Legislature(1995 - 1996)
04/24/1996 08:15 AM House RES
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* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
HB 548 - NORTH STAR OIL & GAS LEASE AMENDMENT Number 050 CO-CHAIRMAN GREEN said the committee would hear from the Department of Natural Resources as to the economic analysis they have performed on the Northstar project of which British Petroleum (BP) has brought a considerable amount of interest to the state with their proposal for an offshore operation. He asked Kevin Banks to come forward to testify. Number 084 KEVIN BANKS, Petroleum Economist, Division of Oil & Gas, Department of Natural Resources (DNR), advised the committee he would be talking about four things that relate to the model, the most important he thought was the assumptions the department uses to develop the forecasts of state revenues and the economics to BP. He provided committee members with a list of assumptions and a simple version of a cash flow model to illustrate the main pieces and to show how the arithmetic in the model works. He said, "Basically, the model is a cash flow model that predicts what kinds of revenues come to BP and to the state and federal government and from that we can make an assessment about the profitability of the prospect to the company and get some prediction of the kinds of revenues the state can earn whether through severance taxes, income taxes, royalties or others." Number 221 MR. BANKS continued, "The model as I say is a cash flow model; it would be the same sort of thing that economists would use for public works kinds of projects to predict benefits and costs and then to calculate the distribution of those benefits and costs to the different players. The state, of course, doesn't participate in the costs, so to speak; that's the obligation of the lessee, but we do earn revenues from taxes, income taxes, severance taxes and royalties and on these leases, we also earn net profit shares. That's the part of the leases that we are changing in the amendments and then we can see the effect of that change on revenue to the state. The most important assumptions we make about the field are how much oil is there in terms of the reserves available to produce and also, what kind of production rates we can expect from those, how many wells you need to produce a certain amount oil and then how quickly that production rate can be sustained and then it begins to drop off. That's the aspect of reserves that's important." MR. BANKS stated, "Then we have to make some kind of assumption about price. In this model, we used the Department of Revenue's mid-case forecast and deducted from a West Coast North Slope oil price a forecast of marine transportation costs and tariffs on the TAPS pipeline. The third most important aspect of the model - the one thing you have to grab a hold of is the cost of developing the prospect....basically, the capital expenditures needed to construct the island, install the facilities, build a buried pipeline to shore, the operating costs, the everyday variable costs and fixed costs it takes to get oil out of the ground and expect to have to pay for wages and fuel and equipment through the life of the prospect and then also abandonment costs, some assessment of what you believe it will cost in the future to remove the equipment and to dismantle the island." Number 319 MR. BANKS further stated, "In the assumptions that we make the model that we used in assessing the deal throughout the process of negotiating it, we used some information that BP supplied to us. In the printout you have here and when you receive a copy of the model assumptions - the list of model assumptions - you'll see there's a couple of places where we've changed some assumptions. So this becomes now, a public version of the model. We've redacted from the model, a couple of items that BP felt were sensitive - internal financial and pieces of information. Among those are the income tax rates they pay to the state, the discount rate they use for calculating the present value of the prospect, the prime rate of interest, whatever that is, that applies to the calculation of the net profit share and their calculation of abandonment costs. Those have been redacted and we've replaced them with numbers that we could come up with on our own. For example, after talking to my counterparts in the Department of Revenue, we applied an effective state income tax rate of 2 percent. The statutory marginal rate is about 9.4 percent, but I'm told that the industry average for oil companies is about 2 percent. So that's the number you will see in the list of assumptions and when we get to the model, you'll see where it shows up there. The prime rate used for calculating the net profit share is from the Daily News; 8 1/4 is the current real prime rate at the moment. We've taken from the Arthur D. Little report that was done for the Governor's Oil & Gas Policy Council, a discount rate of about 10 percent. That discount rate is important only in calculating the net present value of the prospect, which an issue as far as calculating sort of revenues to the state, given the timing that those revenues are earned. In most of the documents that have probably reached you about this, there hasn't been a lot of present worth calculations shown. BP in their proposal has shown the total value of the prospect or revenues to the state in inflation adjusted dollars and we've given you some information that shows what it is in real 1996 dollars." Number 446 MR. BANKS continued, "Moving on to the simple discounted cash flow, this basically illustrates the kind of arithmetic that is going on in the 10 pages of this very hard to read printout. Basically, we need to know what the oil is. From that we deduct royalty oil, here it's calculated at 12.5 percent, and the remaining oil - the working interest oil that the lessee has to make their money on. So right off the top the state gets their royalty. And from the Working Interest Owner (WIO) then, this is the lessee, from their revenue they have to pay for capital expenditures, operating expenditures and to calculate their net revenues. Simple arithmetic - from revenue minus costs, equals net revenue. That's their taxable income and from that we take away their federal income tax and state income tax to get an after tax cash flow. I think, as an economist, I might call that profit, but I know accountants don't look at it quite the same way. I want to just leave you with the point that I was focused more on this revenue stream rather than some kind of financial analysis or impact that this prospect would have on say, an income statement or balance sheet which is something the accountants are thinking about. This is basically an illustration of how the big model works. Nothing to it really. There's nothing terribly more complicated than a little bit of multiplication and subtraction here. We do calculate a net present value of the stream of after tax cash flows that as you see on the bottom of this page - the net present value discounted at 10 percent is, in this case, it shows $1.50 and the rate of return is 11 percent." Number 547 CO-CHAIRMAN WILLIAMS asked Mr. Banks how he got the oil price? MR. BANKS replied, "This little model, Chairman Williams, was a `right out of the air' example to show you. The model itself, while covering lots of pages and lots of calculations, it really isn't rocket science. I suppose if I were a rocket scientist, I could say it wasn't brain surgery. I mean it's not very -- it's not something that involves some sort of mystery." Number 577 MR. BANKS added, "The model basically has three parts to it. In the first page, is where we make some of these assumptions that I first talked about - the reserve, the production rates, the number of wells that will be needed, the capital expenditures, assumptions about operating costs and tax rates - that's all done here on the first page. The second part of the model on pages 2 and 3, especially page 3, represents the results. The calculation of state royalty and income taxes and also the cash flow to BP and the federal government. I might add that you have in the box on the top of page 3, which has "$m,MOD"; that's money of the day, that's in inflation adjusted dollars or what economists will sometimes call nominal dollars and then of course, down below in the second box is real numbers; that would be real 1996 dollars not accounting for inflation. The third part of the model is what follows and that's basically all the financial calculations it takes to get to this page. I'll point out just a couple of things. Returning to the first page, the little box in the top left are most of the assumptions about federal income taxes and interest rates and the calculation of abandonment. There are a couple of boxes - the three smallest boxes on this page, the ones entitled "Supplemental Royalty Control Panel" and the "MonteCarlo simulation" are basically, I call them switches that gives us an opportunity by changing whether or not we want to look at NPSLs, switch that to on and the rest of the model will then calculate a net profit share. I switch that off and the supplemental royalty to on, it will go through and calculate the supplemental royalty. The long rectangular box towards the bottom in the middle is where we get into the assumptions about production, capital expenditures, the price of oil and the tariffs that we are deducting from the West Coast prices." Number 719 CO-CHAIRMAN GREEN asked, "When it comes to numbers of wells drilled and operating costs and costs of oils, are you getting that from the operator or are you doing those on your own?" MR. BANKS said, "I would have to say that the capital expenditures information was given to us by BP. We looked at them, however, did not do an independent engineering study of that. I can say that with respect to the reserve estimates, our staff had quite a bit of information from the previous owner, Amerada Hess, that had been provided to us through the years and we actually had a more independent assessment of the capability of this oil field to produce the oil that BP had said they could. There is a distinction in the level of scrutiny that we could give to that. We simply just don't have in-house, the engineering staff that BP has. Furthermore, I think BP is extending the envelop on capital expenditures, as you are well aware. We do have some information about historical costs on the Slope, which would have been higher than all of these. That would be our immediate assumption would be to say, `Well, if there is an attempt to illustrate to the state that this is somehow not a project that they could do, they've low- balled the estimates for capital expenditures' which would indicate to me that there was not an attempt to gain the (indisc.) some way, at least on that account here." Number 806 MR. BANKS further stated, "Page 2 has a whole list of oil prices and the model took the Department of Revenue oil price forecast for each year and then interpolated a smooth growth in prices for each month. The reason for that is that the supplemental royalty is paid on a monthly basis. So we wanted to capture the effect of changing oil prices each month and the impact that would have on the calculation of supplemental royalty. I'll get into this later, but there's actually a couple things happening on this page. In a single run of the model that we would look to say the prices -- I'm looking in the column for 1999 for example, for January -- the very first price in that column is $17.39, so in January we would assume possibly some -- I can't say that for sure but that's the price that would be used to determine the supplemental royalty, if the state were due that. Down below that January 1999 number, in the second set of rows that's shaded, that number is actually calculated as a part of a distribution of randomly generated prices. So if you wanted to see the impact of varying prices over time, the number that would appear here represents just one run of the model. We have the capability of running the model 200, 300 times to create a distribution of results. If you'd like, I can get into that in more detail later. The supplemental royalty, then, is calculated for each month and an average supplemental royalty is calculated for the year. And then that's the number we use to gin up the final calculation of the value of supplemental royalty to the state." MR. BANKS continued, "Page 3 is where we get all the results. As I said before, we passed out to you and to the Senate, information about what we believe is the potential forecasted revenue to the state and it's simply the sum of these rows which are added up on the righthand column. You can see that we're looking with a fair amount of detail - probably more detail than we can objectively say is -- or at least with precision that's probably beyond our capability to know about the future, but we can tell you some things about severance taxes, ad valorem taxes and the share of royalties we get from the federal tracts in the prospect and income tax to the federal government." Number 958 CO-CHAIRMAN GREEN remarked, "Collectively though that number of things are pretty minor, I would imagine compared to the total value." MR. BANKS replied, "I think you can see from this that the state gets their biggest bang from royalties right off the top. Severance taxes, because the effects of ELF are not very high and income taxes are relatively minor. Ad valorem taxes, by the way, in some of the discussions that I've had with people, we've assumed that most of that - 75 percent of that probably goes to the North Slope Borough. That's just a rule of thumb." Number 963 MR. BANKS noted, "On page 6 - this will be basically the last detail of the model I'd like to point out - is a calculation of the tract allocations. So, you've heard us talk about the net profit share rate at about 89 percent. That represents a weighted average of the net profit share for each of the leases weighted by the amount of reserves that we have tentatively allocated to each lease. This shows that, for example, the federal leases have about 20 percent -- 23 percent of the oil on those two tracts to the north and they bear a 16 2/3 percent royalty to the feds. The state, in turn, gets 27 percent of that back as part of the (indisc.) Lands Act statutes." MR. BANKS remarked, "I've mentioned just very briefly that we have this capability of sort of varying the assumptions to some degree so that we can run the model repeatedly to create a distribution of results. It's not an uncommon process - it's called MonteCarlo, actually. It was invented in the very early `50s to predict whether or not the hydrogen bomb would work before they built it. I think a good way of describing it is - to give you a clue about how the mathematician discovered how it worked - he was playing solitaire and realized that after he'd played a few cards that he could predict the result of the game - whether he would be able to beat the solitaire game or not. So by just looking at the variation of a couple of things at the very beginning, you can get a notion of where you might be towards the end. And that's sort of what MonteCarlo does. It gives us the opportunity to randomize our expectations about capital expenditures, operating costs, particularly oil prices in this model, and the reserve estimates. So on page 2 there's a little box called, `Development Summary MonteCarlo' and you see that the ML for reserves in this case - ML is the most likely - 130; however, there's a max and a minimum of 105 million barrels and 160 million barrels is considered the maximum. We do the same sort of thing for oil prices and that's illustrated in this page - the graphic here. What we've done is that we've assumed that prices will vary each month according to some kind of normal distribution, that there's an equal chance of the prices being higher or lower than what we think is the average. However, what we are randomizing in that is the standard deviation and that is represented by this little triangular box. Historically, prices have varied - that standard deviation has varied between about $1 and $7 with an average of about $1.80. Now that says that the chances are - about 70 percent of the time, the oil price will be either - our average prediction plus or minus $1.80. That's simply what we're saying so the model is allowed to vary that by that kind of deviation from the average. That's how we crank in what I think you can all attest to, the kind of variation you see in oil prices from month to month as it goes up ad down with the markets. Fairly unpredictable variation, so we don't know or we can't predict with any certainty why prices go up and down ahead of time in these short little run ups and downturns. But this gives us an opportunity to say, `Well, within these boundaries we know the prices may sometimes exceed the average by $7 at least 30 percent of the time -- 35 percent of the time -- and may fall below that at times. That has an impact of turning on the supplemental royalty, in fact, every now and then as the price exceeds the trigger price and so you've seen a couple of numbers I think, for supplemental royalty. The supplemental royalty with price volatility is what we mean here - that we've racheted on the supplemental royalty and triggered that event by this kind of variation." Number 1267 CO-CHAIRMAN GREEN said, "That would explain fluctuations due to something beyond the control of the state or the operator. What about the variation on a long-term basis from prognostications such as you said you were being driven by the Department of Revenue's long range oil forecast. Sometimes those long range oil forecasts have a tendency to either be more optimistic or pessimistic. Does this take into account any long range or is it strictly based on the fluctuation along the line that's established?" MR. BANKS said it was the later and added, "The Department of Revenue has predicted that oil prices in real dollars will increase about three-tenths of a percent each year over the next 15 years or so. So there is a slight inflationary effect that they are predicting or an effect that would exceed inflation by a tiny bit. It's almost flat but it has some rise to it so you'll see, for example, in the prediction of the West Coast oil price, in the year 2010 for example, this is a nominal dollar but it's $26.82 and that reflects this tiny bit of growth in real oil prices plus 3 percent or so inflation rate. The trigger price grows at half of that rate or about 1.5 percent of our assumed -- an inflation rate of 1.5; roughly half of what we assumed that's occurring here. The fact is, there is some growth in real oil prices predicted by this model. I can tell you that in the course of going through the negotiations we looked at what happens when the prices are flat. What that does is it turns on the supplemental royalty a little bit earlier or rather delays the supplemental royalty a little. That's really all I have to say about the model and I hope I've raised some questions that I can answer for you." Number 1393 REPRESENTATIVE ALAN AUSTERMAN referred to page 3 and said, "In reading the real dollar figures, indicates to me that this is a 15 or so year field?" MR. BANKS said, "That is correct. The end of field life is 2011. That's as you say, just 15 years of production." Number 1427 REPRESENTATIVE AUSTERMAN referred to the righthand column on the outside of the boxes and asked if those were the numbers that should be looked at for total (indisc.)? MR. BANKS responded that was correct. Number 1440 REPRESENTATIVE AUSTERMAN asked if the bill that was before the committee was based on this model? CO-CHAIRMAN GREEN said, "Well, we have another -- unless you would care to answer that - we have another member of DNR that might want to discuss that. The economics are based on this. The bill and the negotiations as it were, is that what you're getting to?" REPRESENTATIVE AUSTERMAN responded affirmatively. MR. BANKS replied, "What you have here is the public version. There are a few - as I mentioned earlier, Mr. Chairman, there are a few assumptions that we've changed to protect BP's financial -- basically information that's confidential to the firm which we have allowed that they could keep secret. As a result, some of the numbers, some of these totals, will be different than the information that we have produced for you. The basis on which we negotiated the deal was using their confidential numbers." REPRESENTATIVE AUSTERMAN asked if the assumption could be made that BP's numbers would be higher? MR. BANKS replied, "In this particular instance, as I look at it, we have -- the differences that I've reported total income to the state with the supplemental royalty to be $435 million and you can see here that's it's $424 million. The biggest effect in this particular run is on income tax." Number 1545 CO-CHAIRMAN GREEN said he had a few questions that were based on "what if" cases and was aware that the MonteCarlo sort was supposed to address that, but it's limited within the parameters that it's given. He wondered, "if you ran just an arbitrary case with a greater inflation of prices than the one that Department of Revenue (DOR) has. For example, back 20 years ago there were price estimates that by the end of the century oil would be $60 or $80 a barrel, so obviously they were wrong. But instead of a growth rate that is essentially flat with a slight increase due to inflation, did you run one that says there could be some problems with oil supply and therefore over the next 16 years or 18 years or whatever this project is going to go, that we could see a 5 percent increase (indisc.). So, just as a "what if." MR. BANKS responded, "Mr. Chairman, the answer to that question is that at one point in the process of evaluating the deals, as we played the tennis match, we looked at the DOR high priced case, the mid-price case here and a low price case and in the DOR high price, there is an assumption of greater real growth in prices and a higher inflation rate. Something like 4.5 percent instead of 3.2 percent which is in their mid-case. So, yes we did see -- the impact of doing that obviously has an impact on the value of the supplemental royalty and net profit shares; both go up as a result." Number 1669 CO-CHAIRMAN GREEN asked, "And is it fair to ask -- obviously we realize that some of that information is proprietary, but was there a sensitivity to that of significance. In other words, when you went up at 50 percent increase -- roughly, I think is what you indicated to us -- in the inflation rate, that would affect both the supplemental royalty and the net profits and was that effect of significance?" MR. BANKS said, "Let me try to give you an illustration. You have to remember that this model -- and it may be apparent to you by looking at it -- a (indisc.). It's because it started out in the fall as a fairly simple spreadsheet and as we went along, it got more and more complicated, and stuff was simply added to it as our refinements were added - the oil price forecasts and so forth. The point I'm trying to make is that when we did those kinds of runs in early March, we were using a version of the model that was slightly different than this and different only in the calculation of abandonment costs and how those abandonment costs affect net profit share. Now having said that, this model produces a net profit share amount which is slightly less than what we were working with in the course of negotiating. So, let me try to give you an idea. I have results from those sensitivities and I'll try to give you an idea of where we ended up." Number 1777 MR. BANKS continued, "The supplemental royalty in the high priced case - just assuming that the DOR numbers were what we were looking at - went from, I believe we had a number like 37 million and in the high priced case, it went to 102 million. In the low priced case, there is no supplemental royalty. With respect to net profit shares, this model produces a number and we've shared with you a number of about 85 million as the approximate calculation of net profit shares in 1996 dollars in the most likely case. In the high number, it's going to be something in excess of about 2 l/4, I'd say. I'm hedging here because I know for a fact that this model, if I were to run that again, would produce a number that's different than the one that I did in early March. But I think roughly speaking if the proportions are the same, that's the kind of difference that would happen." Number 1860 CO-CHAIRMAN GREEN said in the low case net profits also were zero. MR. BANKS confirmed that. CO-CHAIRMAN GREEN asked, "Would it be a fair assumption -- and I know this is drawing on something you may not want to answer -- if instead of the 50 percent increase, would this be linear or exponential, do you think? These number, for example, the high case going for 100 million, more than doubling, if you were to double the rate of inflation, would we expect say a fourfold increase in net profits or is that beyond what you want to stretch your...." MR. BANKS said he rather not because he only had two estimates to make that prediction. CO-CHAIRMAN GREEN asked if it was a fair assumption that it is sensitive to that? MR. BANKS responded both supplemental royalty and net profit shares are sensitive to it and it would appear -- that the net profit shares, at least on the high side is more sensitive to a price increase over time. Number 1953 REPRESENTATIVE AUSTERMAN inquired about the prices of oil on page 2. MR. BANKS responded, "The Department of Revenue forecast is, I think it's 3.2 percent for the first couple of years and then 3.0 percent thereafter. No, vice versa - 3.0 through about 1999 and then 3.2 percent inflation through the remaining period. There's also a tiny bit at three-tenths of a percent growth in real prices. So the number you see, as I pointed out, 2010 is 26.41. That represents what an accountant would see when he opens up the newspaper in 2010. So it represents a number that includes some inflation over time and a tiny bit of growth in real prices." REPRESENTATIVE AUSTERMAN inquired if these were the Department of Revenue figures. MR. BANKS confirmed that. Number 2022 REPRESENTATIVE AUSTERMAN asked if that compared with the last 10 years - from 1986 to 96 figures and is that basically what the percentage of growth has been? MR. BANKS said he had looked at the last 10 years and there is no reliable correlation between time and price. Number 2073 CO-CHAIRMAN GREEN asked, "We've found there is some sensitivity to crude price. Did you, in these runs where you had difference in ultimate recovery, did you also vary the rate during those cases in order -- did the project expand in time or in production rate or both?" MR. BANKS stated, "We did some forecasts like that for the Senate Resources just last week - week before last. In those assumptions, in the high side - they had asked specifically for a total recovery of about 180 million barrels which is outside the 160 that we had capped in the model. And we did predict that the production rates at peak rose from 50,000 barrels a day to 80,000 barrels a day and then dropped off rather suddenly after that to get us to this same end point. In each case, that 15 year assumption was held, except in one run at a very low production where you hit the same peak (indisc.) 50,000 but then the field is exhausted prematurely or sooner than 2011." CO-CHAIRMAN GREEN questioned, "Did you, from those runs, find a sensitivity that would affect the comparison between supplemental royalty and (indisc.)." MR. BANKS responded, "As I'm looking this up, Mr. Chairman, I want to add that increased production comes at a fairly high cost. The most likely case represents what kind of facilities you perceive you can put on the island initially and that in order to achieve higher rates, it's my understanding that those facilities have to be beefed up by quite a bit and may even require importation of, from other fields, substances that are used to inject into the ground to lift the oil. So there are -- it's true that you might be able to get greater production, but it will come at a cost that has a significant impact on the payout of the net profit share." Number 2287 CO-CHAIRMAN GREEN commented, "I can certainly see that if you time constrain it, but if you were to say that there's more oil there and you may have a few additional wells, but in effect what you could do is rise to the truncation of your erroneously low production and keep that truncation for a longer period of time; similar to what happened at Prudhoe. Obviously, Prudhoe Bay was capable of producing far more than 1.5 million per day, but that was the MER that was established and so that rate was continued over several years whereas it might have gone way up which would have increased the amount of paraphernalia that would have been required to do it. But by not doing it, they just kept what they had and were able to continue the rate which while it does increase the length of time, it still may have a significant sensitivity to the total economics. Did you by chance run anything like that?" Number 2363 MR. BANKS replied, "We were a little bit more optimistic, Mr. Chairman, in terms of how long the rate could be sustained than BP when we had these discussions with them. However, I would have to say that no, that was not a consideration -- sustaining say 50,000 barrels for a longer period of time in order to achieve those higher rates." Number 2400 REPRESENTATIVE DAVIES commented he would be interested in knowing what the results of such a run would be. CO-CHAIRMAN GREEN agreed and added, "Because there may be again a fairly significant sensitivity to that. Now I can understand if you have to beef up facilities so that your capital expenditures skyrocket with an additional.... TAPE 96-66, SIDE A Number 001 MR. BANKS stated, "...royalty. Insofar as you can lengthen field life means that the inflation has caught up with your trigger price. Recall now that the trigger price is inflating at only half of what the inflation is. So the model will produce 7.5 percent supplemental royalties in those out years consistently, assuming the prices (indisc.) as we predicted they would. I think in the model here you can take a look, but you'll see that, I think, in the last four years or so, we're hitting the 7.5 percent all the time, while obviously, if you can continue production beyond that, that will add 7.5 percent of supplemental royalty each time you're charged for it." Number 100 CO-CHAIRMAN GREEN remarked, "It may not be as effective on the net profits, then. If what you're saying is case, if costs are going to trail with an increase in crude price, then that would adversely affect net profits more than it would the 7.5 supplement?" MR. BANKS responded, "I'll speculate and I believe that actually -- you have to keep in mind that we're getting 90 percent of everything over and above what it takes to get the oil out of the ground in the net profit share. So, I would speculate that the net profit share would turn out to be much better in a case like that." CO-CHAIRMAN GREEN remarked, "In additional recovery...." MR. BANKS interjected, "In terms of additional revenues." Number 150 CO-CHAIRMAN GREEN inquired, "Much better meaning, much better than the base case or much better than the supplemental royalty case?" MR. BANKS noted, "Much better than the base case." Number 161 CHAIRMAN GREEN questioned, "How do you speculate it would affect or -- what we're trying to do is maybe get from you a speculation that may avoid asking you to make a run. We may ultimately do that, anyway." MR. BANKS commented, "Maybe it would be best that we do a run like that because then we can avoid misunderstanding." Number 206 REPRESENTATIVE DAVIES referred to the numbers that were given to the Senate and asked what the sensitivities were to the assumptions on the total amount of recovery. Number 241 MR. BANKS said, "Mr. Chairman, they asked us to give them some estimate of what would happen to the field if you were producing at 160,000 million barrels as the top case - sorry, 190,000, I believe it was. And we had supplemental royalties in that instance and I recall that things are dropping off at the end of 2011 of $49 million under that case. In the case for net profit shares, we assumed that production start up would be delayed and that would produce a $217 million net profit share. So that's the comparison for the 190 million barrel case." CO-CHAIRMAN GREEN inquired if that was based on the most likely crude price. MR. BANKS responded affirmatively and added, "The only thing we're changing is reserves and the capital expenditures together." Number 333 REPRESENTATIVE DAVIES remarked, "And also the assumption here is that the rate goes up to keep the time constant." MR. BANKS said that was correct. REPRESENTATIVE DAVIES said he would like to get one that looks at the other case. Number 353 CO-CHAIRMAN GREEN asked if it would be a fairly easily accessible model. MR. BANKS responded he could have something for the committee perhaps by the end of the day. CO-CHAIRMAN GREEN stated, "If we could do that and I would also like to see if -- just for -- I mean, you can always decide whether it's likely or not, but it's good to know -- if we could do what you did for -- just for the base change in price that you would do that as well with this increase in recovery so that you would have both the -- the new case then would show an expanded rate without - - expanded time to get the additional oil and it would also show that this is the most likely crude price -- what if we were to find crude prices going up or inflation going up at I think you used about a 4.5 percent. Again, we're not trying to nitpick, we're just trying to get a feel of sensitivities." MR. BANKS replied, "okay." Number 434 REPRESENTATIVE RAMONA BARNES said, "In your presentation, you said that you knew a lot about these leases because of Amerada Hess holdings of these leases previously. And assuming that you knew a lot about them, then did you not also assume that BP knew a lot about them when they purchased them?" MR. BANKS replied, "We had available to us, information that was supplied to us by Amerada Hess as a result of their plans of development in the course of developing the field or drilling. Some of the -- I think Mr. Boyd can give you more of the details, however, we had information on wells and their development costs as well that was not acquired by BP until they bought the property." Number 527 KEN BOYD, Director, Division of Oil & Gas, Department of Natural Resources, confirmed that Mr. Banks was correct. He commented, "As Kevin said, we had the data and we would get the seismic data that they shot as soon as they shot it. We would get that right away because that's part of the law. But BP would not. The same thing is true of the wells; we would have gotten the wells as part of the plan of development. They were held confidential for a certain number of years. BP sort of bought this as a kit. They got the Northstar kit with engineering studies, the seismic data, the wells -- here's your money - here's your Northstar kit. Good luck because we thought it was going to cost a billion and a half dollars to develop and go see what you can do." Number 584 REPRESENTATIVE BARNES said, "Well, having said that, you don't suppose that BP would have bought it if they thought they were buying a pig in a poke, would you?" MR. BOYD responded, "Mr. Chairman, I believe you'd have to ask BP that. I certainly hope not." REPRESENTATIVE BARNES continued, "But you would think that BP would have known that the way the leases were written, would you not, that there were net profit sharing as well as your royalty written into them?" MR. BOYD replied, "Mr. Chairman, I should back up. By the time BP bought the package, I presumed that they had seen the wells -- three of the wells were public domain. There's still one that's held confidential in this other lease and perhaps had been given a demonstration or been shown the seismic data - probably the maps of the structures and things. So I think BP was fairly well informed. I mean, you can ask them as to what they were shown, but typical of these sort of deals, when someone is trying to sell something, they're not going to (indisc.), but they're going to show it (indisc.) as possible. So, I believe the answer to your question is yes." Number 654 REPRESENTATIVE BARNES said, "Well, if they knew what we know today in the testimony before this committee and other committees exactly what those leases provided for and now they're saying a very short time later that they can't develop them under the scenario they purchased them under, do you have any idea as to why they purchased them?" MR. BOYD responded, "It's a better question for BP, but I believe in previous testimony they say they took a chance. They bought this and said. `Gee, I hope we can go to the state and make a deal and if we can't,' -- I don't know what they would have done. I believe it's a better a question for BP as to what their motive was for buying -- again, in testimony and I don't want to short change BP on this, but they said they thought maybe they could make a deal and that's what they're trying to do." Number 713 CO-CHAIRMAN GREEN commented, "Not speaking for BP, but I think another reason is that they have a history on the North Slope of being able to develop projects at less value than other operators. I know they did that at Endicott and that may have been another thing that drove them, thinking, as Director Boyd had indicated, the original concept was that this was going to cost a lot more than I think now BP feels that they can develop it for. So, therein may have been their ace, thinking, `We'll get this thing and do it at a less up-front money, therefore we can make money.' But that again I think, probably would be a question that we need to ask BP. But it's a combination of things when you're making these kinds of investments." Number 771 REPRESENTATIVE BARNES asked Mr. Boyd to explain how the net profit sharing is different in these leases than in other leases. MR. BOYD said, "I'll let Kevin get into the egregious details but they're not different. It's just a high enough profit share. It was the bid variable for the lease which does make it different. It was actually the bid variable in the sale. When companies were bidding, there was a fixed bonus, there was a fixed royalty and variable. The thing you won with was the net profit share and the net profit share win - it was slightly different on each of the four leases, but it was about 90 percent - 89 percent. Some were 78, some were 91. But that was the number that won. If you bid that high number, you got that. Now that's different than net profit shares in the sense of oil leases where the net profit share was fixed. There are a number of leases that say a 40 percent net profit share (indisc.). But that was a fixed part of the sale. The bid variable is something else. So, I think the only unique part, and Kevin's going to correct me here when I'm wrong, but the only unique part about the net profit share at Northstar is it was the bid variable and it's also the highest net profit share anywhere in the state." MR. BANKS verified that was correct. Number 852 CO-CHAIRMAN GREEN said, "And just for a microcosm of background. In the decade before this, there was a fairly large extension in southern California called the Wilmington Offshore and that was, to my knowledge at least, certainly the biggest and I think one of the earliest of that kind of leasing. And in that case they knew exactly what they had and the only variable was the net profits back to the state and the city of Long Beach. I didn't like it then; I don't like it now, but at any rate that's...." Number 891 REPRESENTATIVE BARNES stated, "The royalty that was in the original leases, could you just explain to us then briefly, what is the supplemental royalty to these leases that we're getting in exchange for giving up the 89 percent net profit sharing." MR. BOYD said, "I'll let Kevin address that, but again four of the leases have a 20 percent royalty and the fifth lease had a 12.5 royalty (indisc.) this other lease, that part of the deal has been jacked up to 20 percent. So, there's a base, I think in more simple terms -- I think of that as a brick of 20 royalty and you build some steps on top of it, but I'll let Kevin go into the supplemental royalty goes from 17....you've always got that 20 percent royalty and Kevin is going to build a ramp on top of that that's gets as high as 7.5 percent on top of the 20." Number 968 MR. BANKS stated, "And in the details, Mr. Chairman, we've set a price at $17.35 - that's the ANS West Coast reported spot price - we calculate an average price each month. If it exceeds that amount, then the proportion that it exceeds that amount is multiplied by 1.5 times to calculate a supplemental percentage. So if it's a dollar more, then BP will pay us 1.5 percent more in supplemental royalties. It's linear - there's no steps in it; it's strictly a calculation of a line and it's capped at 7.5 percent which you'd hit at -- well, at today's price, BP would be paying a total of 27.5 percent because we're right now in this blip of high prices. The trigger price, and this is really the only other refinement -the trigger price will inflate at one-half of the inflation rate, as calculated by the producer price index. So, there's a certain amount of sharing in the inflation risk between the state and BP, so to speak. We get that one-half between the actual rate and the inflation rate on the trigger price, so eventually if prices show a trend that can keep up with inflation - - if oil prices keep up with inflation -- at some point, the state will just -- the trigger price will be lower than the average price and we'll always get some kind of supplemental royalty in the out years." Number 1072 REPRESENTATIVE BARNES asked how the ELF affects these particular leases under this particular scenario laid out. MR. BANKS responded, "In fact, the ELF, Mr. Chairman, has the effect in the early years of -- I think the ELF is at about seven- tenths at its peak, so seven-tenths of 12.25, whatever is the rate in those first few years of production, amounts to about 8 or 9 percent severance tax. It drops off pretty quickly. As the field declines, severance tax doesn't pay anymore. I think I can illustrate that by taking a quick look at the model. I believe on page 4, in the middle of the page, you see the oil severance rate - a row titled under the `Tax ($m, mod)' you see the oil severance rate and the oil ELF and as I said, at it's highest point, it's seven-tenths but then it falls to zero effectively by 2005." Number 1186 CO-CHAIRMAN GREEN said, "Kevin, I have one more of these sensitivity things to ask you about. With BP's exemplary history of being able to develop safely at a lower development investment, have you run any cases to see if there would be a sensitivity to that. That another order of magnitude, for example, which we're getting into the almost never, never land, but they already passed into the never, never land on some of their other developments, according to the other operators initial estimates. So is that a sensitivity issue of (indisc.) capital development?" MR. BANKS replied, "It'll have an effect on the net profit share. It has no effect on the supplemental royalty, obviously. But if you would like us to cook up something like that to see." CO-CHAIRMAN GREEN commented, "And again, this doesn't mean that even if you do one these that it would be logical. It's just to see if there is a sensitivity to it and maybe that's too draconian. Something with enough significance to see if it makes a difference - maybe at 25 percent or so decrease. And I would think probably both wells and facilities. Just to see if it's sensitive to that." MR. BANKS said he would do that. Number 1268 REPRESENTATIVE DAVIES asked if abandonment costs were a big deal in this calculation or not? MR. BANKS replied, "It has an impact on the kinds of taxes that are paid because under -- for income tax purposes, it's a cost that can be charged against taxes before you spend it and it's depleted over the life of the field as oil is produced. So, that's the principal place where it kicks in. It also has a rather perverse effect on the net profit sharing. I say this because according to our regulations, even though they're going to spend this money in 2012, they get to count it against their revenues throughout the life of the field in the calculation of the revenue account and net profit share. So, it's an outright deduction -- it is adjusted by the rate at which the oil is depleted from the field." Number 1334 CO-CHAIRMAN GREEN stated, "Let's say that two years into this, it becomes a 160 million barrel instead of 130, then you have to adjust your amount that you can deduce by the amount of barrels produced over that which will be produced." MR. BANKS inquired, "If in the middle of the field life, you changed your reserves?" CO-CHAIRMAN GREEN said, "Somehow they find something better or..." MR. BANKS responded, "That's right. Those numbers calculated would be lower -- well, per barrel would be lower. The impact it has early on -- as long as the development account -- we can get into net profit share calculations but if there is a development account - in other words, if the net profit shares have not begun to pay, in effect these charges on dismantlement and abandonment are accruing interest. They are accruing interest on the development account in a sense." CO-CHAIRMAN GREEN asked, "The unspent dollars?" MR. BANKS replied, "Yes, sir. That's as I say, it has some perverse effect on the profit share because of that. In our assumption about what the abandonment costs will be in terms of impact to the company's economics, what we focused on is that it's in the cash flow, it is just a number that appears in 2012 and has an impact then on your present value of the prospect. The secondary effect or those other effects are on taxes and profit shares." Number 1416 REPRESENTATIVE DAVIES said, "We've look at in the principal variables that we've talked about are in how much oil is there and the rate of production issues and the price - we've talked about that - and the cost of development, so I think we've sort of covered the waterfront there. But, I guess the argument that BP brings to us as to why we want to go into a deal like this is that they claim, of course, that they simply wouldn't develop under the net profit arrangements in that they indicate that the state -- in that part of the problem is that the state's interest and BP's interest in the waning days of the field are not in alignment. In going through the analysis just in terms of the economic model -- these assumptions that you've made here -- would you be driven to concur with that? Do you see evidence in doing these calculations where as you get out in say the second half of the life of the field that we begin to have divergent interests?" Number 1480 MR. BANKS responded, "Mr. Chairman, I think the answer to that question is they predict that their per barrel funds flow drops off as soon as they to pay net profit shares. I'm sure that will have an impact in one respect, but if there are any possible incremental projects to be done in the field, recognizing that 90 percent of the profits of those would be taken away by the state, it would be a disincentive to incremental production towards the end of the field life. With respect to how that funds flow behaves, I believe that the company could, although my conversations with even our own accountants are not completely in agreement with this, it seems to me if you can anticipate that you're going to have an obligation to pay the net profit share towards the end of the field life, they'll figure out a way of attributing that to the early production somehow; in the same way the abandonment costs are attributed to every barrel that's produced. Now, I'm not an accountant so I don't know what the rules of thumb are for that kind of write down, but it seems to me that that would be a capable thing for them to do. On the other hand, I think you should also ask BP for a more thorough explanation of how that works." Number 1558 MR. BOYD interjected, "Mr. Chairman, I just want to make sure that the committee is clear that we're not making any representation of what BP may or may not (indisc.) field life. But Kevin's question was theoretical -- I mean the answer is really theoretical. What someone may or may not do based on a set of circumstances -- BP has said they would not do it. I can't represent that they will or will not do it, neither can Kevin Banks." CO-CHAIRMAN GREEN said he understood that. Number 1579 REPRESENTATIVE DAVIES said, "I'm not asking that. I'm asking if you look at this analysis, do you see evidence for our interest being misaligned with theirs. That's really what I'm asking." Number 1584 MR. BANKS responded, "Well, the model will show under net profit shares that their revenues are significantly cutoff in the last three or four years of production. It's simply because the net profit shares are being paid at that point." Number 1591 REPRESENTATIVE DAVIES questioned, "But isn't -- I guess -- almost by definition, isn't it also true that at that point in the game they've taken all their costs off and that these are pure profits basically to them and to the state at that point? I mean there's no, except for the continued operations costs, there's no further capital costs to be attributed to the project?" MR. BANKS said, "The way we've modeled it, we have no incremental capex expenditures out there in the field life, you are right. They have earned a return on capital expenditures equal to the prime rate and whatever value the development account had when they acquired the leases from Amerada Hess." Number 1633 REPRESENTATIVE DAVIES asked, "Can you tell me at that point in time how the return to BP, according to these kinds of calculations that you've done, how the return to BP would compare to the operating cost. In other words, if you considered this as an investment and you had the operating cost to be an investment, we have to put up $1.00 a barrel, what is the return to BP on that dollar investment?" MR. BANKS said, "I believe BP has done an analysis like that, Mr. Chairman for the Senate Resources Committee and have shown that their rate of return is something in the order of 10 percent. I think that's the answer to your question. By the way, operating costs are deducted from the revenues that are calculated in the net profit share, as well." REPRESENTATIVE DAVIES said, "I understand that but I'm trying to get a kind of `apples and apples' comparison. If you're in this circumstance and you're BP, and ask, `Does it make sense for me to continue to put this money out in terms of -- considering the operating costs and investment. This may be kind of an unusual way to look at it, but I'm just trying to get some sense for how misaligned we are." MR. BANKS remarked, "I think I'd like to punt, Mr. Chairman." CO-CHAIRMAN GREEN remarked, "Well, that's true. I think that they're asking maybe some questions that -- as long as it's numbers, it's one thing, but if it's philosophy, that's another -- that you get into a situation in that latter part of the life that it would not be to the operator's benefit to make an investment which would then ultimately perhaps would affect the ultimate oil recovery with a possible bizarre, and let's hope it never happens scenario, that the economy would come to such a low rate of inflation that investing in something like this where the inflation rate is fixed would be a better investment than trying to invest in something else with a lower rate of return. Because after all, an oil company is no different that a bank -- they're in business to make money. So if they can get a glob of money and put it in at a rate that exceeds what their normal corporate rate would be -- and that's why I say, God forbid that would ever happen, it could be to their advantage to put it in here. Otherwise, I can't see that it ever would because most oil companies have a higher demand or higher rate of return requirement than they would get in investment here. So then, I guess in that regard, there would be a divergence and I think their corporate president has mentioned that. He has testified to that extent that there would be a divergence of (indisc.) and would not be good." Number 1772 REPRESENTATIVE DAVIES commented, "Mr. Chairman, I stipulated that. I know that's what BP says. I'm just trying to find out what our guys say." Number 1783 MR. BANKS stated, "It would be the same kind of effect if you assumed -- I believe this would be the case -- if you assume in the model that there is no balance in the development account, there's a $262 million assumption in here - that's the size of their development.... CO-CHAIRMAN GREEN interjected, "Plus abandonment." MR. BANKS continued, "That accrues later. But if you assume that it starts out at zero, I think a similar result happens. The cash flow produces a rate of return of just 10 percent. Now is that enough to accumulate investment in a field? And that's the question for BP. As I said, I think I'm trying to interpret your question that in the end of field life, if they are paying the net profit share, the development account balance is zero, they face similar economics. Any investment made because of the impact of net profit shares would be somewhere in the order of 10 percent." Number 1828 REPRESENTATIVE DAVIES stated, "But in investment -- I was talking about the operating costs and (indisc.), but if the company were to make an investment at that point in time, that would also be a capital cost that would come off - it would go back into the development account at that point - that would come out. So I guess one would have to look at whether that - what the tradeoffs would be there." Number 1854 CO-CHAIRMAN GREEN added, "A fixed rate there and an uncertain rate in the future, so it just depends on what would happen." Number 1872 CO-CHAIRMAN GREEN noted, "I know we have several questions of the operator and we will probably -- I don't know how we're going to be able to arrange times, but we do have a lot more questions. Unfortunately, we don't have any more time for this meeting and so we would hope that maybe we can reconvene. In fact, on this issue we won't adjourn, we'll just recess at the call of the Chair and perhaps get in some questions to the operator at that time." REPRESENTATIVE BARNES commented that she had some questions for Jim Baldwin on this issue and asked that he be present at the next meeting. CO-CHAIRMAN GREEN announced the committee would recess the hearing on Northstar to the call of the Chair and move on to SB 198. TAPE 96-67, SIDE A Number 001 CO-CHAIRMAN GREEN reconvened the House Resources Committee at 4:10 p.m. He announced the committee would consider House Bill 548 at this time. HB 548 - NORTH STAR OIL & GAS LEASE AMENDMENT Number 027 ERIC LUTTRELL, Vice President, Exploration and Development, BP Exploration, Alaska, said he was available to answer questions and if time allowed, he would discuss the material that had been distributed to committee members. CO-CHAIRMAN GREEN recalled that Representatives Barnes and Davies had indicated in the earlier meeting that they had questions of the operator. Number 105 REPRESENTATIVE BARNES said her first question had to do with the purchase of these leases from Amerada Hess. She wanted to know, specifically, if BP was not aware of the conditions set forth in the leases at the time BP bought them from Amerada Hess. Number 145 MR. LUTTRELL responded, "When we acquired the leases from Amerada Hess, we were aware that there were net profits (indisc.) on the leases." REPRESENTATIVE BARNES asked, "At that time, did you believe that they were economically feasible to develop under the scenario set forth in the leases?" MR. LUTTRELL replied, "At the time we had an inkling that we might be able to make them economic. We did not have economic runs at that time." Number 164 REPRESENTATIVE BARNES inquired, "Meaning that you didn't presume to change the leases at that point or ask for changes in the leases." MR. LUTTRELL stated, "We bought them with the risk that we might have to ask for a change. We did not have that planned at the time we bought the leases." REPRESENTATIVE BARNES questioned, "I guess since this has never been done in the state of Alaska or anywhere else in the world that I can find, did you think it was something that the legislature would do or did you think it had to come before the legislature?" MR. LUTTRELL replied, "As a matter of fact, we were aware at the time that we bought it that there was already a precedent within the state of Alaska for an exchange between net profits and royalty." REPRESENTATIVE BARNES inquired what that was. MR. LUTTRELL said, "That's a precedent set at the (indisc.) Island case between the Department of Natural Resources (DNR) and Exxon Corporation. So we were aware that at least there was an opportunity to make an exchange. The conditions were slightly different, but at least an exchange had been made." Number 298 REPRESENTATIVE BARNES asked Mr. Luttrell to explain what those differences were. MR. LUTTRELL remarked, "I think it'd be better if you were to ask that of the DNR because they're very technical. It has to do with -- DNR, I think believes that it's easy to do at the time of unit formation and more difficult to do at any other time. The way the read the regulations and the law, they can make that exchange at the time of unit formation, but they would not be able to at other times." REPRESENTATIVE BARNES remarked, "So this situation then is different." MR. LUTTRELL responded, "It is different." Number 350 REPRESENTATIVE BARNES inquired, "If you were not able to make these changes in the leases, what did you think you would do at that time if you were not able to make those particular changes." MR. LUTTRELL replied, "I think I understand the question. The way I would answer the question is that we made what I would call a `risk investment.' We took the leases - we acquired them from Amerada on the thought that we might be able to make an agreement with the state. What we would do if that was not successful, is something which we hadn't done a lot of thinking about. It's simply, we took a risk investment." REPRESENTATIVE DAVIES stated, "Mr. Luttrell, in your responses to some questions that the Senate committee put forward, you'd indicated that you had requested permission from Amerada Hess to provide information to the legislature about the purchase price and that would be under some sort of confidentiality agreement. Did you make that request and have you heard anything from Amerada Hess?" MR. LUTTRELL responded, "We did make the request from Amerada Hess. We have the authority to reveal that information to the legislators in a closed session." REPRESENTATIVES DAVIES inquired if any such discussion had taken place. MR. LUTTRELL replied, "The Senate has not chosen to go into Executive Session to ask that question." REPRESENTATIVE DAVIES inquired if it was Mr. Luttrell's understanding that it was a possibility at this point in time. MR. LUTTRELL responded affirmatively. REPRESENTATIVE DAVIES said, "I was just trying to do some quick figures here. Also, in that same correspondence, you had indicated that you -- and I'm assuming that this is in the context of Northstar although in the sentence it just says `In Alaska we look to make about 3.25 per barrel on our capital investments of 3.50' and I'm just trying to understand how that relates to -- if I multiply the 3.25 times 130, I get numbers that are larger than what are on these graphs and I'm just wondering how I relate those to...." MR. LUTTRELL responded, "What you're referring to is a paragraph that has to do with the relative value to BP of the Venezuelan investments and the Northstar investments -- I think that's what's you're...." REPRESENTATIVE DAVIES responded that was correct. MR. LUTTRELL continued, "In order for you to make the calculation I think you want to make there, you need to net the barrels from 130 down to what we would get relative to the royalty shares." REPRESENTATIVE DAVIES asked, "Take the royalty shares out?" MR. LUTTRELL commented, "I think if you do that, you'll find it. One other thing you need to be careful about is that the graphs you're looking at there are in revenue and I think the number you're looking at is in income and they're similar, but they're not identical." REPRESENTATIVE DAVIES asked if revenue was different than profit? MR. LUTTRELL replied, "Revenue is different than profit." REPRESENTATIVE DAVIES commented, "You'd expect profit to be smaller than revenue." MR. LUTTRELL responded, "Different. Similar but different." Number 630 REPRESENTATIVE BARNES asked Mr. Luttrell to explain the difference for the record. MR. LUTTRELL stated, "I actually don't feel qualified to explain the accounting of why revenue is slightly different than income, but I know it is and I will bring it back as a written document, if that's alright with you." Number 659 REPRESENTATIVE DAVIES said, "I guess the other question I had that related to this morning's discussion, Mr. Chair, was -- which I think is actually dealt with in the handouts that were distributed from BP and they have to do with the issue of alignment and misalignment and whether -- actually I think these charts are consistent with my understanding of what BP had testified earlier about, although they go into it in considerably more detail about the issue of alignment between the state of Alaska and BP and I guess maybe I would just ask that you first -- sort of a two part question -- one is, were you basically in agreement with the presentation that we had this morning in terms of the finances as the state indicated they were, and secondly, if you would like to expand some more on the issues of alignment." MR. LUTTRELL remarked, "As best I can tell, we're comfortable with the state's representation of the economics that were presented this morning in terms of their model of our model, in effect, as a common model and right now we're not running any conditions where we're not getting the same answer, if that's the question." REPRESENTATIVE DAVIES said, "That was the first part of the question. Let me just ask it bluntly. There were some numbers that the state used that weren't your numbers and I'm just asking you to give us some assurance from your point of view that they were fairly representative of the overall agreement." MR. LUTTRELL said he would be more comfortable if Representative Davies would give him an (indisc.) example. Number 817 CO-CHAIRMAN GREEN asked if Representative Davies was referring to field size and projected revenues and things like that? REPRESENTATIVE DAVIES said he was concerned about things like the discount rates, the income tax issues, the ones that were redacted from the...." Number 836 MR. LUTTRELL interjected, "When the state presented the model this morning, it put numbers in there to protect the confidentiality of BP. If you were to look at the numbers that have been presented by the state and BP for the value to the state of things like royalty, severance, supplemental royalty and look at the model presented today, you'll see the numbers are fairly similar. Now that simply means that the assumptions the state used are similar to the assumption that was used in the negotiation. They're not exact but in the rounding error of the kind of numbers we're working, I would consider them to be very similar." Number 883 CO-CHAIRMAN GREEN said, "While we're not sophisticated enough on this committee even to know in minute detail but in direction or relative comparison, you would find -- or I think your answer to Representative Davies' question was that `Ya, certainly in that broad spectrum, you'd expect to see maybe even plotable numbers within reason." MR. LUTTRELL stated, "To answer the question another way, I did provide both of you today, Mr. Chairman, copies of the slides that are now in front of you and for all intents and purposes, it's my belief that if you were to plot the model on a graph like that, the lines would overlay for all intents and purposes. There is nothing in the model as presented to you with BP specific numbers out of them, that would give you a different result, if that's the very specific question." CO-CHAIRMAN GREEN remarked, "And I think, Representative Davies, that we'll be able to do that when we get these runs back, that we'll be able to say that, `yes, this trend graphically is the same sort of thing we would expect to see from that run.' Whether the numbers are exact is not the issue." Number 962 MR. LUTTRELL commented, "Given the scale of those plots, they would plot on top of each other." Number 972 CO-CHAIRMAN WILLIAMS brought up the local hire issue and asked Mr. Luttrell what he could tell the committee regarding how BP would go about the local hire issue on their capital project. MR. LUTTRELL replied, "One of the things that we were very conscious of in the conversation about Northstar and local hire was we did not want to solve a perceived problem of local hire on the part of the oil companies which actually have a very good record of local hire and local employment, on the backs of Northstar. Clearly, they are related issues. Clearly, we understand it's very important to the state of Alaska, the citizens of Alaska and this legislature. If we were to set a target of 90 percent local hire on Northstar, what we would think would happen actually is you'd see people moving across the boundary and some other projects would lower. So it is a problem that is something which we are working very diligently to improve, both ourselves and our contractors on a general basis. I'm sure that's helping you specifically but we recognize the concern of the citizens and the legislature and have committed ourselves to improving our record. That's specifically in the areas of training and in the areas of advertising and making sure everyone has an opportunity to get these jobs. And ultimately, publicly indicating what our record was and how it's improving." Number 1080 CO-CHAIRMAN GREEN remarked, "Well, I think one of the things - I dare say I speak for the committee, but I think I speak in the approach the committee would like to see - is that you have a project and there's some things that could help you and that could help us, but one of the things that really is in the `help us' category is to not only try and get as many Alaskans - people living here now - hired, but I've said this several times and probably will continue to say it as long as they keep bringing me back here, but here's a golden opportunity for the state to get involved in a ramp-up, as it were, for module construction and to me, that is a really key ingredient for the future of this state to have that capability for not only Northstar or heavy oil or the next discovery and I hope there is several of those next discoveries, but also for the Eastern Rim that we might be able to be a staging area for places like Russia and maybe even China. So that really looks good to us so what we're hoping to see from BP would be some commitment that says, `Yes, we will help you kick that fledgling opportunity off' with local people." Number 1169 REPRESENTATIVE BARNES asked if Mr. Luttrell had read the opinion by Mr. Baldwin? MR. LUTTRELL responded, "Yes, but I haven't read it today." REPRESENTATIVE BARNES asked if he was fairly familiar with it? MR. LUTTRELL noted he was reluctant to say he was familiar with it because he didn't have it in front of him. REPRESENTATIVE BARNES stated, "Mr. Chairman, let me first of all say that I don't always agree with Jim Baldwin but sometimes I do and in this instance, I have read this several times and I've read this piece of legislation several times and I do not believe this piece of legislation does in any shape, form or fashion what Jim Baldwin says in this opinion that we must do to show a correlation between changing the net profit sharing from 89 percent to the royalty arrangement - the supplemental royalty arrangement in this legislation. Now let me tell you why. Under his opinion and it's lengthy, what he says is - very clearly over and over and over - that we must show a cause and effect as to how this piece of legislation that is before us relates to changing the terms of a lease. And I submit to you, if you have the legislation before you, you'd please turn it over to the back page and what he says is that as long as we can clearly show that Alaska - the people of Alaska, the state of Alaska - is benefitting from this (indisc.- paper shuffling). Now then, if you were to turn on page 2 on line 9, number 8, it says `BP Alaska, Inc. has committed to hire Alaskan residents and contractors to fabricate modules for the unit in Alaska' and I want to tell you that says absolutely nothing. Nothing. There is nothing binding any where on you. Absolutely nothing binding. And then if you look on line 11, number 9, it says, `the timely development of the unit may result in increased state revenue in future leases.' The word `may' is there and even the most freshmen legislator here knows that `may' means nothing." REPRESENTATIVE BARNES continued, "Then if you look down at number 10, line 13, it says, `the timely development of the unit may result in technological breakthroughs and other cost savings.' Again, we have the word `may' that means absolutely nothing. And I've got real serious problems with this and I have been told, and that's why I asked Mr. Baldwin to present his body here, that officials of BP have said they would accept no changes in this legislation. This legislation is not the agreement that you have with the DNR. This legislation is the piece of legislation that's a contract between this legislature and the people of the state of Alaska. And when we pass it from this body, there had better be something binding in it or we're going to all end up in court under the opinion written by James Baldwin. Now, I'd like to hear your comments." Number 1388 MR. LUTTRELL said, "Representative Barnes, I'm not qualified and I know you have the intention of asking Mr. Baldwin the legal issues and I would request that you do that. BP's commitment is the conversation that we had had with the legislative leadership as well as the Governor about two months ago. Our commitment here was going to be a public commitment to fabricate modules in the state of Alaska and hire Alaskans and that seemed to be, at that time -- the Governor was comfortable with that and the legislative leadership seemed to be comfortable with that -- and that's how it ended up on the agreement. It is our commitment to do this and I'm sure you can bring up any number of contractors who are currently working with us in our alliance and they will tell you that's how we're behaving is though these modules will be built in the state of Alaska. It's how we're designing it to do; it was being designed specifically - my team is out there doing that right now...." Number 1442 REPRESENTATIVE BARNES interjected, "If you've got all these commitments, then you won't mind us nailing it down real tight in this piece of legislation, will you?" MR. LUTTRELL responded, "Our concern about rewriting the actual agreement between BP and the state of Alaska, which is one option that certain parties have wanted to do, was that once you open up that pandora's box, Lord knows what that agreement is going to look like when it finally comes through the legislature. It's just very difficult for us to enter into a conversation which says we can amend it here and amend it there and then ultimately have something that BP would be willing to sign. It's a very difficult thing to negotiate with 60 people." Number 1475 REPRESENTATIVE BARNES stated, "I don't in any way see that you're negotiating with the legislature. I see that you're telling the legislature - you're putting whatever facts you choose to put on the table before us, and based upon the conversations that we're having, we're to approve a piece of legislation. That piece of legislation is not the contracts and it does not necessarily mean that that piece of legislation has to be renegotiated as part of the contracts. What it can say and clearly say is `unless such and such happens, then this is not in effect.' And that doesn't mean that you have to renegotiate but what it might mean is that you had to come up with an amendment with the commissioner of the DNR because we sometimes amend things and you know, we are rarely ever given anything that says `folks, you can't amend this' and the only time I'm aware that there's ever been anything before us that says `folks, you can't amend this' is in the case of royalty oil and once those are negotiated, we have the opportunity to vote up or down on those. And every time that we have had those since 1979, although today I'm a peon, I was in the presiding officer's chair every time those happened, so I fully understand what's at risk here and how it is normally done. This is very different. This is not a contract; it is a piece of legislation - very different." Number 1560 CO-CHAIRMAN GREEN remarked, "Thank you, Representative Barnes, especially for that history and having been peripherally involved back in `79 and subsequently in the `90s, you're right that those were contracts arrived at and approved by the legislature. But in that same document that Mr. Baldwin talks about where in some cases net profits has been considered royalty by both the federal government and the state government and therefore could be construed to be within the purview of the commissioner of natural resources to do the royalty changing as one of his charges, that he goes on to say it would be better if the legislature condoned it with a piece of legislation. Unfortunately, there were very few people here when Jack Chenoweth who is legislative legal advisor to us, gave some testimony that he felt that as long as the legislature would change over a geographic area that would apply to more than one specific location, that was a good idea. However, this is specific to an operator and it was Mr. Chenoweth's concern that that may not pass muster as far as the legislature coming in and modifying that. I don't know whether you've had privy to any of that testimony or not." MR. LUTTRELL stated, "Mr. Chairman, if you could get me a specific question, I'm certain we would be willing to respond." CO-CHAIRMAN GREEN commented, "Well, it was that -- that this project that we're looking at -- since it's specific and not general that we may have trouble with the Constitution on the legislature doing something like this." Number 1667 REPRESENTATIVE BARNES stated, "In the opinion of Baldwin as well as the opinion I have from Chenoweth, it gets to the question of special legislation when general legislation is that which we're supposed to pass. But if you pass special legislation, you've got to show it as a correlation in a bigger scheme of things and they attempted to do that I think in this when they used those words `committed' and `may.' It's just that I don't think they nailed it down. Also, in this agreement, Baldwin is very specific and that's why I need him here, that these things have to be nailed down tight as to what the effect of the legislation will have on the people of the state of Alaska and what we are, under the public purpose section, getting from it. And I think it has to be very, very tight or it will never stand a legal challenge. And when we walk out of here as a legislative body and get beat to death with this, it had better have some benefit to the people of the state of Alaska that's nailed down real tight and that's why I need Mr. Baldwin over here." CO-CHAIRMAN GREEN remarked that unfortunately he was out of town. Number 1717 CO-CHAIRMAN WILLIAMS stated, "I guess, knowing how complicated this agreement was to put together by the DNR and your office, we're not the experts on this. It would be very difficult for me to understand all that you've put before me. But information - and not having this type of information before us and having the time to study these issues - I think maybe what we should be talking about instead of special legislation, is maybe we should be talking about a resolution. I think what we're doing here today is gathering information, talking to people at BP, talking to the Administration and finding out, without really getting into detail, how far off we are. You've got our feelings on the issue of local hire - I think that has been said enough times, I think maybe if we came up with a resolution saying this is what we'd like to see, maybe that what we should be dealing with right now. I'm glad the Governor did bring this before us so that we could at least say that `Hey, I talked to the BP people.' I'm not an expert in oil but I think I've seen enough deals and talked with enough people to understand what is going on here and we're not just trying to push something under the rug or the Administration has done their job in making sure that the state is protected. I think what we're doing here today is reassuring you how important it is that we do have local hire. I understand all the problems and things that you have to go through just to keep within your ranges that you put here before us -- you're putting 444 million at the top and the base at 350 and the 305, I think, at least in that range it's very difficult. These are the ranges that you're looking at in order to make this project a viable project, is that right?" MR. LUTTRELL responded, "Yes, Representative Williams, the information that you're looking at there is at the table of input to the model that we and the DNR have put together and we're comfortable those are good representations of the possible outcomes of cost and (indisc.) reserves." CO-CHAIRMAN WILLIAMS asked how long BP and the DNR had been negotiating these? MR. LUTTRELL replied, "The detailed negotiations started before Christmas and they were in earnest early in the year. But they basically started out where we gave them all information that we were aware of about the field. It was a complete open exchange of information." CO-CHAIRMAN WILLIAMS commented that he had seen logging companies take over a job that to another company looked like it couldn't be done, and because of expertise and management were able to make it work. He added, "Perhaps that's where we are with BP today on the Northstar project." The legislature doesn't have the time to review this and raise technical questions, but he thought what they needed to do was get around the edges and see if it is done in an (indisc.) manner. He said, "We've been working to get the oil field open. I think it's better for the state of Alaska if we do and we try to work in that sense." CO-CHAIRMAN GREEN said he concurred that there was a built in problem with the legislature getting into the details because first of all, there's proprietary information that is actually exchanged between the Department of Revenue and the operators that the legislature won't have privy to. So the legislature couldn't get too detailed except by analogy and he thought that's what BP has tried to do with this and the model this morning in which they put in some almost, but not quite figures that kind of puts the legislature on the outside looking in. He almost agreed with Co- Chairman Williams in that it was perhaps where the legislature should be anyway. CO-CHAIRMAN GREEN asked if there were any other questions for Mr. Luttrell. Number 1985 REPRESENTATIVE DAVIES said, "I have one last question that relates to the sort of category of assurances that BP can make to the state of Alaska or to the citizens of the state of Alaska in connection with this. It's an issue that we've talked about before but I'd just like to have a response on the record. There are a lot of people in the Fairbanks area who asked the question `Why should we make any other deals with the industry until we get some commitment on the gas pipeline issue' and there does seem to be a lot of connection in people's mind on these issues and I wonder if you could comment on that." Number 2024 MR. LUTTRELL responded, "BP and the other operators continue to work diligently to find a market for North Slope gas and to work the cost issues and it's something which they are doing. It's not something which I'm part of; it's in a different part of the BP organization. Beyond that, I don't know what else I can say to you. It is something which we are positively working toward to make work for the state of Alaska and for ourselves." Number 2051 CO-CHAIRMAN GREEN inquired, "Along that same line, are you aware that last week we were visited by - I think it was on Wednesday - we were visited - several offices were - by a representative from the Japan Oil Company or Oil Company of Japan who is housed on the East Coast with another office in Houston. That representative indicated to us that the window of opportunity, as it were, for selling North Slope gas coincided much more closely with the Yukon Pacific presentation than it did with the operator's presentation by as much as eight years. Now I know this is not what you're here to testify on but since the pipeline...." MR. LUTTRELL interjected, "Mr. Chairman, I'm not aware of the visit from anyone." CO-CHAIRMAN GREEN remarked that he had some written information coming and would make that available to the operators. He comment that time is short - if that window is what we're talking about, time is very short. Number 2093 REPRESENTATIVE BARNES commented that she had a letter from the president of China Petroleum indicating they are still very interested in buying our gas and that they're also very interested in joint venturing the pipeline and they want to know what's happening and what we can do to expedite it. Number 2117 CO-CHAIRMAN GREEN said "There has been, at least conceptually, an amendment that may or may not get proposed by this committee - we have made a copy available to you - that covers essentially and in effect what it says is that there would be a strong emphasis to the point of actually saying `this is what we, BP, have done to try and hire locally' while we can't specify local hire because of a federal decision, but then it goes on further to say that the contracting for construction facilities would be done in-state. That is really putting the nail down deep. Do you have anything that you'd like to say on that now or would you rather wait to see -- that may or may not actually even be offered as an amendment, but...." MR. LUTTRELL responded, "Mr. Chairman, there was an amendment put into Senate Resources to amend the actual agreement and we publicly stated at that time that we could not actually accept an amendment to the actual agreement because it was effectively reopening the negotiations. To the best of my knowledge, the amendment that I've seen from your office is an amendment to the actual agreement. It looked to me in reviewing it, that much of what was in that amendment could become actually part of the findings section and actually be quite valuable as part of the findings section and which I would think actually the committee would want to do, but to be part of the actual agreement would require a lot of work." CO-CHAIRMAN GREEN noted, "Well yes and just for the record, that amendment wouldn't do anything as far as reopening the agreement you've got with the DNR; it would only be a commitment in effect - almost a side agreement because it doesn't get into the whether or not this is a good thing as far as changing the royalty schedule or anything like that. It just says that you will make your doggonest effort to hire locally and that you will commit to construction. That's, of course, still subject to the fact that you even have a project here. I know this has not gone through sanction - it hasn't been sanctioned yet so you can't very well commit to something you haven't even gotten approval for." Number 2227 MR. LUTTRELL stated, "Mr. Chairman, let me be real clear about this. On the basis of the agreement that we negotiated with the Department of Natural Resources and now in front of you for approval, I went to London and got specific approval to indicate that sanction would take place. We cannot actually ask the board for sanction until I have a class 2 cost estimate, but BP is convinced that class cost estimate will be of enough quality that we will not make the decision, if you understand what I'm saying." Number 2262 REPRESENTATIVE DAVIES asked, "Mr. Luttrell, so is it still your position that there's no possibility for any opening of the contract at all?" MR. LUTTRELL replied, "Representative Davies, I think you can understand why we have said that all along because of the difficulty of not knowing what the agreement will ultimately reach when it's passed, whenever it happens, from the legislature. So, our sense is that to (indisc.) we were asking the legislature to live with the agreement that we got and decide whether that's the agreement you can agree to. If not, we'll have to go do something else. But if we try to make amendments to that agreement, I'm afraid what's going happen ultimately is that I won't be able to sign it and then we won't have anything either one of us can live with." Number 2288 REPRESENTATIVE OGAN stated, "On that point if I may. Seems to me that if we -- your last statement that you said if we don't have something we can sign, we don't have anything but if we open up the agreement, you're afraid we won't have anything - seems to be one in the same." MR. LUTTRELL responded, "It comes across as one in the same. If we start amending the agreement then I have to go back and decide whether it's something that I can agree to and sign and I'm very much worried that the language will be such that we won't be able to do that." Number 2317 CO-CHAIRMAN GREEN stated, "Well it's possible and this kind of brings in what you've heard from Representative Williams and from all of us, that in order for the legislature to condone this activity, that we might have to actually see contractual obligation. Otherwise, it may be the view of the legislature that we stand back and maybe make a resolution and allow the Administration to continue with the agreements that have been made without perhaps having passed legislation to that effect. I mean, I don't know where we are but those are things that have been kicked around. I can understand your position not wanting to open the negotiations and I hope you can understand our position that unless we can get a commitment that there is something more than the speculated benefit to the state because we'll get more or we'll get almost as much or depending. And with the open end on the sensitivities that we've talked about that if it's bigger than we think or the prices are higher than we think or the development costs are lower than we think, that we're giving up a potential out there that may be almost too much to swallow. So unless we could get a contract that says, `Well ya, but you'll also get guaranteed construction and training and that sort of thing' we may be in a real tenuous position over the next couple weeks." Number 2379 REPRESENTATIVE BARNES asked if that wasn't what Jim Baldwin's opinion said? CO-CHAIRMAN GREEN thought so. REPRESENTATIVE BARNES said, "That's exactly what I think and he works for the Administration who gave us this piece of legislation. Again, I want it made very clear that this is not a contract; this is a piece of legislation. It's very different from the contracts on royalty oil that we've had in the past." CO-CHAIRMAN GREEN asked if there were any other questions. He thanked Mr. Luttrell for his testimony. He said, "We're hopeful that we're not causing you to be cross-threaded with the Senate. I hope we're not sending you mixed signals."
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