01/31/2002 10:07 AM House O&G

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* first hearing in first committee of referral
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ALASKA STATE LEGISLATURE HOUSE SPECIAL COMMITTEE ON OIL AND GAS January 31, 2002 10:07 a.m. MEMBERS PRESENT Representative Scott Ogan, Chair Representative Hugh Fate, Vice Chair Representative Fred Dyson Representative Mike Chenault Representative Vic Kohring Representative Gretchen Guess Representative Reggie Joule MEMBERS ABSENT All members present COMMITTEE CALENDAR HOUSE BILL NO. 307 "An Act delaying to June 30, 2007, the last date by which hydrocarbon exploration geophysical work must be performed or drilling of a stratigraphic test well or exploratory well must be completed in order for a person to qualify for an exploration incentive credit." - MOVED HB 307 OUT OF COMMITTEE HOUSE BILL NO. 308 "An Act extending to discoveries of oil or gas in the Tanana River drainage basin the discovery royalty credits that are authorized for lessees of state land drilling exploratory wells and making the first discovery of oil or gas in an oil or gas pool and for licensees under oil and gas exploration licenses making the first discovery of oil or gas in an oil or gas pool that convert those licenses to oil and gas leases." - HEARD AND HELD PREVIOUS ACTION BILL: HB 307 SHORT TITLE:OIL/GAS EXPLORATION INCENTIVE CREDIT SPONSOR(S): REPRESENTATIVE(S)FATE Jrn-Date Jrn-Page Action 01/14/02 1955 (H) PREFILE RELEASED 1/4/02

01/14/02 1955 (H) READ THE FIRST TIME - REFERRALS

01/14/02 1955 (H) O&G, RES, FIN

01/16/02 1992 (H) COSPONSOR(S): DAVIES

01/31/02 (H) O&G AT 10:00 AM CAPITOL 124 BILL: HB 308 SHORT TITLE:OIL/GAS LEASES; DISCOVERY ROYALTY CREDIT SPONSOR(S): REPRESENTATIVE(S)FATE Jrn-Date Jrn-Page Action

01/14/02 1955 (H) PREFILE RELEASED 1/4/02

01/14/02 1955 (H) READ THE FIRST TIME - REFERRALS

01/14/02 1955 (H) O&G, RES, FIN

01/14/02 1955 (H) REFERRED TO OIL & GAS

01/16/02 1992 (H) COSPONSOR(S): DAVIES

01/31/02 (H) WITNESS REGISTER JAY HARDENBROOK, Staff to Representative Hugh Fate Alaska State Legislature Capitol Building, Room 416 Juneau, Alaska 99801 POSITION STATEMENT: Presented sponsor statements for HB MARK MYERS, Director Division of Oil & Gas Department of Natural Resources Anchorage, Alaska 99501-3560 POSITION STATEMENT: Testified that HB certainty, rather than having ad hoc decisions on each well. ACTION NARRATIVE TAPE 02-4, SIDE A Number 0001 CHAIR SCOTT OGAN called the House Special Committee on Oil and Gas meeting to order at 10:07 a.m. Representatives Ogan, Dyson, Fate, Guess, and Joule were present at the call to order. Representatives Kohring and Chenault arrived as the meeting was in progress. HB [Contains discussion of HB date of the program. CHAIR OGAN asked whether there was further testimony; none was offered. Number 2573 REPRESENTATIVE DYSON surmised that because the committee hadn't heard from others in the industry, it meant they had no reservations about the bill; he expressed hope that it was so. CHAIR OGAN pointed out that the oil industry generally pays attention and that there was proper notification. Number 2514 REPRESENTATIVE GUESS moved to report HB [Contains discussion of HB Noting the [state] budget crisis, he mentioned "development in a very proper and environmentally sound way" for resources found in Alaska; he said this is simply another method of trying to create incentives "to do just exactly that." Number 2330 MR. HARDENBROOK, in response to Chair Ogan's request for a "walk-through" of the bill sections and the justification, noted that he hadn't brought his sectional analysis. He explained, however, that the whole bill basically just adds "the Tanana River drainage basin" wherever [the statute] says for the royalty credit. Mentioning that the Twentieth Alaska State Legislature had placed a royalty amount of 5 percent on oil and gas, he added, "For this, all we have done is extended that to the Tanana River drainage basin so that they can also have that same credit, given that petroleum is found in paying quantities." Number 2286 CHAIR OGAN offered his understanding: "They want an exploration incentive credit [EIC], which they could get up to $5 million; and now, on top of that, if they find something, they get 5- percent royalty." MR. HARDENBROOK replied in the affirmative. CHAIR OGAN surmised that it is for a pool or unit of gas, basically. MR. HARDENBROOK said that also extends to the entire Tanana River drainage basin and the Nenana basin, which is where Andex [Resources] has applied for an exploration license. He added, "While it is a very large area, it's a very small part of the entire basin that we're talking about in this bill." CHAIR OGAN said he wanted to do what he could to help Fairbanks "get energy and keep energy," but was a little worried this whole project could result in negative cash flow to the state. There is already a $5-million credit, assuming [the company] applies and is approved; he questioned the wisdom of knocking the royalty down to 5 percent in addition. He pointed out that it costs money to manage these leases, for example. He asked Mr. Myers whether the Division of Oil and Gas expects to get any revenues out of this project, under the best-case scenario, if both these [incentives] are applied for. Number 2175 MARK MYERS, Director, Division of Oil & Gas, Department of Natural Resources, responded via teleconference. He noted that the license is an exclusive right to explore that doesn't involve bonus bids and that foregoes the rentals; it's worth about $10.5 million "under conservative consideration." is defined at $5 million per project; however, a project isn't defined yet. When the two are combined, "conceivably, you could see one basin, multiple projects, that might consume the entire $30 million." He continued: But let's say that it's half of that - $15 million there - combined with a discovery royalty; that means, as Mr. Dodson said [during that day's hearing few million dollars ... per year. So it takes the state a long time to get to [a] revenue-neutral position. Additionally, we would not anticipate that these leases - I'm talking with the Department of Revenue - would pay any severance taxes, based on current ELF [economic limit factor]. So if they paid any, it would be only a few percent. ... If it's gas, if it's oil, ... the rate would vary. But primarily the only direct revenue stream from the state would be local taxes, income taxes, and then the 5-percent royalty share. So ... the chicken doesn't have much meat on it left, if you combine all the programs together.... I think that's a fundamental issue the state has to grapple with: ... I don't believe a discovery royalty credit can be more justified in this basin than, say, Copper River, Susitna, or, potentially, even the North Slope foothills, where the same arguments about economic incentives, need to explore, could be used. ... And you're looking at it, potentially, involving multiple discoveries. It's per pool. So if each one of those, the different wells, [is] in a different pool, the discovery royalty would be given on those. So when you add it up cumulatively, discovery royalty can be very expensive - in the tens to hundreds of millions of dollars over time. Number 2067 MR. MYERS emphasized that this is a big-ticket item. He suggested the question is whether it is what the legislature wants to do, given the current fiscal situation. Conversely, is it a good incentive? Noting that discovery royalty has existed, in one form or another, since pre-statehood days, Mr. Myers said, "It was initially repealed. Again, the new program came in, in Cook Inlet. So there's a lot of history on what the program has and hasn't done that I'd be happy to share with the committee, if and when you're ready." CHAIR OGAN asked whether anyone in Cook Inlet has applied for this. MR. MYERS answered that Redoubt Shoals had qualified. He added, "There was a reduction royalty for six identified nonproducing pools. We estimate the Redoubt Shoals discovery royalty will cost the state about $29 million in lost royalty." Number 2019 CHAIR OGAN said he'd carried, on the House floor, the previous legislation that passed; the idea was that because of declining productivity in Cook Inlet, the time was right for giving such a break to encourage new development there. He asked whether this has ever been done for a basin where there is only speculative development and no history of production. MR. MYERS answered that the program existed in Cook Inlet and on the North Slope before they had production. The original program for discovery royalty [incentives], very similar to this program, was repealed in 1969. However, many existing leases on the North Slope within units are pre-1969 and have retained that right. For example, the state gave a discovery royalty [incentive] at Alpine and now is in litigation with Phillips and BP over a discovery royalty on a 37-year-old lease within the Prudhoe Bay structure. He cautioned about creating a program like this, because it has a huge legacy. He emphasized that the [legal] case in Prudhoe Bay, if the state doesn't prevail, will cost about $20 million in lost royalty, although it is within the confines of the largest oil field in North America, on a lease that is "where the discovery was not made until it was - quote, unquote - 30 years old." Number 1912 MR. MYERS told members he doesn't believe this has been an effective incentive. History illustrates how the state has given away millions of dollars. Nor does he believe it has accelerated exploration or production, he said. The program has involved intense litigation over the years. It also is a very hard program to define in terms of whether something is entitled to a discovery royalty. Furthermore, it simply isn't a high enough incentive to really change behavior, which he said has been learned from long experience. Mr. Myers elaborated: The problem is, if you look at commodity price variation, you look [at] exploration, ... that explorer has to risk lots of factors ... on a "nonsuccess" leg, and then put that calculation into its model. ... And then, if they're successful, one of the big issues is, what's going to be the price of oil or gas? You're [skimming] about 7.5 percent off the total royalty stream of the total production; that's equivalent to about a change in about one dollar per barrel for oil, for example. So if you look at commodity price variation, that explorer has to take in account that that price of oil's going to vary multiple dollars in a year; that uncertainty greatly overcomes any value they would get in discovery royalty. That said, it's still millions of dollars. But if you look at a development project, development projects cost tens or hundreds of millions of dollars to do. So, again, that few million dollars a year has not, at least historically, driven exploration. ... And, again, the evidence is there in terms of the activities; the evidence is there that we're granting these on ... almost 40-year-old leases, in cases. So, again, I guess I have to stress that we are opposed to this program not because we don't like to see enhanced oil-and-gas exploration and development, but we just think this is not an effective tool, and it's historically been proven not to be an effective tool. Number 1790 MR. MYERS pointed out that the state has other incentives and programs, primarily in the royalty-reduction statutes, that he believes are much more effective in dealing with the risk element. He emphasized that discovery royalty is given whether the discovery needs it or not, based on evidence of the first discovery. On the other hand, royalty reduction is tailored: if the project is uneconomic, the state can lower its royalty. He concluded, "So we have the ability, I think, to stimulate that development and to deal with issues of ... a project becoming uneconomic. And ... we can do it with much more precision, with much more proof, and with much more positive impact to the state treasury." Number 1753 CHAIR OGAN asked, "What part of the bill do you like?" MR. MYERS answered that because of the long, troubled history, the "dollars given," and the inability, to his belief, to show that it has actually accelerated exploration and development, he personally doesn't like discovery royalty at all. CHAIR OGAN again indicated that his own previous involvement in legislation affecting Cook Inlet was to try to help primarily with oil development, since [production] was declining there; the policy call was that those fields required some incentive. He said there is a fair amount of competition in [Cook Inlet] now, and suggested some people might disagree with Mr. Myers about whether the incentives had anything to do with that. Regarding the Tanana River drainage basin, he asked whether there is competition or if [Andex Resources] has "applied for all the good stuff." MR. MYERS replied that the application basically covers the entire sedimentary basin, but not the shallow-gas leasing potential for coal in the "shallow horizon." Referring to the intent, he said: I think exploration licensing is a powerful tool because it lets one company tie up an entire sedimentary basin, and that's ... a huge thing, if they can leverage it. The uniqueness of this basin, the positive thing, is it's not very far from Fairbanks; there's already a local market. Should a gas line be created from the [North] Slope, there is a very, very large ability - there's a potential, assuming we have the right access language - that that gas could be put into that longer transportation system. So it has both the elements of being able to serve a small, very lucrative market and the upside potential to serve a much larger ... market. Number 1630 MR. MYERS mentioned the "really positive, good geology" as well as exploration risk. He pointed out, however, that if an exclusive right is given, companies historically minimize risk by farming out [to other companies] or bringing other companies in at a higher rate. He remarked: In an exploration license, it's the perfect situation, where a company can say, "Look at the good [prospect] here; why don't you come in and share my costs or take a higher percentage of the cost, and I'll give you some of the capital in return." Licenses are designed so that it would be very easy to do that. Also, it allows ... that person exclusive rights to explore, so when they convert to leases, they can bull's-eye exactly what they want, ... with a full data set. MR. MYERS warned that the state would get very little money upfront, only the dollar-per-acre initial application fee. He told members, "The competitive nature of the license is strictly the work commitment, which the [company] needs to do anyway to assess the basin. So the money goes into the ground under this program, not in the state coffers. The anticipation is, in the future, the state's going to recover that ... in royalty." He explained: Now, if you take that away by ... spending the money on incentives upfront, whether that [would] be EICs or discovery royalty, ... you're taking away almost all the value of those discoveries to the state treasury, or very ... near. So you end up ... creating an oil- and-gas situation where your prime value is getting that commodity to the market, and it's serving ... that market, not serving the state treasury. MR. MYERS cautioned members that this is a very serious policy call that the legislature has to make. Number 1527 CHAIR OGAN asked about "other modalities" if someone had a marginally economic field, for example; he referred to an unspecified bill several years ago that Representatives Rokeberg and Green had "pushed through." He said: So they could apply to the state for a royalty reduction if ... they laid out the numbers and said, "Look, we've got a project; here's what we think our find is; here's what our economic models are; this doesn't pencil out for us if we don't get this reduction." They have the ability to apply to the state for that; is that correct? MR. MYERS answered: Absolutely, Mr. Chairman. Under AS 38.105.180(j) we have what's called royalty reduction, where the state looks at ... the economics of the project and determines whether it needs to reduce the royalties. Now, it puts a fairly high burden of proof ... on the lessee to demonstrate that. But, again, we think that it's ... very appropriate; we think it's good legislation; it's very appropriate that the state have that flexibility. But it also targets it ... where it's really needed. The problem with other incentives that are upfront is you don't really know if that incentive is needed. ... But, again, the companies would be very foolish not to take advantage of incentives that exist out there; they're in the business to make money. So ... ideally you structure a reduction so you have a win-win situation: the state gets production it wouldn't otherwise get, even though it's willing to forego some of its royalty share, but ... under royalty reduction, you can effectively manage that process, look at the economic data, and make the conclusion very accurately and with precision, to that particular development, rather than on a very broad basis, as the other incentives are. Number 1413 REPRESENTATIVE FATE asked: How do you compare the new discovery incentive in other areas of the state, including Cook Inlet, where ... they're aggressively looking for new gas, including the North Slope and everywhere else, really, because of the popularity of gas? Does that discovery incentive cost the state "x" number of dollars, and then can you compare that loss to the state to what's perceived as a small potential in the Nenana basin? ... How are those losses comparable if, in fact, ... at this time in exploration that incentive is still utilized on the North Slope and in the Cook Inlet? MR. MYERS replied that each discovery royalty [incentive] is customized in the sense that it refers to an individual pool or "additional accumulation." It depends on the economics of that additional accumulation, if it is found. Basically, it lowers the state's royalty share from 12.5 percent to 5 percent; it is a reduction of 7.5 percent of the oil and gas produced that would normally go to the state. The effect is a direct decrease in the royalty cash flow to the general fund of the state treasury. The amount [of decrease] depends on how it is calculated. He offered an example: If you look at the Fairbanks market, and similar to Mr. Dodson's statement [during that day's hearing on HB million a year; it would then not receive about $3 million a year out of that. So that would be ... sort of the relative effect of that, ... and it would be for a ten-year period from the date of discovery. If it took you three years to bring it online, say, that discovery royalty would only run for seven years; so in that example, it'd be about $21 million. It's not quite ... 3-to-2, but it's 7.5 percent, and the state gets 5 percent. So basically, under the analysis by Mr. Dodson, it would be about $2 million. MR. MYERS told members it depends on the wellhead value and the final delivered-commodity price. He also indicated agreement regarding the size of market Mr. Dodson had mentioned initially. He offered that the upside is that it wouldn't be just a local market, but would be a long-term market with a gas line, assuming proper access language is written into the pipeline [agreements]. He said the number could go up significantly if there were multiple discoveries in the basin and a higher demand for gas than just the local market. Number 1192 REPRESENTATIVE FATE indicated part of his previous question had related to comparing what Mr. Myers had just explained to the loss that could be incurred both in Cook Inlet and on the North Slope, provided that new discoveries take place there, because of the current intense exploration. He said it isn't just a loss in one small basin, but is a potential loss in the rest of the state. He asked whether that is correct. MR. MYERS answered affirmatively, adding: We can quantify, sort of, what we know right now. Redoubt [Shoals], we estimate about $29 million of loss in revenue. ... If Phillips is successful, one of the other main fields is Zariski (ph) Point, which is where they're drilling now; so if they were to be successful, that would be ... similar dollars. Some of these are gas fields, and they would have a lesser impact, probably around ... the $5-million-effect range. So, cumulatively, add that up. Number 1121 MR. MYERS specified that on the North Slope, new leases aren't issued with the discovery royalty provision. It would only apply to leases within existing units that are pre-1969; those are still "popping up," like the one he'd mentioned that is in litigation. He mentioned other examples, noting that the cumulative [monetary] effect on these large fields isn't much different, because it just applies to production from that one lease. However, what might vary is the netback value of oil. For example, if oil were discovered in the Nenana basin, there would be a netback of perhaps $12 to $17, depending on the price of oil. He emphasized that there would be larger numbers for oil than for gas. He added, "In a new basin, you just can't predict how many discoveries, and you hope for the most." MR. MYERS answered Representative Fate's question by reiterating that discovery royalty is a very expensive program for the state, and that "we just don't think it's promise of accelerating exploration and development." Regarding the argument that it has spurred exploration, he countered that the level of the incentive [relative to] the cost of developing a field is almost miniscule compared to the variation [of the] commodity price, and that the $2 or $3 million dollars a year a company gets from a discovery royalty isn't enough to change its development behavior "on most fields that we've seen." added, "We can go back historically, from '59 on, and make that case very strongly." Number 0981 REPRESENTATIVE FATE asked whether Mr. Myers nonetheless believes the discovery incentive would encourage going into basins in Interior Alaska that are even more isolated than the Nenana basin. MR. MYERS answered that he believes the exploration licensing program is the tool doing that. For example, currently there is a license in Copper River; there are two applications in the Susitna basin and one in the Nenana area; and Mr. Dodson and others have expressed interest in the Yukon Flats area, another basin that is both oil- and gas-prospective. All those are along the route of a proposed gas line, he noted. MR. MYERS told members that economic opportunity overall - and not incentives - is what drives exploration for large commercial developments; that includes the ability to commercialize those exploration opportunities, whether to a local market the size of Fairbanks or to put into a larger pipeline for distribution. By contrast, he noted that the problems with dealing with a small village and its energy needs, and drilling dedicated wells, is much more problematic because the economics simply are not as good; he suggested perhaps targeting some of the shallow-gas legislation or incentives there. He continued: With that said, I think [the] exploration license is a very, very powerful incentive, because ... I don't know very many places in the world where you can lock up a very prospective basin near a market for $500,000 and then have the ability to selectively convert to a lease at 12.5 percent and pay virtually no severance tax. ... Those are all very, very positive things for development. Again, I'm not saying ... that they aren't appropriate in this case; I believe they're appropriate and, again, I think the exploration license program is doing what it wants to. Number 0815 MR. MYERS said these are some of the "better looking" sedimentary basins. Mentioning two licenses in Susitna "covering most of that basin," a 500,000-acre license already issued in the Copper River basin, and "a license expected to be issued here in October," he said, "If Yukon Flats is covered, a lot of the prospective sedimentary basins will be already under license." He reiterated that the program is doing what it is supposed to do. He mentioned rising gas commodity prices and renewed interest. MR. MYERS offered his belief that it is his division's job to heavily promote exploration and competition, where possible. He said, "I believe we can sell these licenses, we can see actuation activity and development. Part of it's just getting the word out, and part of it is just the change in economics and the potential for long-term ... gas sales from Alaska to the Lower 48." Mentioning earlier, unsuccessful rounds of exploration in these basins, he said that [lack of success] was largely due to looking for oil. With gas, however, there is a whole new emphasis for exploration. He added that it is positive and that he certainly doesn't want to take away from the efforts of Andex Resources to explore in the basin. He concluded, "But we have to recognize that, I believe, we have better economics than we did in the past and that exploration licensing already provides that tool to accelerate that exploration in the basin." Number 0697 MR. MYERS, in response to a question from Chair Ogan regarding acreage for gas versus oil, reported that currently under license or proposed for licensing is over 2 million [acres] for exploration licenses. There is approximately an additional million acres for shallow-gas leasing. He agreed it is a huge quantity, and suggested Jim Hansen, who was there with him, could look up the number of acres under conventional leasing [for gas]. He added, "It's more than that, to be pretty similar." CHAIR OGAN referred to a recent overview and recalled hearing that there was almost as much shallow-gas activity as there is total licensing for oil. MR. MYERS answered: Mr. Chairman, we leased last year 1.6 million acres on the conventional program, so we have about a million ... with the coal bed. ... So in the same timeframe - and you would (indisc.) shallow-gas leases, assuming we grant the licenses next year - we will issue more acreage, undoubtedly, in these programs than we ... do in our conventional programs. Number 0584 REPRESENTATIVE GUESS requested confirmation of her understanding that Mr. Myers was testifying that, in general, discovery royalty is not the best policy, that it doesn't matter where it is, and that other existing tools do a better job. MR. MYERS said Representative Guess had heard exactly right. He commended her for her summary. Number 0508 JAMES B. DODSON, Executive Vice-President, Andex Resources, L.L.C., came forward to testify on HB ADJOURNMENT Number 0493 There being no further business before the committee, the House Special Committee on Oil and Gas meeting was adjourned at

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