aren't necessarily the producers.
MR. DAVIS related his understanding that there is 4 bcf a day of
production and it works out nicely with three producers with 25
percent and the state at 25 percent. He noted that these
numbers are interchangeable. In fact, the state could own the
pipeline entirely and all the benefits and risks would go to the
state. The difference is that the state wouldn't have natural
gas to go on the pipeline to ship. Therefore, the example Mr.
Davis is laying out is that if the state owns 25 percent of the
pipeline regardless of who owns the other 75 percent, the state
would have 25 percent of the gas that it would have to get to
market. The state would have to be the shipper on somebody's
line. Therefore, he questioned why the state wouldn't become an
equity owner if the state is a shipper accounting for 25 percent
of the revenue. He reminded the committee that the state would
sign the same gas contract regardless of whether the state owns
the pipeline or is part owner of the pipeline, although the
length and terms of contract may differ. In all likelihood the
state will want to sign a long-term gas contract because the
state will want that portion of its economics fixed.
MR. DAVIS [referring to page 28 of the UBS packet] explained
that in a traditional pipeline funding model, there will be a
LLC with a non-recourse to the sponsors, which will actually
build the asset. He assumed that $20 billion would be required
to build the pipeline. The scenario presented assumes the state
and three sponsors each have 25 percent ownership in the
project. Each sponsor is obligated to put in $5 billion. There
is also the assumption that the state has 1 bcf a day of in-kind
gas, which is important because it mitigates the state's risk
from a shipping standpoint. The scenario assumes that the state
enters into a shipping contract for 1 bcf a day. On the sponsor
side, the producers with the other 3 bcf a day of gas can enter
into a shipping contract as well. He noted that there continues
to be the assumption that the pipeline will be financed on an
80:20 project basis. He also noted that the equity participants
would be obligated to pay the tariff whether the gas is shipped
or not.
MR. DAVIS, in response to a question, clarified that the state
would be on the hook for only its portion of the tariff. If the
tariff is a $1.50, then [the state] would be on the hook for a
$1.50 times a bcf a day, which amounts to $1.5 million a day.
The important thing to note is that the state, as a 25 percent
owner, would suffer the consequences if it ships its 1 bcf of
gas a day, but the other shippers don't live up to their end of
the bargain. However, that would be highly unlikely because one
wouldn't enter into shipping contracts with an entity that isn't
investment grade and can't pay its obligations.
Number 136
REPRESENTATIVE GATTO posed a situation in which there are four
participants, one of which goes bankrupt. In such a situation
would the same amount of gas be produced or would the amount of
gas owned by the bankrupt participant not be available, he
asked.
MR. DAVIS related that in such a situation, the bankruptcy judge
and the creditors want to maximize what they will receive.
Therefore, if there are reserves behind the pipe, the bankruptcy
court will want to ensure they move those reserves to market to
be sold. Therefore, those reserves will flow down the pipe and
the tariff will be paid. He clarified that his point is that if
one of the participants is in bankruptcy, the gas doesn't have
to be transported for free. The difficult situation is one in
which the gas marketer, who isn't naturally (indisc.) on gas,
goes broke and there is no gas to flow down the pipe. In that
instance, it's more likely that the bankruptcy court aggregates
the contract.
REPRESENTATIVE GATTO inquired as to the state's liability if
other participants without reserves go bankrupt.
MR. DAVIS answered that the state would be liable for its
portion of the tariff. Given an 80:20 debt/equity structure,
the state could probably afford for one of the equity holders to
go bankrupt. He reminded the committee that the way these
contracts are structured "that is not non-recourse, the equity
is non-recourse." No one can force [the state] to put another
dollar into the [corporation] once it's built. However, with a
contract, the state can be forced to perform unless in
bankruptcy. If all three shippers went bankrupt, the state
would only be liable for its portion of the tariff and in all
likelihood, the state's equity would be eliminated because the
project would go into receivership because it couldn't repay its
debt obligations based solely on the state's portion of the
tariff. He suggested that there would probably be debt service
reserves built into the structure such that the state could
stand low commodity prices for some number of years before [the
project moved into receivership].
CHAIR SAMUELS surmised that could be considered the "tail" that
was mentioned earlier, and therefore something would be given up
at the high end.
MR. DAVIS agreed, and noted that the extent of the liability
would be the state's equity in continuing to ship gas.
Presumably, the state would continue to ship gas. However, in
all likelihood if gas prices went to a $1.00 and stayed at that
price from 2011-2050, building the pipeline would be a huge
mistake. "I don't think there's any way you're going to be able
to structure yourself around that outcome, unfortunately," he
said. In further response to Representative Gatto, Mr. Davis
stated the state would likely be required to purchase business
interruption insurance by the debt holders. Therefore, if the
pipeline is irreparably damaged, the insurance would pay to
rebuild the pipeline which would be recoverable in the rates.
Moreover, the shippers would pay for it.
Number 196
MR. DAVIS continued his presentation and directed attention to
[page 29 of the UBS packet]. He explained that the state
receives 25 percent of the gas in-kind and the state sells that
gas, the proceeds of which will likely be used to pay the tariff
and any excess funds will flow back to the state on the
commodity side. The money going into the operating entity will
be used to cover the operating costs of the pipeline company.
Any excess funds will flow back out as dividends. In response
to Chair Samuels, Mr. Davis said that FERC [filed tariffs]
provide for a 12 percent [return on equity].
CHAIR SAMUELS surmised, "In your scenario on the three-quarters
and one-quarter, we'd get our 3 percent, they'd get their
(indisc.) percent and the profit on an ongoing basis."
MR. DAVIS explained that if there is a $1 billion equity
component, each year the state would receive $120 million in
return on the equity that the state invests. Furthermore, as
the pipeline depreciates, the state will receive [a portion] of
the state's capital. Therefore, of the $5 billion the state's
"notionally" investing, the state will annually receive one-
thirtieth of that back as well. At the end of 30 years, the
state would've received all of the money that it invested plus
the equity and a 12 percent return. What happens in the real
world is that entities continue to invest in pipelines after the
30 years. "Ultimately, no government agency is going to let
somebody run this pipeline for free and so there will be some
type of incentive rate structure put in; you'll always be able
to earn a return on the pipeline," he explained.
Number 228
MR. DAVIS turned to a hypothetical way to fund this hypothetical
case [which is discussed on page 30 or the UBS packet]. In the
hypothetical case the state would enter into a shipping contract
for 1 bcf a day with the operating company. One way to fund
that obligation would be to issue $4 billion of revenue bonds,
which is 80 percent of the project debt, backed by the federal
loan guarantee. The state would also have a $1 billion tax-
exempt revenue bond backed by various sources of credit support.
The $1 billion would "notionally" be the state's equity portion
of the project. Mr. Davis noted that rather than funding the $1
billion with debt, the state could write a check for all or a
portion of it. He noted that there are various ways in which to
protect that, such as the general fund, the property taxes, the
permanent fund, et cetera. The dividends that would come out of
the operating company would be used to pay back the revenue
bonds because that will be the return on the capital. He
characterized the equity side of this as the "freeboard" because
the state would receive say 12 percent annually plus one-
thirtieth of the money back every year. The aforementioned
would go straight into the state's [coffers] or be used to pay
off these bonds. Mr. Davis explained that the state might need
this other credit support because the other source to pay off
the debt is the tariff, which allows the state to capture 100
percent of its costs. Therefore, this would be geared to a 1:1
ratio, which is frowned upon in the financial market because the
state wouldn't be able to cover its obligations if anything went
wrong under such a scenario.
MR. DAVIS pointed out [referring to a chart on page 31 of the
UBS packet] that if one looks at the excess revenue to the
state, one sees that the gas price in Alberta has to be around
$2.00 mcf for the state to breakeven. He noted that this
project probably wouldn't be built unless the project is 100
percent contracted. Mr. Davis then turned attention to page 32
of the UBS packet, which outlines the expected benefits and
potential risks to the state. One obvious benefit to the state
would be the freeing of significant stranded assets that would
provide a lot of liquidity to the state. Furthermore, the
state, as an equity participant, would be able to contribute in-
kind gas in order to support the state's portion of the
pipeline. Moreover, the state, as an equity participant, would
have limited its risk exposure to $1 billion with a $20 billion
project. "If you look at that risk-reward continuum, you get 25
percent of the upside, you're bearing 5 percent of the cost in a
disaster scenario," he related. He highlighted that the
combination of shipping contracts, federal loan guarantees, and
the state's moral obligation creates a clearly financeable
structure in the current market.
MR. DAVIS said that most of the risks to the state have been
reviewed. However, he reminded the committee that if other
sponsors don't perform on their obligations, that would be bad
for the state. If the volume of equity gas produced by the
shippers doesn't meet its contractual shipping obligations to
the pipeline, the state will still have to pay its contractual
obligation. Although there will be various sources of excess
revenue to make up that difference, the state would still have
to pay its contractual obligation. He noted that the state
could sell that capacity to someone else. Again, it would be a
bad outcome for the state if the revenues from the sale of the
gas are less than the [shipping] tariff and the state would
suffer directly the difference between the sales price for a
molecule of gas and the cost to ship it down the pipeline.
Therefore, UBS's analysis has determined that the gas price
would have to go to less than $1.73 in Alberta. However, he
reminded the committees that other sources of revenue in the
project would help mitigate the aforementioned to some degree.
Mr. Davis said that the state should also keep in mind that the
state, as a shipper, will want to make sure that whoever
contracts for the tariff within the state has the financial
resources to meet that obligation. Again, he highlighted that
it will be difficult to input an equity component in the capital
structure of higher than 20 percent if the state has an 80
percent federal debt guarantee.
SENATOR THERRIAULT requested [referring to page 31 of the UBS
packet] some clarity regarding when the state is in the black.
MR. DAVIS clarified that the state would be in the black at
$2.00. However, if the price of gas falls below $1.73, the
state would have other sources of money to offset that [price].
He, reminded the committees that other producers wouldn't be
able to avail themselves of those other sources of money.
SENATOR ELTON pointed out that if the state is an equity owner,
it would also receive revenue from throughput.
MR. DAVIS agreed, but characterized it as "it's like losing
money and making it up on volume." He posed a situation in
which the state's tariff obligation to itself and its
bondholders is $1.75. If the state can only sell the gas for
$1.50, then for every molecule of gas shipped down the pipeline
the state would lose $.25.
Number 387
JOE FORRESTER, Managing Director, UBS Financial Services Inc.,
highlighted the significance of the federal loan guarantee in
terms of changing the state's risk profile and guaranteeing
market access at the best possible rates. Mr. Forrester
suggested that the committees bear in mind that under existing
law, federally guaranteed debt for a project of this type must
be taxable. "You can do a piece of a project with the federal
guarantee debt on a taxable basis and the remainder of the
portion on a tax-exempt basis, if you comply with applicable
rules," he related. In the hypothetical case presented by UBS,
if the state attempts to do any portion of the $1 billion on a
tax-exempt basis and are subject to the general rules applicable
to other kinds of tax-exempt financing by other tax-exempt
issuers there will be constraints upon the business structure
the state develops. In this context, if one is discussing 25
percent ownership by the state, the impact of the private
activity bond rules is the nature of the sales contracts at the
other end of the pipeline. Generally speaking, the private
activity bond rules, in the context of a revenue producing
project, restrict the amount of the project that can be financed
with tax-exempt bonds that are subject to private business use.
"And if you have a long-term contract, the tail end of the
pipeline to sell gas to other than a state or local government
unit or a 501(c)(3) entity, that represents tainted private use
and you fall into the trap of issuing taxable private activity
bonds," he explained.
MR. FORRESTER, referring to page 34 of the UBS packet, stated
that he would be remiss in not mentioning taking advantage of
the unique status of the Alaska Railroad Corporation under the
IRS code. Prior to 1984 and again in 1986, a number of entities
were entitled to issue tax-exempt bonds for purposes beyond the
constraints and limitations imposed by the IRS code on domestic,
state, and local government units. He noted that in the case of
the ARRC, the Railroad Transfer Act contained limited exemptions
from those constraints. At least for railroad purposes or
projects connected to the railroad, ARRC should be able to issue
tax-exempt bonds free of the private activity bond limitations.
If one just looks at the words, there are no limitations at all.
Therefore, ARRC would be authorized as a matter of "black letter
writ" to finance the entire $1 billion of remaining non-
federally guaranteed state contribution on a tax-exempt basis.
Furthermore, it could finance the ExxonMobil Corporation equity
contribution on the federally guaranteed part. Whether the
aforementioned authority could be used on a real world matter,
is a political decision the state faces. Mr. Forrester
concluded as follows:
Nonetheless, I think it's important to realize that
the important thing from the standpoint of the state
ought to be to develop a business plan that makes
sense away from tax-exempt financing, see if you can
then tweak that business plan to enable you to take
advantage of tax-exempt financing or to finance pieces
of the project on a tax-exempt basis that don't
involve the kinds of private business issues that the
pipeline itself might present.
Number 471
SENATOR GUESS requested that Mr. Forrester review the model in
which the state wouldn't use ARRC for the $1 billion of equity
the state must provide in the hypothetical case.
MR. FORRESTER clarified that the following is his personal view,
not that of UBS. He opined that Alaska has gained a great
victory with the federal loan guarantee, which he characterized
as the linchpin around which the state should build its business
model. He foresaw the US Department of Treasury and the IRS
getting very upset with an attempt to finance free of the
private activity bond rules a project that wasn't a "twinkle in
the eye of Congress" when the special language was inserted for
[ARRC] and the Railroad Transfer Act. The state must ask itself
whether it wants to fight the aforementioned battle in order to
achieve only incremental financing cost benefit when the state
can develop its business model such that 20 percent of the sales
are at the tail end of the pipe into the spot market and clearly
fit within the private activity bond rules and not rely on
ARRC's exemption.
REPRESENTATIVE CROFT noted that the aforementioned refers only
to the bonding part [of the project] and there's another tax
advantage, which is the [state's] tax-exempt status.
Representative Croft related his understanding that the state
would decide not to take advantage of the state's tax-exempt
bonding status, and therefore the state loses some tax benefit
there while retaining its [tax-exempt] entity status. He asked
if those two status are roughly equal or is one more important
than the other in terms of long-term profitability.
MR. FORRESTER opined that the [tax-exempt] entity [status] is
much more important than tax-exempt bonding, although he
mentioned that it would be nice to have both.
Number 522
MR. DOHERTY provided the following conclusions [referenced on
page 35 of the UBS packet]. He related that optimal risk
sharing is critical to the project's success, which he indicated
meant using other people's money first. He highlighted the
benefits of securing the federal loan guarantee for a portion of
the project; securing non-recourse project financing; securing
long-term fixed commodity price and throughput contracts from
producers/sponsors; securing a portion of contingent commodity
risk protection from shippers. Mr. Doherty turned attention to
page 36 of the UBS packet, which relates UBS's conclusions
regarding the state as an equity participant. He opined that
the state as an equity participant is viable if structured
appropriately. With the state as an equity participant the
state frees its stranded assets; can contribute its in-kind gas
to purchase 25 percent of the project as an equity participant;
can create effective and appropriate risk sharing among the
state, other equity participants, and the federal government;
and can mitigate some of the commodity price risk.
REPRESENTATIVE CROFT turned attention to the following statement
on page 36 of the UBS packet, which read: "State effectively
contributes its in-kind gas to buy into 25% of Project as an
equity participant." He questioned how the state will use its
in-kind gas to [buy into 25 percent of the project].
MR. DOHERTY explained that if the state is a 25 percent owner of
the project, the state needs to contribute 25 percent of the
gas. Therefore, if the state structures its royalty regime such
that it has beneficial interest in 25 percent of the gas being
produced, the state would be on equal footing with a one-quarter
participant in terms of the gas being contributed to the project
or an equivalent shipping contract rate as well as an equivalent
return on capital in the program.
REPRESENTATIVE CROFT surmised that the state has a royalty share
of about one-eighth and a severance [tax] that approximates that
in terms of impact. However, he didn't believe that the state
owned one-quarter.
MR. DOHERTY agreed. He specified that UBS is suggesting the
state review the overall Stranded Gas Act as well as the overall
negotiating position of the state's potential returns and taxes
for this gas to possibly combine [the severance tax and in-kind
royalty] for a larger percentage. Mr. Doherty posed an example
in which the percentage is 15, and suggested that the state
could modify its equity level participation.
CHAIR SAMUELS surmised then that Mr. Doherty is saying that
under the state's current deal, the state could take its eighth
and the severance tax and property tax and could roll it "on to
a ball" and say that [the state] gets 25 percent of the gas.
MR. DOHERTY agreed.
REPRESENTATIVE CROFT surmised that would modify every lease [the
state] has now. He commented that the Stranded Gas Act wouldn't
just be rewriting the tax structure.
MR. DOHERTY interjected that there would be a different regime.
Number 647
MR. DOHERTY pointed out that on page 37 of the UBS packet it
lists aspects that UBS hasn't addressed today. The detail of
those are found in Appendix 2 of the UBS packet. He said that
there are other avenues available to mitigate risk or contribute
to the overall pipeline system, in terms of alternative business
models, that although ancillary to the federal guarantee and
equity participation, can still bring value. Mr. Doherty said
that UBS has attempted to provide a road map with regard to the
risks, assessing those risks, mitigating risks, establishing a
hypothetical business model from an [equity perspective that is
viable and provides significant return to the state in nearly
all commodity price environments].
TAPE 04-31, SIDE B
SENATOR GUESS inquired as to how a situation would be structured
such that there would be access for future development as well
as the ability to use natural gas in-state.
MR. DOHERTY suggested that there are several factors already in
place and can be put in place to ensure that access. First, if
the federal loan guarantee is utilized, it includes several
provisions that ensure Alaskans can participate from an equity
perspective and utilize the gas from the North Slope for local
Alaskan use. Furthermore, [the federal loan guarantee] includes
significant ability for Alaskan corporations to participate. As
it relates to how the state decides to negotiate the underlying
contracts with the participants, the state clearly has
significant latitude to incorporate policy and economic issues
as well as other important aspects that aren't financial.
MR. DAVIS addressed the issue of expansion. He explained that
once the base pipeline is in place, expansions are economic
because they increase compression on the pipeline or can loop
the pipeline. Therefore, every expansion to the pipeline
results in a decrease in costs for all the shippers. Therefore,
he suspected that there may be the opportunity to expand the
pipeline. He related that in his experience with pipeline
expansions, the first couple of expansions are very economic.
CHAIR SAMUELS interjected, "Everybody wins if it goes down, and
then there's an argument on incremental after that, I believe is
what we've been told."
Number 690
SENATOR ELTON recalled that on page 35 of UBS's packet it
discusses risk sharing and expresses the need to secure long-
term fixed commodity pricing for shipping contracts. He
inquired as to the duration of a typical shipping contract now.
He also asked if a typical shipping contract spreads the risk.
MR. DOHERTY turned to the hypothetical case in which the state
is an equity participant, and related that there is a natural
hedge in terms of entering into a long-term contract for that
gas because that equity participant owns it. Furthermore, if
the sponsors and the current owners of the reserve participate
as shippers, there is a natural hedge there as well. If the
contract is less than the term of the debt, there is some
renewal risk. However, from the bond market perspective, that
renewal of the contract risk can be moved through structurally.
SENATOR ELTON asked if the aforementioned is predicated on the
producers being the pipeline sponsors. Furthermore, will the
answer remain the same if it isn't a pipeline by the producers,
he asked.
MR. DOHERTY said that the state would receive significant
benefits from the federal loan guarantee.
MR. DAVIS interjected that Alaska is a unique case. If the
sponsors of the project are the producers, the sponsors will be
willing to enter into much longer contracts than the state would
be able to under a third-party shipper scenario. He opined that
in today's market, the likelihood of getting users to sign up
for a significant portion of the capacity say 12 years hence for
15 years in the future is remote. Therefore, he suggested that
it is going to be the producers. He related that in today's
market, a very long-term contract is 10 years and for a pure
project advance pipeline a 15-year contract would be long-term.
The market has become much shorter term in the last five years.
Number 721
MR. ZIGLAR concluded by saying that the UBS presentation has
tried to provide the committee with "the good, the bad, and the
ugly." He noted that although there is a lot of good with the
project, there are some risks. He opined that most people as
well as the US Congress would agree that this pipeline is good
for national energy security. Furthermore, this project would
have a great positive impact on the state and its economy. The
congressional action was positive and seems to express the need
for the state to move along [in constructing the pipeline].
Based upon a number of scenarios reviewed by UBS, UBS believes
that the Alaska project is both feasible and financeable.
Furthermore, UBS believes that the state can participate as an
equity participant with reasonable risk and an attractive return
to the state if the state decided to be an equity participant.
The committee took an at-ease from 3:40 p.m. to 3:54 p.m.
Number 761
PHILIP KOROT, Senior Vice President, Lehman Brothers, informed
the committees that the committee packets should include fairly
extensive written testimony from Lehman Brothers, from which
Lehman Brothers representatives intend to highlight key issues.
He explained that Lehman Brothers' comments are directed at an
overview of the capital markets and public-private partnerships
in the capital markets concerning the energy sector. He related
that since 2003 Lehman Brothers has been the number one
underwriter in the US equity and energy new issuance market.
Furthermore, it has acted as a book-runner on 39 transactions
worth almost $6 million. During that same period of time,
Lehman Brothers has been the number one underwriter of US
investment grade energy debt, acting as a book-runner on over 20
transactions worth $9.5 - $10 million of debt issuance. Lehman
Brothers has also been named project finance house of the year.
He noted that Lehman Brothers is involved on the equity side as
well as the fixed income side with most of the major projects
around the world as well as with most of the energy sector
players around the world. Mr. Korot characterized the
discussion [on Alaska's project] as a combination of what the
state can do from a public finance standpoint or from a public
venture standpoint, either in partnership or coordination with
the energy sector, the producer, or the pipeline.
MR. KOROT announced that he would provide an overview of the
market, some observations of the market, how those would
generally impact Alaska's project, and how those would generally
impact some of the negotiations and decisions yet to be made.
Until the details are decided, it's hard to know exactly what
direction the project or projects should take. In general
terms, the projects that have been discussed, whether the LNG
project or the pipeline through Canada, are economically
feasible and financeable in the capital markets.
Number 793
ROBERT MILIUS, Senior Vice President, Lehman Brothers, said that
he would begin by relating some general conditions in the
capital markets as well as certain trends that will impact the
financings of the Alaska project. He noted that most of the
time and effort spent on this matter was done before the federal
guarantee was available. Therefore, the framework was in regard
to what could be accomplished in the private sector capital
markets without much government support or incentives. He
related that he would also focus on how he believes the Alaska
project will be received by the capital markets and the handful
of issues that will require significant management in terms of
driving the marketability and financability within the capital
markets. He said that he will also discuss specific financing
structures, options, and alternatives available as well as how
the Lehman Brothers sees the role of the state and federal
governments in moving this project forward.
MR. MILIUS turned to the general themes of the capital markets,
and acknowledged that some of the themes are fleeting. The
first theme is that over the last year and a half the economy
has been strengthening, although there has been a fair amount of
volatility. The second theme is that energy has been "red hot"
in the capital markets. Never before has there been such
appetite for exposure to the energy sector, within the equity
capital markets as well as the fixed income side. Virtually,
all sectors of energy is trading at all time highs in the equity
market.
REPRESENTATIVE CROFT asked if people want to push money into
this or is there a lot of money that wants to enter into the
energy equity market.
MR. MILIUS answered that he believes some of it has to do with
commodity price fundamentals. Interestingly, if one were to
look at the stock for Chevron Texaco, it recently reached more
than $50 a share. The last time that stock was at that point,
it was spring of 1999 when oil prices had dipped to about $10 [a
barrel] at the end of 1998. When oil prices recovered and the
price [per barrel] hit the mid to upper teens was the last time
Chevron Texaco was at the price it currently sits in the equity
markets. Now it's a very different commodity price environment,
and therefore one could argue that this market is under bought
rather than needing to be sold. More relevant to this project
is the most recent time of strong gas prices, which was 2001.
At that point, gas prices were backward aided and the forward
curve was a declining forward curve. However, today gas is in
the $5-$6 range and oil prices five years out are in the $30-$35
range. There is no precedent for such perceived sustainability
of commodity prices in the history of the energy markets. In
fact, across the board this is an all time high of commodity
prices and there's a strong view that these conditions are
sustainable. The key message is: "The capital markets are very
much aware of these trends in commodity prices, obviously, and
also have a view with both equity analysts ..., fixed income
analysts on Wall Street, and other industry experts sort of
share the view that commodity prices are sustainable."
MR. MILIUS turned to interest rates, which are at close to 40
year lows. However, within the energy [market] the supply of
new corporate debt issued into the capital markets has declined
meaningfully. Just a couple of years ago, new supply was in the
$30-$35 billion a year range, while today it sits at $12-$15
billion. There is a fundamental supply-demand tension that
works to the benefit of issuers, and because of the strength of
the commodity prices, he viewed it as sustainable. What's
happening is that all the energy companies are generating
tremendous amounts of cash that they are using to pay down their
debt or buy back stock. For example, Chevron Texaco, ExxonMobil
Corporation, and BP all have negative net debt, which means
their debt is approximately zero. The aforementioned is
important to understand because investors in the fixed income
markets essentially have no opportunity to gain exposure to big
oil because there are no bonds to buy. Therefore, the only
opportunity the capital markets have for exposure to these
companies in the fixed income side is this type of non-recourse
project financing type debt that may be issued for Alaska's
project.
MR. MILIUS turned to the re-emergence of non-recourse project
financed debt, specifically within the energy sector. The last
time there was a significant amount of new issuance of this non-
recourse debt was in the late 1990s when there were a number of
project financings in Venezuela to finance the public-private
partnerships in the oil sector. At about the same time, the
first LNG project in Qatar was financed in the capital markets.
However, in the late 1990s there was a tough period in the
economy when Russia defaulted on its debt and the capital
markets had limited appetite with regard to placing money in
emerging markets. Obviously, Alaska is in a different situation
than in other parts of the world. He predicted that in the near
term there will be a significant amount of new issuance of this
sort of project finance debt. He provided examples.
Number 811
REPRESENTATIVE CROFT remarked that those examples could mean
that there's a market for it or that it has been used up. He
surmised that Mr. Milius means that there is significant unmet
demand for even a project of the size of Alaska's project.
MR. KOROT answered, "Significant capacity to take it in." He
estimated that the cost of capital for a project of this size
and complexity is probably in the 8-9 percent range on a blended
basis. Obviously, the aforementioned would vary depending upon
when the project comes to market, the interest rates at that
time, the extent of the federal loan guarantees, and the various
participation of other pieces of debt. "There's a significant
positive aspect in the market, both for this type of project
finance as well as the various segments of the project finance,
whether or not they have federal guarantees," he said.
MR. MILIUS, in further response to Representative Croft, related
that Lehman Brothers believes that [the Alaska project] is
eminently financeable in the capital markets, both in the fixed
income side and the equity side. The later is important because
there still remains a fair amount of uncertainty regarding who
will ultimately own the equity in this project. There is the
potential for a significant amount of equity ownership in this
project in the capital markets. He reiterated that he sees an
incredibly robust appetite for exposure to a project like this.
Investors understand the dynamics in the natural gas markets in
the US and increasingly understand the structural deficit that
is faced in the US. The investors also see this as a market
that will continue to be strong from a commodity price
standpoint.
Number 950
MR. MILIUS turned to the key selling points and key
considerations with Alaska's project as well as the framework
Lehman Brothers would suggest. If one observes the fundamentals
in the US natural gas markets today, one would see that the
production in the Lower 48 market is in the neighborhood of 19
tcf a year and pipeline imports from Canada have been fairly
consistent over the last 2-3 years at about 4 tcf per year,
which amounts to a market of about 22-23 tcf a year. He related
that LNG has been a miniscule part of the equation and only in
the last two years has it averaged 400-500 bcf total, which is
less than 2 percent of the total market. Over the next 15 years
or so, Energy Information Administration (EIA) projected data
shows production in the Lower 48 at about 18-19 tcf and pipe
imports from Canada at about 4 tcf per year, both flat.
Assuming demand rises to 30-35 tcf, there is a potential gap of
12-16 tcf per year that needs to come from somewhere. While the
first-mover advantage is very important, he emphasized that it's
also important to remember that if the true projections are that
demand will rise to 32-35 tcf per year and if EIA data is
correct that Lower 48 production is flat, the US will need all
the gas it can find from all possible sources. Therefore, even
with the potential in Alaska of a 4-5 bcf per day range, which
would increase [the Lower 48 production] to about 2 tcf per year
with LNG imports of 6 tcf per year 7-10 years out, there is only
9-10 tcf total and that amounts to about 32-33 tcf per year
going forward.
REPRESENTATIVE CROFT asked if 6 tcf is an optimistic number for
LNG.
MR. MILIUS replied yes, for the near term in the next five to
seven years.
REPRESENTATIVE CROFT related his understanding that Mr. Milius
believes there is a potential market with just equity investors.
MR. MILIUS said that what he is talking about is similar to
independent pipeline companies. The potential market that is
potentially interesting is the master limited partnership (MLP)
market, which has grown to be about a $60 billion market.
Historically, the MLP market has been sold into the retail
marketplace and its investors seek yield. The MLPs are tax
efficient entities that are publicly traded partnerships that
don't pay taxes at the corporate level, although the partners
are taxed individual. The MLP market is potentially a very
"deep one" for a project such as this, although he surmised that
there might need to be changes to parts of the tax code to
broaden the market to potentially draw more money into a project
like this. The Alaska project is exactly one in which the MLP
market will be very interested. Therefore, he related that
there are pockets of equity capital beyond the sponsors and
immediate stakeholders who are interested in owning a piece of
this project.
MR. KOROT remarked that just as there are different types of
fixed income or debt instruments in financing the project,
Lehman Brothers believes there are different ways in which to
bring the parties together to provide the equity. Having a
capital market component of the equity is an alternative that is
attractive. The question is how to bring the lowest cost of
capital to the project on a blended basis while taking advantage
of all of the benefits available so that the tax law changes on
depreciation mean that the dividends on an MLP are basically
equivalent to a tax-free return for a potential equity investor.
Therefore, the rates of return could be offset because [the
investors] are lending the money, putting in equity, and
receiving a tax-free return.
REPRESENTATIVE CROFT surmised, "In effect, the accelerated
depreciation cannot just be an incentive to get this thing
started; we can almost sell it. ... that becomes something that
can lower our cost of capital because of its tax advantages to
individual investors."
MR. KOROT agreed with Representative Croft to the extent that
the producers don't own the equity in the project. "And we've,
in essence, securitized it in the capital markets; that sort of
benefit which we pass through to those owners on their pro-rata
share basically gets their returns to be lowered based upon the
fact that those returns now are sheltered or tax free." The
goal is to bring down all of the costs of capital such that the
project is at a lower [risk] point.
Number 080
MR. MILIUS reiterated that to some extent there is a first-mover
advantage. However, he predicted a very meaningful structural
deficit that worsens over time and thus results in tremendous
potential for Alaska's project. Mr. Milius announced that he
would now discuss how this project would be perceived in the
capital markets, the strengths of the project, the risks of the
project, and general ideas regarding how the risks could be
managed. He opined that this project would be very well
received in the capital markets on the equity and the debt side.
Industry fundamentals are compelling and robust and many believe
those fundamentals are sustainable and will potentially improve.
Another positive for this project is the incredible sponsorship
this project will have when taken to the capital market. He
clarified that the sponsorship refers to the state, all three of
the producers, and the pipeline operator. Mr. Milius related
the belief that the capital markets will be somewhat route
neutral when viewing this project. In addition to this
tremendous stranded gas resource being commercialized and
developed, there is the national energy security aspect to this
project. Whether the project is a pipeline that moves through
Canada or an LNG-oriented project, it will sell well in the
capital markets if it's structured appropriately.
MR. KOROT interjected that either of the routes, from a capital
market standpoint, can be financed for both the debt and the
equity. Certainly, the guarantees and the accelerated
depreciation make it more financially attractive while lowering
the cost of capital. Mr. Korot related that the ability to
structure both in today's marketplace makes them attractive
investments for the various classes of investors. Moreover, the
ability to start a project relatively soon would be of utmost
importance from a capital market standpoint.
Number 137
MR. MILIUS turned to the risks associated with a project the
size of the Alaska project. There is some resource and geology
risk associated with the North Slope gas reserves, as well as
environmental, regulatory, legal, and permitting risks. To a
lesser extent there is some political risk. Moreover, there is
technology- and facility-related risk related to whatever
project is developed. Mr. Milius said that he wanted to focus
on the project completion risk and market risk, which will drive
the marketability and financeability of the Alaska project. The
aforementioned will be the two things on which the rating
agencies will focus the most when rating the project. With
regard to the construction risk and the completion guarantee,
project finance lenders don't typically take construction risk.
Usually a completion guarantee from credit worthy parties would
be required in order to provide a standby equity commitment to
place more money in the project to fund cost overruns. Although
it's most likely that the equity holders of the project would
provide the completion guarantee, it doesn't necessarily have to
be. A completion guarantee is also [required] because the debt
holders want to know in a "dooms day" scenario how they would
obtain their money back. The potential for federal loan
guarantees is very significant, although there is probably a
fair amount of details regarding how they exactly work.
Preliminarily, Mr. Milius said that the federal loan guarantee
will make investors comfortable during the construction period
because those investors will receive their money back. However,
because only up to 80 percent of the overall cost is being
guaranteed, all of the cost overrun risks associated with the
project haven't be underwritten. Therefore, the equity holders
or whomever would provide the completion guarantees would bear
the cost overruns. The federal loan guarantee has significantly
cut the level of risk for whomever bears the completion
guarantee. The most logical parties to bear the completion
guarantee would be the equity holders, who would likely include
the producers.
MR. KOROT clarified that Lehman Brothers' views the pipeline as
a transportation mechanism. While it's logical for the
producers to be involved in that transportation mechanism to get
the assets out of the ground, it isn't the only way to do it.
Still, it remains reasonable to assume the producers would
participate and their participation has been significantly
reduced by the participation of the federal government.
MR. MILIUS reiterated that whomever provides a completion
guarantee upfront will expect a disproportionate share of the
rewards on the backend. "Those rewards come in the form of ...
participating some way in the benefits of this overall project
... when gas prices are above the ... operating costs and
capital costs of the project ...," he said.
Number 002
MR. MILIUS informed the committee that there is precedence among
gas developments and pipeline financings in which fixed income
capital market investors have taken on some of the risk. For
example, the Express pipeline done in 1988 had multiple
traunches of debt of which some of the more senior traunches of
debt were secured by contracts that were taker pay, hell or high
water, floor price type contracts. The same pipeline had a more
junior traunch of debt in the capital structure in which
investors were taking "merchant risk." More recently and more
relevant to Alaska's project, Qatar's initial financings back in
1996 and 1997 were all supported by fixed-price contracts with
specific off-takers and long-term contracts.
TAPE 04-31A, SIDE A
MR. MILIUS related that the direction that market is moving in
and the structure in which it looks to put in place is one in
which more of the risk will be borne by the capital market
investors around gas prices, which he said is true for a variety
of LNG projects around the world. Furthermore, the trend is
that LNG contracts are shorter in duration while the spot market
for LNG is growing. Mr. Milius opined that the markets are
moving in a direction in which more merchant risk is something
the capital projects will be willing to bear around gas projects
or LNG projects. A key question that will drive an investor's
willingness to take on that risk is regarding where the project
fits on the overall global cost curve for gas on a delivered
basis to the end markets.
MR. MILIUS turned to the issue of managing the risk and how it
would be apportioned among the stakeholders, and related that
there are a lot of options. The most obvious option is that the
state or federal government would underwrite some floor price
for natural gas. However, he said he understood that the
federal government isn't interested in the aforementioned for
this project. Therefore, he opined that Alaska would also want
to avoid that option. Another option would be in which off-
takers of the gas would provide a floor, which would be done
through a taker-pay contract. In the aforementioned option, the
investor would need to closely review the creditworthiness of
the off-taker. A third option would be a "collar structure" in
which there would be a floor and ceiling price for gas. Under
the aforementioned option, the [producers] would approach the
off-takers and in turn for a long-term commitment to a price,
the producers would be willing to cap the price. Therefore,
there would've been some discussion regarding how to structure
the risk and whether a government would need to bear some of the
risk. Effectively, the risk would be apportioned to the private
sector, who would bear it through commercial arrangements
through which they shared [the risk]. With gas prices in the
$5-$6 range, there is the potential that utilities and
municipalities in the Lower 48 would have significant
[incentive] to sign long-term contracts with favorable prices.
The challenge is that the trend with gas supply contracts has
been toward shorter duration. Therefore, the utilities and the
municipalities in the US will likely view that as a significant
risk for a 20-year contract. The fourth strategy would be one
similar to that of the Express pipeline in which there were
multiple tiers in the capital structure and each supported by
different kinds of contracts with different elements of
certainty around gas prices.
MR. MILIUS said that UBS didn't come with all the answers
regarding how [a contract] could be structured. However, the
issue around gas price risk is one that the capital markets
increasingly understand and are willing to bear a meaningful
amount of risk around gas prices, provided that the project is
reasonably competitive on the cost curve. Furthermore, he
opined that there are many potential solutions and routes to be
explored where this risk would be borne among the commercial
private sector parties rather than in the public sector.
MR. KOROT opined that the biggest risk is to do nothing because
the long-term economic viability of the state and its revenues
will be impacted if nothing is done. The risks associated with
this project don't jeopardize any of the state's other programs
or revenues. The question is how to take an asset in the ground
that doesn't have a value and move it to market so that it
generates revenues and provides the services in a timely
fashion. The window, he opined, isn't open forever. The types
of financing one reviews for the Alaska project are bifurcated
and structured such that the cost of capital is lowered, but not
by increasing the risk on a recourse basis to the state or
potentially putting the future programs of the state at risk.
Rather, he suggested creating a financeable project that can be
split into many segments, including a public-private venture.
This is a process done in many industries. Mr. Korot said that
it's not Lehman Brothers' job to tell the state what to do, but
rather to relate that the capital markets understand that this
type of project is feasible and can be done in today's market
with relatively attractive overall costs of capital.
ADJOURNMENT
There being no further business before the committees, the Joint
Committee on Legislative Budget and Audit and Senate Resources
Standing Committee meeting was adjourned at 4:43 p.m.
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