Legislature(2017 - 2018)BUTROVICH 205

01/24/2018 03:30 PM RESOURCES

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Audio Topic
03:30:10 PM Start
03:30:38 PM Overview: Alaska's Oil & Gas Royalty, Unitization Process
04:58:42 PM Adjourn
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
Alaska's Oil & Gas Royalty, Unitization Process
- Department of Natural Resources
Division of Oil & Gas
-- Testimony <Invitation Only> --
                    ALASKA STATE LEGISLATURE                                                                                  
              SENATE RESOURCES STANDING COMMITTEE                                                                             
                        January 24, 2018                                                                                        
                           3:30 p.m.                                                                                            
MEMBERS PRESENT                                                                                                               
Senator Cathy Giessel, Chair                                                                                                    
Senator John Coghill, Vice Chair                                                                                                
Senator Natasha von Imhof                                                                                                       
Senator Kevin Meyer                                                                                                             
Senator Bill Wielechowski                                                                                                       
Senator Click Bishop                                                                                                            
MEMBERS ABSENT                                                                                                                
Senator Bert Stedman                                                                                                            
COMMITTEE CALENDAR                                                                                                            
OVERVIEW: ALASKA'S OIL & GAS ROYALTY, UNITIZATION PROCESS                                                                       
     - HEARD                                                                                                                    
PREVIOUS COMMITTEE ACTION                                                                                                     
No previous action to record                                                                                                    
WITNESS REGISTER                                                                                                              
ED KING, Special Assistant to the Commissioner                                                                                  
Department of Natural Resources (DNR)                                                                                           
Juneau, Alaska                                                                                                                  
POSITION STATEMENT: Provided overview of Alaska's oil and & gas                                                               
royalty, unitization process.                                                                                                   
ACTION NARRATIVE                                                                                                              
3:30:10 PM                                                                                                                    
CHAIR  CATHY   GIESSEL  called  the  Senate   Resources  Standing                                                             
Committee meeting  to order at 3:30  p.m. Present at the  call to                                                               
order  were Senators  Coghill, Bishop,  Wielechowski, Meyer,  and                                                               
Chair Giessel. Senator Stedman was excused.                                                                                     
^Overview: Alaska's Oil & Gas Royalty, Unitization Process                                                                      
   Overview: Alaska's Oil & Gas Royalty, Unitization Process                                                                
3:30:38 PM                                                                                                                    
CHAIR GIESSEL announced the only  order of business today was the                                                               
oil and  gas royalty and  unitization process overview.  She said                                                               
Alaska was one of the nation's  largest producers of crude at one                                                               
point  in  its  history.  The   State  of  Alaska  has  a  unique                                                               
subsurface mineral  resource and as  the land owner  is receiving                                                               
royalty for  that. The Department  of Natural Resources  (DNR) is                                                               
entrusted to extract  the maximum value from  those resources for                                                               
the people of  Alaska and it does that through  a system of lease                                                               
sales,   royalty  contracts,   and   by   authorizing  plans   of                                                               
development.  Today they  would  hear more  about  that from  the                                                               
3:31:44 PM                                                                                                                    
ED  KING, Special  Assistant to  the Commissioner,  Department of                                                               
Natural  Resources (DNR),  Juneau,  Alaska,  made the  disclaimer                                                               
that  this is  an  educational presentation  and not  necessarily                                                               
instructive. He didn't want to  imply that this committee doesn't                                                               
know any of  these things he is talking about  here, but he wants                                                               
to make  sure the  public is up  to speed on  some of  the topics                                                               
that get glossed over in other contexts.                                                                                        
3:32:58 PM                                                                                                                    
MR. KING  said he would be  talking about oil and  gas contracts,                                                               
leases and royalties,  and how the Division of Oil  and Gas (DOG)                                                               
manages  the state's  mineral resources  that it  owns under  the                                                               
lands  that were  conveyed to  it at  statehood. The  DNR manages                                                               
those minerals by  leasing rights to an oil and  gas developer to                                                               
extract  those  resources, bring  them  to  market, and  generate                                                               
revenue from them. This is not  uncommon; it happens all over the                                                               
world, not  only in oil and  gas, but in any  other business that                                                               
has  these kinds  of contractual  relationships between  business                                                               
He described the types of oil and gas contracts:                                                                                
-Service contract: A contract that  an oil owner would enter into                                                               
with an  oil and  gas producer,  like one  would contract  with a                                                               
builder  to build  a house.  In these  cases, the  resource owner                                                               
maintains ownership  of the resource  and takes on all  the risk.                                                               
The contractor  usually gets  paid back through  the sale  of the                                                               
oil, anyway,  so there isn't  necessarily a cash outlay,  but the                                                               
risk is born by  the owner of the resource and  is not shifted to                                                               
the  developer.  This  is  the  least  common  of  the  types  of                                                               
contracts, but he has heard  they are becoming more popular. They                                                               
can be found  in places like Iraq where when  one hears that Iraq                                                               
has a  99 percent government  take, it  is because they  are only                                                               
paying a major international oil  company to produce its oil. The                                                               
company isn't bearing any of the risk.                                                                                          
3:35:17 PM                                                                                                                    
SENATOR VON IMHOF joined the committee.                                                                                         
-Production sharing  agreement/contract: Outside  of the  U.S. in                                                               
the modern era,  this is the most common type  of agreement where                                                               
the  owner of  the resource  partners with  an international  oil                                                               
company. It is  very common in Eastern Europe  and South America.                                                               
Typically, the  international oil company will  front the capital                                                               
and then recover it through the recovery of the resource.                                                                       
-Concession  agreement:  In the  U.S.  and  Canada where  private                                                               
individuals  actually  have  mineral  rights, this  is  the  most                                                               
common  type  of agreement.  This  is  where one  concedes  one's                                                               
rights to  the royalty  or the  resource to  another party  for a                                                               
period of time.  Then they would be responsible  for bringing the                                                               
resource  to  production and  take  the  risk  of the  costs  and                                                               
capital. They  have ownership of  the resources while  it's under                                                               
contract.  These  agreements  can  be  structured  to  look  very                                                               
similar  to production  sharing  agreements (PSA),  but the  main                                                               
difference is  in how the  owner of  the resource is  defined and                                                               
who bears the risks, and ultimately who gains the rewards.                                                                      
MR. KING  said this broad  spectrum of contracts provides  ways a                                                               
government  and oil  company can  interact with  one another  but                                                               
comparing these  contracts to  one another  can be  misleading as                                                               
the terms are very difficult to compare.                                                                                        
3:38:30 PM                                                                                                                    
MR. KING said Alaska is unique,  being the sovereign owner of the                                                               
resource, whereas  in the Lower  48, private individuals  are the                                                               
owners.  Alaska  is  also  governed by  a  constitution  that  is                                                               
largely developed around this private mineral interest.                                                                         
He briefed  the committee  that when Alaska  became a  state, and                                                               
even  pre-statehood  in the  1920s  when  the U.S.  military  was                                                               
converting  from  coal to  oil,  it  became really  important  to                                                               
protect its ability to provide  the protection that it needed to.                                                               
So, the Mineral  Leasing Act of 1920 was enacted  it separate the                                                               
oil and gas from other minerals  and required federal lands to be                                                               
managed  through the  leasing  of those  oil  and gas  resources.                                                               
After WWII, a concern arose that if  the U.S. used up all its oil                                                               
and gas it  wouldn't be able to maintain its  defense program and                                                               
governments  around the  world started  looking at  other sources                                                               
for oil and  gas. Lots of exploration activities  went on through                                                               
Europe, China, Russia, Northern Africa  and the Middle East. This                                                               
Mineral Leasing Act  is still what is governing  all the activity                                                               
that is happening in Alaska. So,  through the 1950s and as Alaska                                                               
entered statehood in 1959, the  federal government leased oil and                                                               
gas rights in the Cook  Inlet, specifically and the pre-statehood                                                               
leasing structure was used as a  template for how the state would                                                               
progress after getting to statehood and writing a constitution.                                                                 
Under the Mineral Leasing Act,  a decision was made that revenues                                                               
generated on federal  leases would be divided: 50  percent to the                                                               
state  that  owned  the  resource,  10  percent  to  the  federal                                                               
government,  and the  other 37.5-40  percent  to the  Reclamation                                                               
Fund, a  fund that  was created  in the  early 1900s  to generate                                                               
infrastructure projects,  like dams and irrigation  to settle the                                                               
western states.                                                                                                                 
When the Alaska Statehood Act  was passed, the ability for Alaska                                                               
to draw off that fund didn't  exist. So, Alaska was given that 40                                                               
percent.  When people  talk about  the  90 percent  to Alaska  on                                                               
federal lands and  10 percent to the federal  government, that is                                                               
the evolution of  events that lead to that  outcome. All revenues                                                               
that are  generated on  federal lands under  federal lease  go to                                                               
the federal government and 90  percent gets returned to the state                                                               
to be used for whatever the state deems appropriate.                                                                            
3:43:34 PM                                                                                                                    
In 1959, Governor Egan questioned whether  it was worth it to use                                                               
the  state's  land selection  for  oil  and  gas lands  since  90                                                               
percent of  the revenues were coming  to the state anyway.   When                                                               
Governor  Hickel  became  the  governor  in  1966,  he  made  the                                                               
decision to select  a lot of those lands on  the North Slope. The                                                               
federal lease  sale model was  used, and the state  received $900                                                               
million ($5 billion in today's dollars) in its first lease sale.                                                                
MR. KING  said that  there are places  in the  National Petroleum                                                               
Reserve -  Alaska (NPR-A)  where that  90/10 split  doesn't apply                                                               
and then it  is a 50/50 split. The 1002  Alaska National Wildlife                                                               
Refuge  (ANWR)  provision  that   just  passed  in  a  continuing                                                               
resolution  (CR) in  Congress replaced  the 90  percent provision                                                               
with  a 50  percent provision  and the  50 percent  going to  the                                                               
state is dedicated  to the NPR-A Impact Fund.  Article 8, Section                                                               
12, of  the Alaska Constitution  laid out in the  Mineral Leasing                                                               
Act provision where  the state was mandated to lease  its oil and                                                               
gas resources, and that first sale was following that provision.                                                                
The  Alaska  Land  Act  was subsequently  passed  by  the  Alaska                                                               
Legislature  under AS  38.05.180, the  state statute  that guides                                                               
all DNR's  processes. It demands  that the state use  leasing for                                                               
managing its oil and gas resources.                                                                                             
When the  energy crisis happened in  the 1970s, there was  an oil                                                               
embargo  and prices  spiked up.  Those were  the conditions  that                                                               
allowed the Trans-Alaska  Pipeline System (TAPS) to  be built. It                                                               
happened again in 1977 as  construction was just being completed.                                                               
With the issues around land claims  just prior to that, the state                                                               
didn't have any  lease sales between 1974 and 1980.  So, the when                                                               
Permanent Fund provision talks about  the pre-1980 leases and the                                                               
post-1980 leases,  this is what it  is referring to. And  this is                                                               
why  the state  is  using  leasing and  not  some  other form  of                                                               
contract to manage its oil and gas resources.                                                                                   
3:47:30 PM                                                                                                                    
MR.  KING said  it's  important to  remember that  a  lease is  a                                                               
contract  (slide 4)  between the  state and  another party.  When                                                               
signing a contract, the legislature  through the Alaska Lands Act                                                               
gave DNR  the authority to  enter into these contracts.  So, when                                                               
DNR holds  a lease  sale and  issues these  leases, the  state is                                                               
entering into  a contract with  a producer to take  possession of                                                               
the oil in return for a  portion of the production and many other                                                               
things within the lease agreement.  Importantly, it is a contract                                                               
and therefore governed by contract  law; it can't just be amended                                                               
or changed because one party wants to.                                                                                          
However,  the Legislature  gave  DNR the  authority  to change  a                                                               
contract in very specific instances. One  is when a lease joins a                                                               
unit. DNR also has the  authority under .180(j) to reduce royalty                                                               
rates  in specific  instances. Those  are the  only instances  in                                                               
which DNR has the authority  to renegotiate a contract. Any other                                                               
renegotiations must  happen with  the legislature's  approval and                                                               
neither DNR nor the lessee can do anything on their own.                                                                        
3:49:20 PM                                                                                                                    
MR. KING  said a  lease has  several important  provisions (slide                                                               
5). This exclusive  right for access to the resource  is done for                                                               
a set period  of time, historically 10 years.  Recently, that was                                                               
reduced to seven years with  an opportunity to extend for another                                                               
three if a company is diligently progressing towards production.                                                                
The lease terms  provide three important revenue terms;  one is a                                                               
royalty, which is  a reservation of part of  the state's interest                                                               
in  the resources.  When the  resources are  produced, the  lease                                                               
allows a company  to sell those resources for  their own benefit,                                                               
but whatever the royalty rate is  that is reserved for the state.                                                               
The minimum royalty  allowed is 12.5 percent  or one-eighth. When                                                               
the barrels  are produced  and brought to  market, the  state has                                                               
the right to that one-eighth of that production.                                                                                
There is also a rental payment for  each of the 10 years, even if                                                               
oil isn't produced.  This ensures that the state  is getting some                                                               
revenues from the contracts the state enters.                                                                                   
The third  revenue term  is a  "bonus bid,"  which is  an upfront                                                               
payment that  a company will provide  to the state for  the right                                                               
to enter into a contract.                                                                                                       
3:51:56 PM                                                                                                                    
Lease interests can be transferred  or reassigned with department                                                               
approval.  Whatever  the primary  term  is  that  is how  long  a                                                               
company has  to get the lease  into production. If they  get into                                                               
production, they  are allowed to  maintain that lease as  long as                                                               
they are producing.                                                                                                             
3:52:48 PM                                                                                                                    
Leases are issued  annually on an areawide basis  (slide 6). Only                                                               
lands owned  by the  state are leased,  about 105  million acres.                                                               
All other  acres are federal  or Native Corporation lands,  and a                                                               
few homesteads  (owned prior  to statehood).  The Bureau  of Land                                                               
Management (BLM) leases federal lands.                                                                                          
SENATOR  BISHOP asked  him to  clarify  what he  just said  about                                                               
private lands.                                                                                                                  
MR.  KING  said that  the  Alaska  Native Claims  Settlement  Act                                                               
(ANCSA)  gave 40  million acres  to the  Native corporations  and                                                               
those  are considered  private  lands. A  very  small sub-set  of                                                               
people were land  owners in Alaska before statehood  and they do,                                                               
in fact,  own the mineral  rights. Those are also  private lands.                                                               
However, when he  says, "private lands," he  is typically talking                                                               
about Native corporation lands.                                                                                                 
SENATOR BISHOP  said he  believes some  production is  coming off                                                               
some of those lands.                                                                                                            
MR. KING said yes, in Cook Inlet.                                                                                               
3:55:21 PM                                                                                                                    
He said  the federal waters around  the state are managed  by the                                                               
Bureau of  Ocean and Energy  Management (BOEM) that  conducts its                                                               
own lease  sales. Those are  not within the state's  borders, but                                                               
the production can  flow through the state borders,  so the state                                                               
is  still interested  in those  lease  sales in  the Chukchi  and                                                               
Beaufort Seas and Cook Inlet.  BLM and BOEM are both subdivisions                                                               
of the Department of Interior.                                                                                                  
State land  leases are carried  out by DNR,  specifically through                                                               
the  Division  of  Oil  and  Gas  (DOG)  leasing  section,  which                                                               
prepares and evaluates  lease sales, and issues  the leases. They                                                               
get support from the Resource  Evaluation and Commercial sections                                                               
within the DOG.  These people have a high degree  of education in                                                               
either  geology,  geophysics, petroleum  engineering,  economics,                                                               
finance, and things like that. They  make sure that the bid terms                                                               
in  the lease  sale are  generating the  maximum benefit  for the                                                               
3:57:01 PM                                                                                                                    
MR. KING  said the  department doesn't  always just  lease lands.                                                               
There are  areas where the  resource potential is less  known and                                                               
in those situations, they can  issue an exploration license. Then                                                               
a company  can go out  and have  exclusive rights to  explore for                                                               
resources in  that area. If  a company has success,  that license                                                               
can be converted into a lease.                                                                                                  
3:57:52 PM                                                                                                                    
He  said leasing  in Alaska  has evolved  a lot  since the  first                                                               
sales  in the  late  60s.  Now the  department  just provides  an                                                               
areawide lease  sale every December.  An area might be  the whole                                                               
North  Slope or  the Beaufort  Sea (slide  7). Effectively,  this                                                               
means  that  all  the  state  lands  included  in  the  sale  are                                                               
available for  bid. A big production  is made out of  opening all                                                               
the  bids in  the Dena'ina  Center in  December and  reading them                                                               
aloud. The  department makes sure  the bidders are  qualified and                                                               
the highest bidder is awarded the lease.                                                                                        
AS 38.05.180  also authorizes special  lease sales for  tracts of                                                               
land with  different bid  terms. It could  be a  six-year primary                                                               
term  and drilling  a  well  within the  first  three years,  for                                                               
example.  Currently,  the  department is  evaluating  whether  it                                                               
wants to hold a special lease sale next summer.                                                                                 
3:59:46 PM                                                                                                                    
SENATOR VON  IMHOF asked if  he is  allowed to indicate  what the                                                               
special lease sale might be.                                                                                                    
MR.  KING  replied  that broadly  the  department  received  some                                                               
seismic tax credit data that has  just been made public, and some                                                               
of  the  lands under  that  data  are  unleased lands.  So,  they                                                               
thought they  would pull  those lands out  from the  areawide and                                                               
conduct  a special  lease  sale  to see  if  there is  additional                                                               
interest  given the  additional  information. It's  on the  North                                                               
4:00:32 PM                                                                                                                    
CHAIR GIESSEL  asked if DNR is  charging a fee for  access to the                                                               
seismic information that is being released now.                                                                                 
MR. KING answered yes; a  regulation change implemented a fee and                                                               
the  department  has  collected $140,000  with  another  $100,000                                                               
coming soon.  The DNR anticipates  $300,000 I receipts  this year                                                               
from the seismic data sales.                                                                                                    
4:01:08 PM                                                                                                                    
MR. KING proceeded to discuss  royalties and bonus bids saying it                                                               
is very difficult to evaluate competing  bids on a tract of land,                                                               
because  of multiple  terms  that can  be  altered. So,  instead,                                                               
everything is held constant except  for one term, and the bidders                                                               
can bid  that one  term. The  division can  choose which  term to                                                               
bid; it  can be  the royalty  rate, the bonus  bid or  some other                                                               
term. This  is what  "bid variable" refers  to. In  modern times,                                                               
the bonus bid is almost always the bid variable.                                                                                
4:02:37 PM                                                                                                                    
SENATOR WIELECHOWSKI asked what the average price is per acre.                                                                  
MR. KING  replied that it  depends on the  lease and how  much is                                                               
known about the potential in the  area. Leases in North Dakota in                                                               
2003, for instance,  would only get $25/acre, but as  soon as the                                                               
shale  revolution started  and the  resource became  known, there                                                               
was a lot of competition around  getting into those leases and it                                                               
drove the  bid variables up  to thousands of dollars.  In Alaska,                                                               
something similar happened:  in the early lease sale  there was a                                                               
lot  of  uncertainty  around  the potential.    After  the  first                                                               
Prudhoe Bay State Well No. 1  was drilled in 1968 and success was                                                               
had, the next lease sale brought in $900 million worth of bids.                                                                 
Generally  speaking, the  value  of the  resource increases  with                                                               
proximity to infrastructure  and what is known  about a formation                                                               
structure.  If  not  much  is  known   and  it  is  a  ways  from                                                               
infrastructure, the bid is usually minimum.                                                                                     
SENATOR WIELECHOWSKI asked how much that is.                                                                                    
MR. KING answered $25/acre.                                                                                                     
SENATOR WIELECHOWSKI said  he just wanted to know  an average for                                                               
Alaska leases versus North Dakota or Texas.                                                                                     
MR.  KING said  he didn't  have that  figure off  the top  of his                                                               
head, but he would get it.                                                                                                      
CHAIR  GIESSEL  asked if  Mental  Health  Trust (MHT)  lands  are                                                               
managed through DNR and if they have the same terms.                                                                            
MR.  KING  replied   that  the  trust  is   managed  through  the                                                               
Department  of   Revenue  (DOR).   The  trust  received   a  land                                                               
allotment, which  is managed by  the Trust Land Office,  and that                                                               
is housed  within DNR,  but it conducts  its own  land disposals.                                                               
DNR provides the trust's procurement and support.                                                                               
SENATOR BISHOP said he thought DGF  funds were provided to fund a                                                               
position in DNR.                                                                                                                
MR. KING said balancing the bonus  bid versus the royalty rate is                                                               
a delicate matter,  because the royalty is only paid  if one gets                                                               
to production.  So, the higher  royalty rate only makes  sense if                                                               
one actually  gets to production.  When a company is  deciding on                                                               
how much it wants to pay for  a lease, it takes into account what                                                               
it knows about  the resource and what potential  economic gain it                                                               
can get  from it. The higher  the royalty rate is  the less value                                                               
the lease has and the lower the bonus bid is.                                                                                   
SENATOR BISHOP commented that the companies are making a mini-                                                                  
RIK/RIV decision inside the bonus bid.                                                                                          
MR. KING agreed  that the company makes the decision  on how much                                                               
it is willing to pay for the lease.                                                                                             
4:08:21 PM                                                                                                                    
He explained  that prior to  1980, all  leases were for  a fixed-                                                               
rate and under  a DL-1 lease. Leases are contracts  and endure as                                                               
long as one has production. So, even though they had only a 10-                                                                 
year primary term, about 300  leases that were issued before 1980                                                               
are still producing oil today.                                                                                                  
During  the 1980s,  a lot  of countries  started to  move towards                                                               
production  sharing  agreements;  the federal  law  and  Alaska's                                                               
Constitution   still   ruled   here.   The   federal   government                                                               
experimented with new  ways to issue lease terms and  one of them                                                               
was  a  "net  profit  share   lease  (NPSL),"  which  turns  into                                                               
something very  similar to a  production sharing  agreement, even                                                               
though the  construct and specific legal  situation is different.                                                               
The  state  had  one  lease  sale where  the  NPSL  was  the  bid                                                               
variable. Twenty-four of the NPSLs are still active today.                                                                      
Another  way  the federal  government  and  the state  were  both                                                               
experimenting with lease terms was  through a sliding scale where                                                               
the royalty rate  would change based on some factor:  the rate of                                                               
production or  the price of  oil, for instance. Today,  all North                                                               
Slope  leases   are  issued  at   a  fixed  one-sixth   rate  and                                                               
competitors are  allowed to  compete using the  bonus bid  as the                                                               
4:12:03 PM                                                                                                                    
SENATOR WIELECHOWSKI asked what percent  of produced oil pays the                                                               
higher one-sixth royalty.                                                                                                       
MR. KING answered  about 70 percent of the oil  is still from the                                                               
DL-1 leases  that were  issued in  the 60s and  early 70s  with a                                                               
12.5 royalty rate.                                                                                                              
SENATOR  WIELECHOWSKI  recalled  SB   21  (passed  in  2013)  had                                                               
provision  that  said  companies  that paid  this  16.67  percent                                                               
royalty actually paid lower production taxes. Is that correct?                                                                  
4:13:03 PM                                                                                                                    
MR. KING  answered yes;  a provision in  SB 21,  AS 43.05.160(g),                                                               
allowed for an additional gross  revenue exclusion, so 10 percent                                                               
of gross value  was removed from the taxable  income. However, no                                                               
leases qualify  for that  provision today.  Only three  units may                                                               
qualify in the future and those are in question.                                                                                
SENATOR  WIELECHOWSKI asked  if the  12.5 percent  royalty mostly                                                               
applies to the legacy fields.                                                                                                   
4:14:34 PM                                                                                                                    
MR. KING answered yes.                                                                                                          
SENATOR WIELECHOWSKI  said he  was trying  for a  fair comparison                                                               
with Texas and  the consultants said the average  royalty rate on                                                               
private lands there is about 25 percent.                                                                                        
MR. KING answered  the royalty owners have been  able to leverage                                                               
higher  rates there,  because  there is  a  lot less  uncertainty                                                               
around whether  the resource exists  and whether  it's producing.                                                               
It is  true that a new  lease that is  less than 10 years  old in                                                               
North Dakota  or Texas probably  has a  much higher rate,  in the                                                               
20-25 percent range.                                                                                                            
SENATOR WIELECHOWSKI asked if he  would agree that Prudhoe Bay is                                                               
the largest oil field in North American.                                                                                        
MR. KING  answered yes,  and the  state would  be getting  a much                                                               
larger share  of the revenues if  it had any land  to lease there                                                               
SENATOR  WIELECHOWSKI said  companies in  Texas and  North Dakota                                                               
are fracking and getting all they  can out of the fields and then                                                               
moving on to new fields and  that have a 25-percent royalty rate.                                                               
He asked him to look into that.                                                                                                 
SENATOR WIELECHOWSKI said comparing  prolific fields like Prudhoe                                                               
Bay and  Kuparuk, the  first and second  largest fields  in North                                                               
America  versus  a  prolific  field  in  the  Permian  Basin  for                                                               
instance, they are  paying a 25 percent royalty down  there and a                                                               
12.5 percent royalty  here. So, they are paying twice  as much in                                                               
royalty there than they are here. Is that correct?                                                                              
MR. KING answered yes. He  reiterated that when these leases were                                                               
issued the  knowledge of the  prolific nature of  those resources                                                               
was not known. Because they are  contracts that endure as long as                                                               
the oil is being produced, the  state does not have discretion to                                                               
now change them. If we were able  to go back knowing what we know                                                               
now  and issue  those  leases  today, we  would  get much  higher                                                               
CHAIR  GIESSEL said  the Pikka  Unit  is above  the 16.6  percent                                                               
royalty line and  will have the higher royalty rate  and asked if                                                               
there are  unleased areas around  it, since a  highly prospective                                                               
layer has  been identified across  this area. She asked  what the                                                               
chances of the  state increasing the royalty rate  above the 16.6                                                               
percent are.                                                                                                                    
MR. KING answered  those leases were issued  before the resources                                                               
were known,  but it was a  result of leasing those  lands that we                                                               
now know about  those resources, so we can't  change those rates.                                                               
The Pikka  Unit has a higher  royalty rate and when  it goes into                                                               
production it will pay more revenues  to the state. There is very                                                               
little unleased acreage  in the area, but  the Nanushuk formation                                                               
looks like  it's trending  to the  West, and  what has  been seen                                                               
recently is  even across  the federal lands,  in the  NPR-A, that                                                               
trend  looks  like it  will  continue.  So,  there  is a  lot  of                                                               
interest there.  The Horseshoe  well was drilled  a year  ago and                                                               
had good results, so it looks like that trend will continue.                                                                    
CHAIR GIESSEL  followed up that  the head guy from  United States                                                               
Geologic  Survey (USGS)  presented in  Anchorage in  November and                                                               
talked about that stratigraphic layer going eastward, as well.                                                                  
MR. KING  responded that their  packets have  a tract map  of the                                                               
last lease  sale and it  indicates a  few purple boxes  that were                                                               
unleased acreage when the lease sale  was held. Even if the trend                                                               
does extend to  the east, a lot of those  lands have already been                                                               
leased. Hopefully,  the lessees are  in a position that  they can                                                               
locate those resources and develop them.  But it is not as likely                                                               
that we will generate higher rates  of royalty as a result of the                                                               
new information.                                                                                                                
4:19:43 PM                                                                                                                    
SENATOR WIELECHOWSKI  asked if  there are any  efforts in  DNR to                                                               
take advantage  of the world  market, which is seeing  these much                                                               
higher royalty  rates, or  is the state  sticking with  the 16.67                                                               
percent rate it currently has.                                                                                                  
MR. KING  answered when  the department  issues lease  sales they                                                               
are being  issued at the  16.67 percent  rate. If more  was known                                                               
about  the  resource, they  would  be  able  to charge  a  higher                                                               
royalty  rate, but  until then  there  is a  lot of  uncertainty.                                                               
Pushing the royalty  rate up too high introduces the  risk of not                                                               
getting a  lessee. The other  side of that  coin is even  if they                                                               
royalty rate is lower than other  areas, if there is a well-known                                                               
resource  under  it,  there should  be  competition  around  that                                                               
resource  and  the state  should  get  a  higher bonus  bid.  So,                                                               
charging a  lower royalty  rate is  not necessarily  injuring the                                                               
state, because it is still getting an increase in revenue.                                                                      
4:20:59 PM                                                                                                                    
SENATOR WIELECHOWSKI said he would  disagreed because the rest of                                                               
the U.S. is  getting an average of 25 percent  and Alaska is just                                                               
getting 16.67 percent, and from prolific fields.                                                                                
The country  of Norway, for  example, actually goes out  and does                                                               
the  seismic themselves  and gets  the data  back. They  make all                                                               
that seismic information  public and that drives  up the interest                                                               
in the  field.   Is there  any talk  in DNR  about doing  that in                                                               
MR.  KING  replied  that  he  would  have  to  choose  his  words                                                               
carefully, because while being an  employee of the administration                                                               
he  has  personal  opinions,  as   well,  but  yes  DNR  has  had                                                               
conversations on how the maximize  the value of the resource. One                                                               
way that might  happen is making sure to use  the seismic data it                                                               
has  collected  over  the  last   10-or-so-years  and  making  it                                                               
publicly available to  generate as much interest  as possible and                                                               
higher bonus bids. The option  for the legislature to appropriate                                                               
money  to the  Division  of Geological  and Geographical  Surveys                                                               
(DGGS) to  go out and procure  the state's own seismic  is within                                                               
its  purview and  the department  would support  that. "We  can't                                                               
make that decision ourselves."                                                                                                  
SENATOR  WIELECHOWSKI said  yes  you  can. You  can  come to  the                                                               
legislature say this is something we  need to do. Can they expect                                                               
that from  the administration or  is it simply not  interested in                                                               
pursuing it?                                                                                                                    
4:23:27 PM                                                                                                                    
MR.  KING replied  that they  haven't introduced  any legislation                                                               
that looks like that.                                                                                                           
SENATOR  VON IMHOF  asked  if  a bonus  payment  is one-time  and                                                               
royalty is on an annual basis.                                                                                                  
MR. KING answered yes, but the  royalty is based on the amount of                                                               
production and is paid monthly.                                                                                                 
SENATOR  VON IMHOF  mused  that  it appears  that  the state  has                                                               
seismic data  that it is selling,  and that it has  seen it prior                                                               
to selling it.  She wondered if the state  would ever incorporate                                                               
that  information in  the upcoming  special lease  sales that  he                                                               
mentioned earlier.                                                                                                              
She also can't help but muse  that while other states have higher                                                               
royalty  payments, they  also have  other attributes  that Alaska                                                               
doesn't  have, like  easy  access  to the  resource  and a  nicer                                                               
climate in which to work.                                                                                                       
4:25:34 PM                                                                                                                    
SENATOR MEYER said he was going  to say the same thing. It's hard                                                               
to compare  Alaska to the  Lower 48 where  one can work  all year                                                               
round  and  can  produce  oil   quicker  and  cheaper.  There  is                                                               
obviously less risk, because you know  the oil is there. Where as                                                               
in Alaska millions of dollars have been spent on dry holes.                                                                     
SENATOR WIELECHOWSKI  countered that  Alaska is  one of  the most                                                               
profitable places, on  a per barrel basis, in  the world compared                                                               
to North Dakota and Texas.  When ConocoPhillips' SEC filings have                                                               
come  out over  the  last several  years, he  has  asked for  the                                                               
numbers, and  on a  per barrel  basis Alaska is  one of  the most                                                               
profitable places in  the world, if not the  most profitable. The                                                               
same filings  indicate ConocoPhillips  made hundreds  of millions                                                               
of dollars here and lost a billion  down in the Lower 48 over the                                                               
last  few years.  Comparing it  to North  Dakota and  Texas, even                                                               
breaking  out the  oil, Alaska  is so  much more  profitable even                                                               
though the climate is tougher and  it's harder to do business. He                                                               
asked Mr. King,  "Do you disagree? Is that contrary  to what your                                                               
figures show?"                                                                                                                  
MR. KING  said he  needs to be  careful, because  any information                                                               
that is provided  to DNR that is associated  with the proprietary                                                               
rights of  a company is confidential.  He could say that  one big                                                               
difference in  Alaska versus  another region in  the U.S.  like a                                                               
Bakken  or Eagleford-type  play,  those plays  require  a lot  of                                                               
upfront capital  and have  a short  life. Whereas  a conventional                                                               
oil play  that was  more typical  in the 60s  and 70s  required a                                                               
large upfront  capital investment but  then had a long  life. So,                                                               
the billions  of dollars that  were spent to develop  and prepare                                                               
Prudhoe  Bay for  production were  spent and  recovered over  the                                                               
last  40 years.  There is  an important  difference between  when                                                               
these   different  capital   expenditures   are  recovered.   So,                                                               
recovering one's  investment right away  versus over time  can be                                                               
SENATOR  WIELECHOWSKI  said  since  Senate Bill  21  passed,  oil                                                               
production  is up  about 10,000  barrels,  but Texas  that has  a                                                               
royalty  rate  twice as  much  and  taxes  twice as  much,  their                                                               
production  has  increased to  2  million  barrels a  day.  North                                                               
Dakota, which has a  royalty rate twice as big as  ours and a tax                                                               
rate  twice as  much  as  ours has  increased  its production  by                                                               
500,000  barrels a  day.  "Would  you say  that  is something  we                                                               
should look at when evaluating our tax and royalty structure?"                                                                  
MR. KING  replied that in  these mostly  political conversations,                                                               
he would  as an economist suggest  they do look at  those numbers                                                               
and  all  the  other  factors  that impact  the  economics  of  a                                                               
project. But looking at just a  tax rate or any individual metric                                                               
out of  context will always lead  you down a path  that might not                                                               
be  completely accurate  in the  holistic view.  "If you  already                                                               
know the  outcome you  are looking  for, it's  very easy  to find                                                               
data to  support whatever  decision you want  to make,"  he said,                                                               
because it  is a  complex system  and there is  no right  or easy                                                               
4:31:35 PM                                                                                                                    
SENATOR BISHOP  commented that  production in  the Lower  48 just                                                               
goes to show what  easy access will do for an  oil field. On that                                                               
point, he  would like to see  how many companies in  the Lower 48                                                               
went bankrupt in the last four years over the low price.                                                                        
4:32:35 PM                                                                                                                    
MR. KING said collecting seismic  information can be done through                                                               
a permit; it  doesn't require a lease (slide 10).  If you do have                                                               
a lease, you are called a  lessee or working interest owner (WIO)                                                               
and  are required  to submit  a "plan  of operations."  A working                                                               
interest owner  has voting rights, contributes  capital, and gets                                                               
a share of the revenues.                                                                                                        
He said  that all the  permitting and the  work that needs  to be                                                               
done on  the surface  is done  by the  permitting section  of the                                                               
DOG.  When WIOs  find  a resource,  sometimes  it extends  beyond                                                               
their lease  borders. So, often  several leases overlay  the same                                                               
reservoir.  Early in  oil  and gas  law there  was  the "rule  of                                                               
capture:"  you  stuck a  straw  in  the  ground along  with  your                                                               
neighbor who was  also tapping that same reservoir  and sucked as                                                               
hard  as you  could. More  recently they  have allowed  for those                                                               
leases to join one another and  be managed as a single lease. So,                                                               
there aren't  competing property rights amongst  lease holders. A                                                               
lease  combined into  a  jointly managed  agreement  is called  a                                                               
unit. A  single unit operating agreement  provides for management                                                               
of   all   the   leases.  Unitization   provides   for   economic                                                               
efficiencies and  avoids waste. If everyone  is in a rush  to get                                                               
as much out  as they can as  fast as they can, it  can damage the                                                               
reservoir  and  leave  the  resource in  the  ground.  The  lease                                                               
remains in  effect as long as  it is in  the unit. The DOG  has a                                                               
Units Section  that manages and  ensures that the  agreements are                                                               
being  abided  by.  They  also have  support  from  the  Resource                                                               
Evaluation and  Commercial Sections to  make sure that  the plans                                                               
of development and activities that  are happening within the unit                                                               
are in the best interest of the state.                                                                                          
4:36:45 PM                                                                                                                    
Generally, a  unit has  a five-year initial  term (slide  12). If                                                               
the unit doesn't  get to production within those  five years, the                                                               
unit terminates. If  they do start drilling wells,  then the unit                                                               
can endure and get production, which  is what the state is after.                                                               
When a resource is found  under the ground, a "participating area                                                               
(PA)"  is  created. Ten  years  after  the  unit is  created  the                                                               
division has an  opportunity to "contract the  unit," which means                                                               
taking  out leases  in the  unit that  don't look  like they  are                                                               
going to contribute production.                                                                                                 
4:37:50 PM                                                                                                                    
The units have to do plans  of exploration (POE) as well as plans                                                               
of  development (POD),  which happen  every year.  It's typically                                                               
includes  things  like  how  many wells  are  being  drilled  and                                                               
facility  improvements  to  make   sure  the  resource  is  being                                                               
optimized. The  Resource Evaluation Team and  the Commercial Team                                                               
look  at  those PODs  and  make  sure  they are  consistent  with                                                               
prudent operations of management of  the land and optimization of                                                               
the  resource. If  the plans  are  deficient, they  are asked  to                                                               
amend them  before they can be  approved. If a unit  doesn't have                                                               
an active  plan of  development, then it  can be  terminated. The                                                               
plan of  development is an appendix  to the unit agreement  and a                                                               
unit without a  unit agreement has no effect, so  the unit can be                                                               
4:38:51 PM                                                                                                                    
DNR uses the  term "participating area" (slide 14) to  refer to a                                                               
reservoir, a pool, or field,  which all have different aspects. A                                                               
PA is  an area of  land that has  a resource that  is technically                                                               
and economically viable to produce.                                                                                             
Within a unit each of the  leases are converted to "tracts within                                                               
a  unit," which  are given  a factor  percentage, allocating  the                                                               
resource back  to the leases. So,  within a unit one  lease might                                                               
be  12.5  percent, another  lease  might  be 16.67  percent,  and                                                               
another lease might be an NPSL.  It is important to know when the                                                               
oil comes out of  ground where it came from for  the state to get                                                               
the right amount of royalty.                                                                                                    
MR. KING  explained that when the  unit is first formed,  and the                                                               
participating  area is  first  approved,  the department  doesn't                                                               
always  know  what the  subsurface  looks  like. So,  they  might                                                               
create a  tract factor  based on aerial  extents. When  it starts                                                               
producing oil,  models can  be run to  better understand  what is                                                               
happening.  Then  they  can reallocate  what  the  tract  factors                                                               
should be.  This is  called a  "redetermination." This  is rea;;y                                                               
important  when a  unit has  either multiple  owners or  multiple                                                               
royalty rates.                                                                                                                  
4:40:45 PM                                                                                                                    
He said  a lease is based  on surface acreage and  that line goes                                                               
all the way  through the core of  the earth. The PA  is one layer                                                               
of rock,  so it  is possible  for a  lease to  have participation                                                               
from multiple PAs.  So, the tracts have to be  allocated based on                                                               
each  PA. A  single lease  can have  contributions from  multiple                                                               
He said the  department wants to make sure the  state gets all it                                                               
is due,  so they  have an  accounting and  audit section.  As the                                                               
companies  are producing  they provide  reports to  the division.                                                               
The  accounting  makes  sure  those   reports  are  complete  and                                                               
accurate. The  lessee is responsible  for maintaining  books, and                                                               
the state has the right to audit them.                                                                                          
4:42:34 PM                                                                                                                    
CHAIR  GIESSEL asked  how  the Alaska  Oil  and Gas  Conservation                                                               
Commission (AOGCC) participates in the process.                                                                                 
MR. KING replied  that AOGCC's interest is in  the subsurface and                                                               
making sure that the resources  are protected and not wasted. DNR                                                               
is  the  owner and  manager  of  the  resource,  so they  have  a                                                               
SENATOR BISHOP said  AOGCC annually pulls a "prover  ball" out at                                                               
Pump  Station  1 and  measures  it,  because  that is  where  the                                                               
barrels flowing down TAPS are counted.                                                                                          
4:43:33 PM                                                                                                                    
MR. KING said  there have been questions about what  a Net Profit                                                               
Share Lease  (NPSL) is and  that 24 of  them are still  in effect                                                               
today. An  NPSL is just  like a regular  lease: it has  a royalty                                                               
term,  a  bonus  bid,  and  a  rental  payment,  but  it  has  an                                                               
additional term. An example might  be a lease that has one-eighth                                                               
royalty  plus  30  percent  of  net  profits.  When  they  "reach                                                               
payout,"  recovering all  their  development costs,  is when  the                                                               
state starts getting the NPSL payments, as well.                                                                                
4:45:05 PM                                                                                                                    
The department doesn't have to  worry about allocating costs when                                                               
an  entire unit  is  an  NPSL, but  the  allocation becomes  very                                                               
important when there  is only one lease within the  unit, and one                                                               
or two staff are dedicated to managing the monthly NPSL reports.                                                                
4:45:50 PM                                                                                                                    
DNR has  authority from the  legislature to reduce  royalty rates                                                               
only in  very specific instances,  either when a  producing field                                                               
gets to the  end of its life  and produces a lot  more water than                                                               
oil or  when a  marginal project  needs an  adjustment to  tip it                                                               
into  production.  He  explained  that at  some  point  the  12.5                                                               
percent royalty  becomes more  burdensome than  the value  of the                                                               
resource. So,  in those situations  DNR is allowed to  reduce the                                                               
royalty rate  as low as 3  percent. Another way they  are allowed                                                               
to  reduce  the royalty  rate  is  if  the shut-in  actually  did                                                               
happen, to encourage them to put it back into production.                                                                       
Finally, the  DNR is allowed  to reduce  the royalty rate  at the                                                               
front end  of a  project in  order to  tip a  marginally economic                                                               
project into  development. Usually  those terms  are front-loaded                                                               
to last  a year or  two and  once production starts  the original                                                               
lease terms will be reinstated.                                                                                                 
4:47:14 PM                                                                                                                    
CHAIR GIESSEL asked where they have given royalty relief.                                                                       
MR. KING  replied that DNR  has two royalty relief  provisions in                                                               
Oooguruk and  Nikiatchuq. A  third royalty  relief was  issued in                                                               
the Nuna  development, which is  also part of the  Oooguruk Unit.                                                               
It expired before  it reached production. So,  they are expecting                                                               
when an  investment decision is  made, they will most  likely ask                                                               
for that  relief, again.  Then it will  have to  be re-evaluated.                                                               
The  legislature through  statute  also reduced  royalty in  Cook                                                               
4:48:08 PM                                                                                                                    
SENATOR  MEYER asked  if the  operators of  those fields  he just                                                               
mentioned are Caelus or Eni.                                                                                                    
MR.  KING replied  that Eni  is  the operator  at Nikiatchuq  and                                                               
Caelus is the operator at Oooguruk.                                                                                             
SENATOR  BISHOP commented  that the  Nuna rate  modification also                                                               
had an Alaska-hire provision.                                                                                                   
4:48:58 PM                                                                                                                    
MR.  KING said  the  Commercial Team  does  an economic  analysis                                                               
(slide 18). One of their other  functions is to make the decision                                                               
on  whether they  want  the royalty  in kind  (RIK)  or in  value                                                               
(RIV). The state  has the right to either receive  barrels of oil                                                               
or receive the  cash equivalent of those barrels.  An analysis is                                                               
done  looking for  buyers  and if  a buyer  is  found that  would                                                               
generate  more revenue  to the  state than  what the  operator is                                                               
getting  at that  production area,  they enter  into a  contract.                                                               
That  tends  to be  the  case  with oil,  because  transportation                                                               
deductions are allowed back to the  wellhead and that is the rate                                                               
the  state uses  to calculate  the value  of the  oil. By  taking                                                               
physical possession of that oil and  not have to pay the shipping                                                               
cost, the state can usually  generate a little bit extra revenue.                                                               
This  is what  the state  team does  when they  talk to  in-state                                                               
refiners.  DNR's  negotiating  team   is  responsible  for  those                                                               
MR.  KING said  the value  of  the oil  depends on  where it  was                                                               
produced  in  the state.  Slide  20  displayed  a list  of  price                                                               
differences in transportation costs with all else constant.                                                                     
4:51:31 PM                                                                                                                    
SENATOR WIELECHOWSKI  said the total  numbers for NPR-A  and ANWR                                                               
are the  same and asked  why the unrestricted general  fund (UGF)                                                               
number is so different for those two.                                                                                           
MR. KING answered a provision  in the NPR-A restricts all revenue                                                               
to the state to the  NPR-A Impact Fund. The continuing resolution                                                               
that allowed  a lease  sale in ANWR  didn't include  the language                                                               
that  would restrict  those  funds.  So, the  50  percent of  the                                                               
federal take  that is  shared with  the state  would flow  to the                                                               
General Fund and to the Permanent Fund.                                                                                         
SENATOR WIELECHOWSKI said a lot  of his constituents want to know                                                               
what the federal royalty rates are in ANWR.                                                                                     
MR. KING answered that 50 percent  of the proceeds from the lease                                                               
sale that will happen  in ANWR will flow to the  state.  Of that,                                                               
half goes to the general fund  and half would go to the Permanent                                                               
Fund with  the caveat  that one  half of one  percent of  that GF                                                               
money has to flow to the Public-School Trust Fund.                                                                              
SENATOR WIELECHOWSKI  asked why  half goes  to Permanent  Fund in                                                               
that case instead of 25 percent.                                                                                                
MR. KING replied  because the leases are after  1980, a statutory                                                               
provision requires a 50 percent contribution.                                                                                   
SENATOR WIELECHOWSKI  asked if  the state would  get half  of the                                                               
bonus lease, which it could be billions!                                                                                        
MR. KING responded that they hope it will be.                                                                                   
SENATOR WIELECHOWSKI  asked if the  federal royalty rate  is 12.5                                                               
MR. KING said he would have to double-check.                                                                                    
SENATOR WIELECHOWSKI asked if the  state gets half of the federal                                                               
royalty rate.                                                                                                                   
MR. KING  answered yes. The company  pays its royalty to  the BLM                                                               
and  then BLM  cuts  the state  a  check for  half  of what  they                                                               
SENATOR WIELECHOWSKI  asked if they  have the same  provision the                                                               
state has to deduct transportation costs from the royalty.                                                                      
MR. KING  answered yes.  He wanted to  illustrate that  where the                                                               
oil comes  from really  does matter  in terms  of revenue  to the                                                               
state,  because areas  that are  further away  from TAPS  require                                                               
more  transportation and  areas  that are  more isolated  require                                                               
more costs.   Additional  factors will  complicate this  a little                                                               
bit more.                                                                                                                       
4:55:12 PM                                                                                                                    
SENATOR WIELECHOWSKI asked if he had  a sense of the timeline for                                                               
the ANWR lease sale.                                                                                                            
MR. KING  answered they hope to  have it together for  next year,                                                               
but they have four years to get the first sale.                                                                                 
SENATOR WIELECHOWSKI  asked if  it would have  to go  through the                                                               
NEPA process.                                                                                                                   
MR. KING  replied that no  infrastructure is being  developed, so                                                               
there is  no actual  project that  would need  to go  through the                                                               
NEPA process right now. Once  oil is discovered and someone wants                                                               
to develop it, going through NEPA is likely.                                                                                    
SENATOR  COGHILL   commented  that  the  original   agreement  at                                                               
statehood was the 90/10 split for  ANWR and that has been a point                                                               
of contention.  Many feel that Congress  unilaterally changed it.                                                               
But that  is probably the deal  that got it passed.  He commented                                                               
we can't change it, but it seems like they can.                                                                                 
4:56:36 PM                                                                                                                    
SENATOR  MEYER  listed  seven  operators:  Savant,  Eni,  Caelus,                                                               
Hilcorp, BP, ConocoPhillips, and ExxonMobil.                                                                                    
MR. KING  added Glacier is the  operator at the Badami  unit, not                                                               
Savant any more.                                                                                                                
SENATOR  MEYER  said  it  seems like  we're  making  progress  in                                                               
attracting smaller companies  to Cook Inlet and  the North Slope.                                                               
The number of operators has doubled.  But it's still not the most                                                               
profitable and  easy place to make  money. If that was  the case,                                                               
there are thousands  of oil companies worldwide and  they are all                                                               
in it to make money, and the state wouldn't have to offer tax                                                                   
credits if it was that lucrative.                                                                                               
MR. KING added that Brooks Range Petroleum is an operator of the                                                                
Mustang Unit and they are not in production. Armstrong operates                                                                 
the Pikka Unit.                                                                                                                 
SENATOR MEYER said he was referring to producing companies.                                                                     
4:58:42 PM                                                                                                                    
CHAIR GIESSEL thanked Mr. King for his presentation and finding                                                                 
no further business, adjourned the Senate Resources Standing                                                                    
Committee meeting at 4:58 p.m.