HOUSE BILL NO. 81 "An Act authorizing the commissioner of natural resources to modify a net profit share lease." 9:55:43 AM RYAN FITZPATRICK, COMMERCIAL ANALYST, DIVISION OF OIL AND GAS, DEPARTMENT OF NATURAL RESOURCES (via teleconference), notified the committee that the department was currently working on prior questions from the committee and would provide answers in writing. Co-Chair Merrick alerted Mr. Fitzpatrick the meeting would end at 10:15 a.m. due to floor session. Mr. Fitzpatrick continued with a presentation from a prior meeting titled "HB 81 - Net Profit Share and Royalty Modifications on Oil and Gas Leases," dated April 15, 2021 (copy on file). He began on slide 19 and addressed the primary objectives of the bill. The bill would give the Department of Natural Resources (DNR) the authority to modify net profit share lease (NPSL) rates. He relayed that the bill created an additional qualifying scenario for the modification of NPSLs. Mr. Fitzpatrick noted he had described [in the previous hearing on HB 81] three scenarios in which modification of royalties were currently allowed. The bill would add a fourth scenario for end of field life where additional capital investments were required to increase production in order to keep the field in production. He elaborated that it was similar to the second scenario he had described the previous week, but instead of declining production resulting in an increased per barrel cost, the fourth scenario would require additional investment to increase production that would result in the field maintaining its status as economically producing oil and gas for an additional number of years. Currently, the additional scenario was limited to the modification of net profit share and did not include royalty. Mr. Fitzpatrick addressed the last objective of the bill that would resolve an existing statutory ambiguity related to production [on slide 19] for the first scenario (production from a new oil or gas field). He explained that currently the modification scenario was only allowed if the field had not produced previously; however, during the exploration phase there may be test production during exploration. He clarified that the objective resolved that the test production would not disqualify the field or pool from modification; it was only referring to commercial production after the field had been developed. He added that it was the department's current interpretation and was not intended as a change in policy. 9:59:09 AM Mr. Fitzpatrick advanced to slide 20 titled "What Type of Modification is Warranted?" The slide included information about how the current modification process worked for royalty modification and how it may change under the legislation related to NPSL modifications. He explained that currently there was a minimum royalty percentage, which meant if a royalty modification were granted, DNR could not reduce royalties below 5 percent for a new field or pool or 3 percent for fields or pools at the end of their lifespan. He elaborated that the bill proposed a minimum net profit share of 10 percent. He detailed that even if a modification were granted, DNR would not have the authority to reduce the net profit share below 10 percent. He noted that the provision mimicked the minimum royalty rate currently in the modification statute. Mr. Fitzpatrick drew attention to an error on slide 20, item C. He remarked that the item should read "the modification must be based on a sliding scale mechanism" instead of "may be based." Currently in statute, a royalty modification was required to be based on the sliding scale based on the price of oil and may also be based on other factors such as production or expenses. The bill allowed for the modification of net profit share royalties and added a fixed royalty component to one of the options DNR may consider. However, the package of modifications (such as fixed royalty, sliding scale royalty, or net profit share) was required to take the price of oil into account and apply the sliding scale mechanism built into at least one of the aspects. Additionally, production or per barrel cost could also be considered, similar to current statute. He noted that the modification could not only be to a fixed royalty and fixed net profit share rate. He explained that there had to be some element of a sliding scale included that recaptured foregone revenue if the price of oil increased, production increased, or costs were reduced. Mr. Fitzpatrick addressed the last bullet point on slide 20. He relayed that current statute allowed the modification of royalty to be below or above the current royalty rate. The bill would allow net profit share rates to go below or above the current net profit share rate. He explained that in certain circumstances it may be in the state's interest to craft recapture mechanisms. He detailed that if there was foregone revenue because of a royalty modification earlier in a field's life or at low oil prices, under certain circumstances (especially if there was a significant increase in oil price), a modification could be crafted so the royalty rate or net profit share rate increased above the original rate to allow the state to recapture foregone revenue. He expounded that similar to the way DNR may employ the mechanism with a royalty modification, the statute would allow DNR to do the same with the net profit share modification. 10:02:57 AM Representative Josephson was sensing the proposal was more nuanced and had more caveats than contingencies. He observed that the proposal included language that contained more words. He thought the language described circumstances where the state instead of being "generous" would be a bit more self-serving when merited based on price increases or other similar situations. Mr. Fitzpatrick did not believe the bill language was intended to change the thresholds for granting relief or to change the authority of the department to craft recapture mechanisms. He explained that the current statutory language allowed recapture mechanisms for royalties. He reported that if the department was allowed to modify net profit share rates, the recapture mechanisms could also be crafted through a modification of the net profit share rate (i.e., increasing the net profit share rate above the current rate); however, it was only intended to mimic the current system for royalty modifications. Representative Josephson remarked that there was a give on the side of the state until such time as the profitability was apparent and then there was the takeback. He asked if it was the scenario Mr. Fitzpatrick was suggesting may happen in the reform of the NPSL. Mr. Fitzpatrick replied it was the intent of the statutory language to allow the mechanism under the proper circumstances. He explained that the language did not require the recapture mechanism. He thought back to the different modification scenarios currently in statute and explained that the recapture mechanism would make a lot of sense for a new field or pool given the production time horizon of 20 to 40 years. He elaborated that during the course of production, the price of oil would vary fairly dramatically over the time period. He noted the dramatic change in oil prices over the past several years. He elaborated that if DNR granted a modification and the price of oil was in the lower price band, it may justify a modification. He provided a scenario where the price of oil increased significantly two or three years following the modification. He explained that DNR wanted to craft the modification to phase out if the field was economic without the royalty modification or net profit share modification. Additionally, if a field or pool got to a point where the production was so economic that it could bear the additional royalty burden, it made sense for the state to increase the royalty rate or net profit share rate above the existing level to recapture some of foregone revenue that may have taken place earlier. Mr. Fitzpatrick considered another scenario towards the end of field life. He explained that the recapture mechanism may not make sense if the anticipation was that a modification was being granted to keep a field in production for an additional year or two. He detailed that there would be a phase out mechanism for higher oil prices at that point in the life of a field, but perhaps not a recapture mechanism. 10:07:40 AM Representative Wool understood why a producer may want to negotiate a lower royalty rate or net profit share rate because it was uneconomic without the lower rate and the state wanted to be able to negotiate to get some production. He considered a scenario where the rates were lowered, and production increased. He could not imagine producers would ask the state to raise rates when they were making a substantial amount of money. He reasoned the state would have to step in under the scenario. He asked for verification the state would only be able to raise rates that had already been lowered. Mr. Fitzpatrick answered in the affirmative. He relayed that the only time the state could raise the rates above the initial rate, was when the state was granting the relief in the first instance. He elaborated that the royalty modification decision would grant a reduction in the royalty rate or net profit share rate. The decision would also include a schedule specifying when the modification would phase out with oil prices, increased production, reduced costs, and other. He explained that if the state elected to add a recapture mechanism in appropriate circumstances, the recapture mechanism would have to be included in the initial decision. He detailed that the state and producer would have notice from the initial publication of the decision specifying when the recapture mechanism would go into effect. Representative Wool thought the state would want to specify at the onset when the recapture mechanism would kick in. He reasoned that if the mechanism were based on price, the state would likely know upfront when something was profitable and when it was not. He asked if the mechanism would turn on and off as price fluctuated. Alternatively, he wondered whether a producer would get the reduction, the state would dial in the recapture if appropriate, and once the increase kicked back in, the process would conclude. He asked for verification that the reduction would not go back and forth depending on the price of oil. He thought the scenario would not be very efficient. 10:10:08 AM Mr. Fitzpatrick replied that the situation could vary depending on the modification. He reported that current statute allowed for significant flexibility in crafting the modifications and the sliding scale reversion to the original rates or recapture mechanisms. He believed one of the modifications DNR had previously granted was based on the price of oil, where the modification phased in and out as oil prices increased or decreased. He reported that the mechanism had worked well from the administrative side for the particular field. He remarked that there could be scenarios where a modification was granted that only allowed modification for a certain term of years until a certain level of costs were recouped. He stated that whether or not a modification phased in and out with the price of oil or other factors, could be individually tailored to a particular field or pool. Representative Wool thought the state would want to include a recapture in all of the reduction arrangements if certain parameters were hit. He thought it would be the prudent thing to do. Mr. Fitzpatrick answered affirmatively. He explained that the phase out of the modification was statutorily required. He detailed that for scenarios where a recapture mechanism was warranted, DNR currently preferred including the recapture mechanism whenever it would be justified in one of the modifications. Co-Chair Merrick apologized for running out of time. She noted that the presentation would continue during a future meeting. She thanked Mr. Fitzpatrick for his testimony. Mr. Fitzpatrick thanked the committee. HB 81 was HEARD and HELD in committee for further consideration. Co-Chair Merrick reviewed the schedule for the afternoon.