CS FOR HOUSE BILL NO. 207(FIN) am An Act relating to adjustments to royalty reserved to the state to encourage otherwise uneconomic production of oil and gas; and providing for an effective date. Co-chairman Halford directed that CSHB 207 (Fin)am be brought on for discussion and referenced SCS CSHB 207 (Res). JOHN SHIVELY, Commissioner, Dept. of Natural Resources, and KEN BOYD, Director, Division of Oil and Gas, Dept. of Natural Resources came before committee. The Commissioner voiced a preference for the House bill over the Senate version and advised that he would present background information on the legislation. A number of ideas have been proposed to provide incentives for development of marginal fields in Alaska. Early in this administration, the proposed royalty incentive was determined to be "something we could do this year" while the oil and gas policy commission examines other methods of "making the state more competitive, internationally." The bill allows the Dept. of Natural Resources to determine whether or not a field or pool of oil that could be developed has been delineated. If such a delineation has been made, an applicant can request a royalty reduction. The Commissioner would then have to find clear and convincing evidence that a reduction should occur. He must further find that it is in the best interest of the state that a royalty reduction be given. The legislation mandates that the Commissioner "look at the upside potential." If an incentive is provided based on certain economics and those economics change, the state has the right and responsibility to obtain its share of the upside. That could be accomplished in a variety of ways. The administration believes it could be done through negotiations. The economics of an oil field are driven by three factors: 1. Costs (both operating and capital). 2. The price of oil. 3. The volume of oil. Costs may be relatively well known and can be reasonably estimated. Price is "at best a guess." Agreements could take into account price changes. The volume of an oil field will almost always be understated at the beginning because fields are generally not fully delineated. Advancing technology also improves ability to recover oil. The Commissioner is thus required to examine and respond to increases in volume. Commissioner Shively stressed the importance of early incentives to the long-term economics of a field. By taking some of the risk in the beginning, the state can obtain some of the advantages at the end as prices improve and volume increases. Speaking to SCS CSHB 207 (Res), the Commissioner advised of objection to the sunset provision which would send the message that the state is "only half-heartedly interested in giving incentives." An additional section that seemingly provides for unilateral redetermination by the Commissioner, "later in the deal," is not appropriate and makes the legislation useless. Negotiations in this area have been had and substitute language will be proposed. Provisions relating to required findings may "force us to lose some litigation." The department is suggesting that the findings be permissive rather than required. Legislative oversight language in the Senate bill is "very cumbersome." The requirement for the Governor's approval of a royalty incentive package is not appropriate. The Governor generally does not approve "these kinds of things." The Commissioner voiced his belief that the House did a good job in developing its bill. He then reiterated his preference for that version and expressed a willingness to work with committee on the Senate bill. Senator Phillips inquired concerning a definition of "clear and convincing" and the "state's best interest." Commissioner Shively advised that "clear and convincing" is a legal standard--a very high standard. Current law allows for royalty reductions for fields that are abandoned or about to be "shut in." It merely provides for "a clear finding." Best interest findings have been somewhat defined by litigation. Under best interest findings, the Commissioner has "some flexibility in looking at what is in the best interest of the state." It could relate to jobs, keeping facilities open, the tax base, pipeline tariffs, etc. Best interest language is presently in statute, but there is no statutory definition for the term. Co-chairman Frank asked if language intended to eliminate litigation remains within the Senate version. Commissioner Shively referenced language indicating that "this decision is not appealable by the applicant." The original legislation said that the decision was not appealable. That caused some confusion. A court can assume jurisdiction over any decision by the executive branch. If provision of an incentive was suspected of being fraudulent or not in accordance with law, "somebody could sue the department and would get a hearing." End: SFC-95, #65, Side 2 Begin: SFC-95, #67, Side 1 Co-chairman Frank asked if information upon which the department based its decision to allow a royalty reduction would be made public through the court system if a suit is filed. Commissioner Shively responded, "not necessarily." The courts have the ability to receive confidential information and keep it confidential. Information held confidential by the department would continue to remain confidential through the court process. In response to a further question from the Co-chairman, Commissioner Shively acknowledged that courts have much discretion. Should the court wish to make something public, it would do so, and, because of separation of powers, the executive branch could do nothing about that. Senator Rieger asked whether provisions relating to litigation reflect concern regarding attorney fees awarded public interest litigants when the intent is harassment rather than appeal of a particular finding. He then inquired regarding the department's position should court rules be amended to provide that if a final determination is appealed, public interest litigant fees could not be awarded to the losing party. Mr. Shively explained that the intent behind support for "the broader language" concerning appeal is not to "keep everything out of court" but to set a very high standard for the court in terms of review of the decision. The attempt is to reduce opportunity for frivolous lawsuits. Fees to public interest litigants were not discussed by the administration when the bill was developed. Commissioner Shively then expressed his personal opinion that public interest litigants should not be awarded attorney fees when they lose. He noted instances of award of such fees that were "on the high side," and pointed to difficulties associated with what is reasonable in terms fee awards. Senator Sharp remarked that he would not be interested in any bill that would allow public interest groups to become a party to the litigation. The Senator advised that unless that aspect is fixed, he would continue to have a problem with the legislation. Commissioner Shively voiced a desire to bring "some reason to that system" but acknowledged that if the standard for all legislation was that public interest groups could not sue, little legislation would be passed. The administration believes the standard originally in the bill limits, to the maximum extent possible, litigation attempting to second guess what the Commissioner did. That is as far as one can go in any legislation. That provision was included in the House bill. The Senate version prohibits appeal by the applicant. Co-chairman Frank voiced his understanding that existing law allows for a royalty reduction only after two years of production. Commissioner Shively explained that royalty reduction statutes have existed since statehood. Original law was largely patterned after federal law, allowing royalty reduction in any case. A subsequent change required production of a field for two years. That was repealed a number of years ago. At the present time, the only allowable royalty reductions after production are for fields "that have already been shut in or fields about to be abandoned." Mr. Boyd added that the earlier, two-year production statute was repealed in 1990, "when Conoco first applied and could not meet the two-year standard . . . ." The present statute requires a "clear showing that a royalty reduction is necessary." Discussion followed between Co-chairman Frank and Mr. Boyd regarding the basis for an earlier decision by former Commissioner Heinz. Mr. Boyd advised that the benefit of extending the life of the field was over shadowed by the cost of the extension. Estimates indicated that over the 22-year life of the field, in the low price case, the state would lose $60 million. The upside benefit for the last three years would have been a much smaller number. No matter what numbers were used in possible scenarios, it appeared that the state would never benefit. In response to a further question from the Co-chairman, Mr. Boyd said current law allows for a royalty reduction to extend the life of a field. Senator Zharoff asked how the proposed process would be applied. Commissioner Shively presented a scenario whereby an oil company or group of lessees make a discovery. That discovery (whether it be a whole field or pool) would be delineated. Delineation of a find generally requires drilling. Following delineation of the find, the applicant would present the economics of the field (investment of capital and operating costs, prices over the expected life of the field, and anticipated volume of oil). The applicant would then demonstrate that reduction of the royalty would change the economics of the field and allow the applicant to make an investment. The Commissioner must find clear and convincing evidence that "those economics are correct." Once the economics have been verified, the Commissioner must find that provision of the royalty reduction is in the best interest of the state. One of the methods of doing so would be to show how the state would benefit in the upside should the economics change (prices escalate, the anticipated volume increases, etc.). Other items within the best interest finding might include the effect on the pipeline tariff (if the field was on the North Slope), use of existing facilities, job creation, etc. Under the Senate version, the Commissioner would make that decision, and the Governor would review the decision. If the Governor concurred, a 30-day public comment period would commence. At the same time, the information would "come to the legislature." The legislature could require that confidential information be submitted to the Legislative Auditor. The legislature could then hire its own consultant to review the information. The Commissioner could also be requested to appear and provide an explanation to the Legislative Budget and Audit Committee. While the committee would have no approval authority, it could comment upon the proposed reduction. All of the foregoing must occur within the 30-day public hearing process. At the end of the 30- days, a public hearing would be had. Information gathered from the public and the legislature would be reviewed by the department. The Commissioner would then make a final best interest finding which the Governor would review. If the Governor approves, the agreement would be signed and become effective. In response to a question from Senator Zharoff regarding time frames involved in the process, Commissioner Shively estimated it would take 60 to 180 days to negotiate an agreement on the economics and other requirements. Time would then be added for review by the Governor. If approved by him, the 30-day public comment period would commence. The Commissioner would then have 30-days after public comment in which to make a final determination. Mr. Boyd cautioned that the foregoing reflects the process in its simplest form. He stressed that it could become more complicated and take longer. Much depends upon the field, its economics, the company, other owners, etc. Time frames associated with negotiations give rise to the administration's concern regarding sunset provisions in the Senate bill. There are presently several obvious fields that might be looked at in the next two or three years, but there are others drilling for prospects that have not yet been found. Further, some lease sales have not yet taken place. It takes time--approximately four years--to "get to a delineated field." Sunset provisions would end the program in five years. The bill would thus not appeal to anyone who does not already have something on the drawing board. In response to an additional question from Senator Zharoff, Commissioner Shively noted that the Governor would have to sign off on the project twice--once after the preliminary findings and again after final findings. He then suggested that the Governor would certainly be aware of "a decision that is this big." A Commissioner is unlikely to provide a royalty reduction without informing the Governor. Commissioner Shively advised of a lack of understanding regarding actual need for the Governor's signature. He noted arguments that oversight by the Governor would make the decision less political. He asserted that it would, in fact, make it more political. He then presented a scenario whereby the granting of a royalty reduction in an election year might be largely a political rather than economic decision. Speaking further to concerns regarding oversight, Commissioner Shively stressed that the "real competency to make this decision" does not rest with the Commissioner, Governor, or legislature. It is within the division of oil and gas where professionals make the necessary analyses. That is where protection for the state rests. The Commissioner pointed to testimony from Tesoro regarding negotiation of the recent royalty contract and noted that it attests to the fact that the state has "some very good negotiators in that division." Co-chairman Frank raised concern that the public might not have much information upon which to base comments during the 30-day public process. He then inquired regarding what data might be available for public review. Commissioner Shively advised that public comment requirements were added in the House. He acknowledged that potential problems could arise. He further suggested that the public would probably know more than merely that a decision has been made. The public may know everything. "There is an option for the applicant to have confidential information, but it is not required." He suggested that the proposed procedure is "a little different than some of the information that the industry usually wants to keep private, particularly when they're early on in the development of a field, and they don't want the information on their wells to be public." The Commissioner suggested that while pricing information and other economics of the find might be kept confidential, the department would be able to discuss the general concepts of the field, the approximate size, amount of the reduction, the structure for taking into account the upside in price and volume, etc. In further discussion with Co-chairman Frank, Commissioner Shively clarified that department rather than applicant information would be made public. Co-chairman Frank voiced need to be convinced that the bill is necessary. He stressed need to understand the methodology of how it would work and ensure that public interest is protected on the upside. Mr. Boyd spoke to difficulties associated with information on a new field that has not yet been productive. He described sophisticated computer models that would be utilized. It is a matter of deciding what factors need to be considered. That involves careful analysis. Staff is fully capable of utilizing the computer model. The bill also provides the ability to hire consultants to assist with assimilation of data. The ultimate decision, however, rests with the Commissioner. Co-chairman Frank asked why the bill was not applied after production to ensure that a reasonable rate of return is not denied because of the royalty. Commissioner Shively acknowledged that rate of return is used, in some countries, to drive investment. That is one of the reasons North America is becoming less competitive. Business here does not look at rate of return since it is more complicated to do so on a sustained basis because it requires more auditing than the proposed legislation. The administration has not ruled out that system. It was felt that within the time frame of this legislature, it was not reasonable to develop that kind of law. That is one of the concepts that will be placed before the oil and gas policy council. The proposed bill fixes existing law. While it is not the final answer to every oil field, it is a good start to development of marginal fields. Discussion followed regarding controversy over the administration's position on habitat conservation in the Tongass National Forest. Co-chairman Halford referenced language at page 4 specifically prohibiting disclosure of information upon which the determination is made to legislators. Commissioner Shively explained that the language was developed in Senate Resources. He then voiced a preference for House oversight language. Co-chairman Frank said that when the bill was before Senate Resources, he sought information on the workings of the legislation and was subsequently provided a sheet presenting a hypothetical case. The Co-chairman distributed copies of the handout (copy of file), provided by British Petroleum, and voiced his understanding that figures are based on an assumption of a 125 million-barrel field, 50,000 barrels a day, and $325 million in investments. Discussion of numbers on the handout followed. Commissioner Shively noted numerous questions regarding underlying assumptions associated with how taxes were figured, how operating costs were derived, how fast the investment would be returned, what interest rate was used, whether or not the applicant is borrowing money, whether or not the ELF was considered, etc. would have to be answered before a clear and convincing decision could be made that the economics require a royalty reduction. Computer models associated with the program are considerably more complex than information shown on the handout. Co-chairman Halford voiced need to "see the process work by example." He then asked how much royalty relief per barrel would be provided if the price is $18.00 and the maximum reduction was allowed. Commissioner Shively expressed a willingness to "work something through an economic model," but he cautioned that much depends upon a variety of variables. Co-chairman Halford voiced his assumption that "We're trading jobs inside government (through state spending) for jobs outside of government (in the private sector) for the same number of dollars." He stressed need to understand that the equation is working and "We're getting our money's worth in the private sector." Commissioner Shively questioned whether that was truly the concept. He noted that if there is no development, there are no jobs in the private sector nor income to the state. He suggested that the number of jobs should not be a factor of the economic equation in a trade-off for royalties. While it might be a factor in best interest findings, the economics need to stand on their own in terms of the field and agreed-upon rate of return. The Commissioner agreed that Alaska production of facilities and local hire might be part of the negotiations. He stressed, however, that they would not be part of the economics. Co-chairman Halford observed that if activity and jobs in the private sector are not generated as a result of the royalty reduction, constituents will feel the state has given something away that should not have been given away. Commissioner Shively concurred. He stressed opportunity for increased revenue at the end of the field over loss afforded by a royalty reduction. Both loss and opportunity are equal parts of the equation. Co-chairman Halford asked if a provision could be included which requires "as much upside potential as downside potential." Commissioner Shively said he had discussed the issue with Senator Rieger. Price provides the biggest potential for upside increases. Senator Rieger noted that a decision to "do a modification of a field" has to be made on the economics or straight finances of the project. He referenced difficulties associated with inclusion of benefits that are not quantifiable. The Senator further advised of his belief that it would be possible to prescribe some base parameters and advised that he had been working on language "to try to spell that out without unreasonably constraining the department or the industry in how they work out a deal that makes sense." For undeveloped fields, a royalty reduction provides industry insurance of downside protection. Industry should be willing to give as much or more, upside, in exchange for that insurance. End: SFC-95, #67, Side 1 Begin: SFC-95, #67, Side 2 Senator Rieger acknowledged that the problem with new, undeveloped fields is that no one knows what will happen. He ventured a guess that the fields, under the most likely scenario, will "pencil out." While risk runs from negative on one side to the high end on the other, both sides might come out ahead on a risk-sharing basis. Modification should not be considered a concession. He again voiced need for established parameters. Commissioner Shively acknowledged the importance of responsibility on both the upside and downside. House legislation clearly specifies that responsibility. That was one of the state's original principles in meetings with industry to develop the initial draft of the bill. The administration is willing to "look at how to set those parameters." The Commissioner cautioned that "trying to set them exactly is a challenge" because of three different fact situations: 1. New marginal fields. 2. Fields that are declining or about to be shut in. 3. Already abandoned fields. It is unclear whether the same principles will work in all three cases. Further, one kind of arrangement for one field might not work well for another, depending upon size and location. Commissioner Shively stressed the importance that the proposed legislation send a message to industry that "This isn't just a gift." In order to provide incentive to proceed with marginal fields, the state must be assured that industry will "pay the state back, not just what we would have gotten, but more than we would have gotten if things get substantially better than we anticipate." Co-chairman Frank referenced page 3, line 9, and questioned use of the word "may" rather than "shall." Commissioner Shively explained that permissive language was used so as not to confine the Commissioner in terms of what he or she might ultimately do. Co-chairman Frank asked if the administration would oppose changing to "shall" to ensure that the state recovers on the upside, should upside conditions occur. Commissioner Shively concurred with comments by the Co-chairman. He advised of substantial problems with referenced language and said he was working with Senate Resources staff to try to redo the provisions. Present language appears to allow the Commissioner to unilaterally "come back in and change a deal . . . ." He acknowledged need for provisions requiring that the state receive upside benefits. The Commissioner advised that the department has "provided language to do that." Co-chairman Halford referenced earlier review of the handout provided by Co-chairman Frank and noted mention of need for 12 persons to "run a marginal field." He then said he was experiencing difficulty separating economics and policy relating to jobs in consideration of whether or not to grant a royalty incentive. He then asked what ongoing employment a 100,000-barrel-day field would provide once it was productive. Commissioner Shively said staffing needs would vary, depending upon location of the field and proximity to existing facilities. A distant field might require new processing facilities and additional people. If it is located close to existing facilities, fewer people would be needed. Commissioner Shively noted comments suggesting that development of Badami might require 12 people. ("That may be 12 BP people.") BP and ARCO also do a lot of work through contractors. The referenced 12 positions do not include support staff, drilling, or pipeline maintenance. There is no question, however, that as the industry has become more efficient, and technology has improved, the number of jobs it takes to run an oil field has been reduced substantially. Co-chairman Halford voiced concern that the economic determination could "come out marginally in the positive" but produce few operating jobs and rely on equipment and facilities manufactured outside the state. A question is then raised concerning the benefits derived by the state from allowing a royalty reduction. Commissioner Shively concurred and explained that, for that explicit reason, the decision of whether or not to grant the reduction is not driven purely by economics. That is the reason for best interest findings. Co-chairman Halford expressed frustration over the fact that other states (Texas and California were mentioned) derive greater benefit than Alaska in the process of dealing with Alaska oil. He voiced concern that royalty relief might provide further benefits to states other than Alaska. SENATOR LEMAN, Chairman, Senate Resources Committee, ANNETTE KREITZER, aide to Senate Resources, and JIM EASON, Senate Resources Committee consultant, next came before committee. Senator Leman voiced support for the concept of flexible oil royalties and expressed a preference for the Senate Resources version over that passed by the House. The Senate bill addresses two areas of concern: 1. Oversight by both the Governor and the legislature. The first proposal was for the legislature to grant approval or disapproval. Problems became apparent due to the fact that the legislature only meets 120 days each year. Provisions were thus crafted that provide for Legislative Budget and Audit Committee review. The House bill provides for this review but does not include provisions for presentation of underlying, confidential data to committee. Oil companies are concerned regarding protection of confidential data. Rather than making this data available to all 60 members, provisions allow for availability to the legislative auditor and his staff or contractual professionals conducting review. In that way, everything available to the Commissioner would also be available to those reviewing his action. Senate Resources also feels that the granting of an incentive should be signed off on by an elected official. A requirement for signature by the Governor was thus added to the bill. 2. Sunset. Senator Leman suggested that the impetus for the bill is "likely Badami." It is thus important that the legislation pass this year "so BP can take . . . [an] agreement to their board of directors in October and possibly begin building the ice roads and do some work this winter." It is unlikely any other projects will be at a stage where passage of legislation this session is critical. Provision of royalty relief for non-producing fields is not done "anywhere else in the world." Sunset would allow the legislature, five years hence, to review the process to "see how this has been working." The legislature could, at that time, extend the sunset or remove it altogether. A second reason for the sunset rests in intent to encourage development activity to occur sooner rather than later. Speaking to appealability, Senator Leman referenced prohibited appeal by the applicant, in the Senate version. He explained that it is intended to engender greater public confidence in the process. He voiced his hope that litigation would not ensue and that the process would be done in such a way that there would be no need for litigation. In response to a question from Co-chairman Frank regarding Legislative Budget and Audit Committee review, Senator Leman reference a proposed amendment adding "unless directed otherwise" to language requiring that information be provided to the Legislative Budget and Audit committee for review of underlying data. Co-chairman Frank asked if information would be given to committee should application for royalty relief be made but not granted by the department. Senator Leman answered that provision of information would only follow approval of the application via issue of preliminary findings and commencement of public comment. Comments followed by Co-chairman Frank regarding past requests for royalty reduction that have been turned down. Further discussion followed regarding appearance of the Commissioner and Legislative Auditor before the Legislative Budget and Audit Committee to speak to royalty incentives approved by the department. Senator Leman acknowledged that the Legislative Auditor would not be able to share confidential information, contained in underlying data, with the committee. The committee would thereafter issue a recommendation for approval or disapproval. Testimony before Senate Resources Committee indicated that if the Legislative Budget and Audit Committee recommended "against the deal" both the industry and the administration would "back away from it and would not want to pursue it." Review and approval or disapproval by committee would be "advisory." Referring to sunset provisions, Co-chairman Frank voiced his understanding that the expiration date would cut off opportunity for new royalty reductions. It would not terminate those already in place. Senator Leman concurred. Discussion followed between Senator Phillips and Senator Leman reiterating reasons for and aspects of legislative oversight. Senator Leman acknowledged concern on the part of the administration that legislative oversight intrudes on executive branch authority. Further comments followed comparing proposed oversight with standard legislative approval of leases and contracts such as the Tesoro contract. Senator Phillips next referenced earlier comments relating to approval of Badami by the BP board of directors. Senator Leman advised that he was told that obligation of a $325 million project would have to obtain board approval. That project will compete for capital investment with other projects throughout the world. Senator Sharp asked if the Legislative Auditor would have ability to hire experts to review underlying documentation supporting the granting of a royalty incentive. Senator Leman answered affirmatively, noting that agents hired by the auditor would be subject to confidentiality provisions. Senator Sharp voiced concern regarding leaks of confidential information. Senator Sharp next referenced limitations on legal challenge and voiced his belief that past challenges have "in effect killed every major lease sale in the last ten years . . . ." He further spoke against award of judgment amounts even when public interest groups lose and voiced need to shut down that process. Senator Leman advised that he shared the Senator's concern. He explained that limitations on appeal by the applicant reflect the fact that "Anybody, probably, could appeal in court anyway." Bill provisions require that a higher standard will have to be met, evidencing extensive deviation from law. JIM EASON advised of several provisions that discourage litigation. Language at page 5, subsection (9) lists four categories of issues the Commissioner will consider in making best interest findings. The House bill simply provides that the Commissioner make a finding that the proposal is in the state's best interest. That is the standard set for all best interest findings under Title 39, including oil and gas lease sales. While the standard held for a number of years, challenges began to develop in 1984. Each time, the supreme court seemed increasingly likely to step in and submit to both the agency and legislature its own view of what should be included in findings when statutes are silent. The legislature thus undertook greater specificity when it enacted SB 308, last year. That listing of specific items has not yet been challenged. Senator Zharoff raised a question concerning royalty contract review and opportunity for in-stream adjustments. Mr. Eason said that changes would constitute amendments to the lease. Nothing in the legislation compels the Commissioner to set limits on the time in which those amendments might operate. He could, with agreement of the applicant, decide that the selected structure and mechanism would only operate for a certain period of time and then revert or change to some other procedure or be available for reopen. That will be decided "up front of the findings." Responding to an additional question from Senator Zharoff regarding confidentiality, Mr. Eason explained that, under current statutes, well information (productivity, source of the oil, well tests, records and interpretations, etc.) is confidential for two years. There are also provisions for extension of confidentiality indefinitely, if a showing can be made that certain conditions exist. If conditions are met, the Commissioner must extend the confidentiality period until those conditions no longer exist. For other materials that would be submitted with royalty reduction applications (geophysical and seismic data, engineering and financial data) there is no expiration of the confidentiality period. They are confidential in perpetuity. They do not become public unless the applicant agrees to release them. Senator Zharoff next inquired concerning the definition of "marginal field." Senator Leman explained that testimony in Senate Resources described such fields as those that "with a royalty adjustment could help meet the yield threshold for investments." BP indicated that it had investments worldwide. To bring Badami to a point where the corporation would want to make a capital investment, royalty adjustment would have to be made to reach the appropriate threshold. Many factors would be involved in the economics: ultimate recovery, the pumping rate, price of oil, cost of development, etc. Review of identified fields that have not been developed suggests that the economics have not allowed for development. In response to a question from Co-chairman Frank regarding Legislative Budget and Audit review, Senator Leman advised that the committee may choose to say nothing, approve, or disapprove the proposal. It could further offer comments to the Commissioner during the public comment period. Co- chairman Frank asked if delegation of legislative authority to the Legislative Budget and Audit Committee would raise constitutional questions. End: SFC-95, #67, Side 2 Begin: SFC-95, #69, Side 1 ANNETTE KREITZER acknowledged discussion of the issue when the bill was in the work draft stage. She further noted advice from Legislative Legal Services indicating that language incorporated within the Senate bill should not pose a problem. Senator Phillips asked that the issue again be examined by Legal Services and that legislative attorneys provide an opinion on whether a constitutional problem is raised by Legislative Budget and Audit approval or disapproval of a proposed contract. In response to a question from Co-chairman Halford concerning the viability of the Senate bill, Mr. Eason explained that he commenced work on the bill with the presumption that the legislature wished to pass legislation that would provide royalty relief for fields that are shut in, have produced and been shut in, or are nearing the end of productive life. That involves both the taking of opportunity and risk. The bill seeks to reduce, to the extent possible, the risk of trying to define something--the parameters of which are many and relatively unknown--so that there are protections for both sides. Mr. Eason stressed need for sunset limitation to aid future review, follow-up, and oversight. The proposal before committee is "heretofore untried." It starts from the premise that "You can't define what 'marginal' is very well." Under the circumstances, however, there are ways of crafting language that will show legislative intent and the public 's expectation to the applicant, Commissioner, Governor and all those involved in the process. Mr. Eason concluded his remarks by advising, "If everyone does their job, as planned, we'll make it work." Responding to a comment by Senator Phillips, Mr. Eason explained that in developing the Senate version, he attempted to "make it something that works for everyone." He stressed that he did not mean to leave the impression that implementation of the bill would be as simple and as straightforward as the House version or the version introduced by the Governor. Protections incorporated within revised language will make the bill more viable once enacted and in actual operation. Discussion followed between Co-chairman Frank and Mr. Eason regarding current royalty reduction law. Mr. Eason stressed that existing law does not contain specificity in terms of what the Commissioner must consider when reviewing data. He then spoke to deficiencies in the House version of HB 207 which calls only for review of production and financial data reasonably available to the applicant. That creates a potential conflict in terms of what is "reasonably available." Rather than allow that to become the focus of arbitration or litigation, the Senate bill seeks review of "all the things that a company would think about when it makes a decision to proceed or not proceed." That includes production information, development information, construction costs, transportation information, etc. The Senate bill contains greater specificity in standards for review. Current law is not a barrier to application for royalty reduction once production has begun, if a showing can be made. Additional discussion of existing law followed. Mr. Eason read existing language at page 2, line 29, which would be removed from statute by the Senate bill. Comments followed regarding House removal of statutory language at pages 6 and 7. Mr. Eason voiced his understanding that proposed deletion represents the House belief that the department needs the flexibility to consider other things beyond maximum economic return. Other considerations may not be "exactly translatable to the . . . balance sheet." Employment, encouragement of exploration on adjacent leases, and maintenance or increase of the flow of oil through the pipeline to maintain lower tariffs were cited as examples. Co-chairman Frank directed that the meeting be briefly recessed. RECESS - 4:15 P.M. RECONVENE - 4:40 P.M. Upon reconvening the meeting with Co-chairman Frank and Senators Rieger and Sharp in attendance, Co-chairman Halford asked that industry representatives speak to the bill. JIM PALMER, Director for External Affairs, British Petroleum, came before committee in support of the House version of the legislation. He explained that development in Alaska is in competition with other potential BP projects worldwide. With the opening of the former Soviet Union and activities in South America, Africa, Vietnam, etc., there are many places and opportunities for investment of capital. The task of BP's Alaska employees is to "make sure we get our money to develop the fields here in Alaska." There is opportunity in smaller fields around Prudhoe Bay. It may be the only opportunity to ensure that production levels do not decline precipitously. Prudhoe Bay production declined approximately 15% last year. Overall North Slope production declined 3%. The difference between the two reflects ability to achieve greater production from smaller fields. Milne Point and Pt. McIntyre were mentioned. That is the challenge--to make sure smaller fields come on line to help offset Prudhoe Bay decline. Badami lies to the east of Prudhoe Bay and Endicott. Appraisal drilling from this winter is now being analyzed. BP's best belief is that there is sufficient oil to produce "perhaps 50,000 barrels of oil." To make the field competitive, engineers and contractors must reduce costs to approximately $300 million. If this is not accomplished, investment dollars will not be provided. The proposed bill allows a field like Badami to "come on line." Mr. Palmer stressed that the hope is to "get Badami so competitive and so economically robust that perhaps we wouldn't have to come to the state for a royalty adjustment." One of the greatest risks is low oil prices. Having the state share that risk on the low side and share benefits on the high side, in an equal manner, is the intent of the proposed bill. Senator Rieger asked if, aside from Badami, undeveloped fields would be feasible on a "straight analysis" of the operating costs versus revenue. He acknowledged that the big concern is up-front capital and the risk associated with whether projections would come to pass. Mr. Palmer advised that each field is different. Production figures, price scenarios, operating costs, and capital costs all change. Capital costs depend upon how far the field is located from the pipeline, the geology of the reservoir, and other factors. What Alaska BP staff is attempting to do is make the project more competitive to ensure that the board of directors in London chooses this project to fund rather than one in the North Sea or elsewhere. That is the immediate challenge. In response to a further question from Senator Rieger, Mr. Palmer acknowledged that the biggest variable to profitability is the price of oil. The second most important is recovery. The more barrels of the oil, the greater the area over which costs may be spread. The number of barrels in the reservoir at Prudhoe Bay made the pipeline possible. For a smaller field such as Pt. McIntyre, there is not enough oil, on a per barrel basis, to make investment feasible. Senator Rieger asked if royalty modifications on the upside could, for the state, be greater than the downside royalty reduction. Mr. Palmer voiced his belief that it should be equal. Both parties should feel it is in their best interest to proceed. If investments occur and assumptions change, both benefit if changes are beneficial, and both share some of the risk if changes are detrimental. Senator Rieger questioned whether the situation should be equal. He noted that the state is absorbing some of the risk in granting an incentive. He then suggested there should be some requirement that the upside represent the absorption of risk assumed by the state. Mr. Palmer noted that the developer is taking a substantial risk as well. Senator Phillips voiced his understanding that the industry was concerned by provisions requiring legislative approval or disapproval. Mr. Palmer answered, "Our belief is [that] the legislature has to be comfortable with any deal to go forward." BP acknowledges it will have other dealings with the legislature in the future. To proceed on a project without "the comfort of the legislature would be not in our best interest." The Legislative Budget and Audit oversight proposed in the Senate Resources bill raises questions of certainty and "quickness of decision." Industry seeks to avoid the political disagreements that surrounded 1983 royalty oil contracts. Senator Phillips referenced earlier comments that Badami would be brought before the BP board of directors in London to compete with other projects for board approval. He then noted that Alaska's 60-member legislature serves as the board for the state's 600,000 residents and suggested that approval by the legislature is equally important. Mr. Palmer reiterated need to avoid political wrangling. Senator Phillips stressed the importance of approval on both sides of the agreement. Mr. Palmer attested to the oversight and negotiating skills of staff within the Division of Oil and Gas at the Dept. of Natural Resources, advising that they "protect the state's interest extremely well." Co-chairman Halford asked why the legislation seeks to place in statute a prohibition against providing certain information to legislators. Mr. Palmer replied, "That was done in the Resources Committee." He voiced his assumption that the provision was included because much confidential information will be provided to both the department and Legislative Budget and Audit Committee. It would be a competitive disadvantage to BP, and perhaps the state, should that information not be held in confidence. As an example, he noted that a leak of information associated with settlement of BP's income tax case was found to be very valuable, in terms of negotiating posture, to companies that had not yet settled. Mr. Palmer acknowledged that confidential information would have to be provided to the department and sufficient information must be given for the legislature to feel comfortable making a determination and recommendation. Co-chairman Halford voiced his understanding that if Badami were developed and produced 50,000 barrels a day, and royalty was reduced from 12.5% to 5%, the difference in income to the state would total $13.5 million a year. He then asked how many people would be involved in direct operation of the field once it is up and operating. How many would be involved, on an annual basis, in development, drilling, camp operations, etc.? The Co-chairman stressed that for him the issue is not only an economic equation but also a question of jobs. He then asked where the $300 million cost of development would be expended. Is there anything the legislature can do to encourage construction of parts, pieces, modules, etc. in Alaska versus another state? The Co-chairman voiced frustration, saying: Every time I get a chart that says where the money from Alaskan oil goes, it's frustrating to see other states making more than we are. Mr. Palmer responded by reiterating that one of the challenges facing the industry is to get operating costs down. BP will have very few direct employees on site. Estimated numbers range from 15 to 20. In addition to BP employees, there would be a drilling crew. Doyon is the nearest neighbor. It has sizeable drilling crews employed by the corporation. Camp personnel would also be on site. At the present time, NANA does the catering and performs housekeeping for BP. Logistics (trucking and airplane operations) would involve additional non-industry employees. Further, there would be "all the construction people." Without exception, BP is "looking . . . at Alaska companies to do that." While the decision on modules has not yet been made, BP would "very much like to, if it's economically possible, build those in Alaska." BP is looking for building sites with a capability and capacity of "doing those things." Pipeline jobs would involve "Houston Contracting," a subsidiary of Arctic Slope Regional Corporation, and would be filled out of Fairbanks' labor halls. VECO has a portion of the work and Alaska Interstate would be the supplier of gravel. When pressed by the Co- chairman regarding the actual number of jobs involved, Mr. Palmer replied that he did not know. Discussion followed regarding the handout distributed by Co- chairman Frank containing hypothetical information associated with an application for a royalty incentive. Mr. Palmer pointed to figures indicating that at $28 oil, the investment does well. However, at $10 a barrel, it does not. The proposed incentive asks that the state share some of the downside risk in exchange for potential upside benefits. The point of the handout is to show the impact of price. Senator Zharoff inquired concerning the industry position on sunset provisions in the Senate bill. Mr. Palmer advised, "We would prefer it not be in the legislation." He added that one of the important aspects of the bill is to "get additional people to Alaska to invest in Alaska." He questioned whether a 5-year program would do so. Senator Zharoff inquired regarding oversight by the Governor. Mr. Palmer acknowledged that the state must be comfortable with the arrangement. He stressed need for simplicity in the approval process to speed exploration and development, since it would make projects more economical. Mr. Palmer expressed concurrence in the provision prohibiting the applicant from appealing the decision of the Commissioner. He then voiced his belief that "That should apply to everyone." Discussion with attorneys indicates that would negate opportunity for "anybody . . . to take us to court . . . ." It would establish a higher standard for reducing nuisance suits. Senator Sharp raised a question regarding other small fields. Mr. Palmer advised that BP recently acquired and is interested in getting North Star into production. Senator Sharp reiterated earlier comments that state interest extends beyond just maximization of revenues. He suggested that the state must take risks necessary to "keep the TAPS operational until the ANWR card is played . . . ." If the pipeline is closed in eight or ten years because of lack of production, the benefits of ANWR may not be realized. End: SFC-95, #69, Side 1 Begin: SFC-95, #69, Side 2 Senator Sharp voiced his belief that the Senate version of the bill provides a greater level of comfort than the House bill. Co-chairman Halford noted a number of amendments for the legislation and suggested that discussion of their purpose and impact commence. Senator Rieger referenced his "all encompassing" Amendment No. 3. He explained that the proposed bill addresses two separate types of leases: 1. Badami and new unexplored fields where the risk and need for royalty modification results from a high degree of uncertainty regarding eventual outcome as opposed to actual economics. 2. Known fields that are marginal, have shut down, or are in danger of shutting down. There is little risk here since operating characteristics are known. In these cases, problems result from the fact that the royalty is based on a valuation that differs from the value to the producer. The situations and economics are totally different in the above cases. The type of royalty modification is also different. That has not been well spelled out in the legislation. Senator Rieger stressed that the upside of a royalty modification should be adequate to compensate the state both for the downside it is assuming as well as assumption of the risk. That is something that could be worked out to be mutually advantageous to both industry and the state. Speaking to "marginal fields at the other end of the spectrum," Senator Rieger suggested that relief to prolong the life of a field might not necessarily be achievable solely through royalty reduction but from recalculation of "where you value royalty." The problem is that royalty is calculated "someplace . . . several steps down the line" rather than at the same point from which the field owner views it. The proposed amendment thus requires: 1. That the state and industry must agree on a set of base assumptions that form an agreed upon most likely future outcome, exclusive of the riskiness of that assumption. 2. A royalty modification based solely on price. That would then track with price increases and decreases. The upside must totally compensate the state for the downside. 3. If, even under the base assumption, a field is so marginal the producer is requesting a royalty modification, a provision would allow an optional royalty modification based on ultimate recovery. 4. For fields in danger of shutting down, the amendment would allow the point of valuation to be moved closer to the in-ground value. That would allow some portion of the field production cost to be deducted before royalty calculation. Instead of a royalty reduction, there would actually be a royalty increase but of a much smaller number. It would provide greater downside protection to the operator and greater upside potential to the state. Senator Rieger noted that bill findings and recommendations speak to employment of Alaskans, use of contractors, etc. While these values are useful social and policy goals, they could tend to confuse the issue in discussion of the actual structure of a royalty modification. The proposed amendment removes those provisions and focuses modification on the financial aspects. There will thus be no confusion in attempting to trade off the number of jobs versus foregone revenue and other considerations. Senator Rieger spoke to lack of clarity regarding the time frame for appearance before the Legislative Budget and Audit Committee, suggesting that the time table appears extremely narrow. The amendment thus eliminates provisions thereto. The Senator said he was proposing the amendment for general feedback from the department and industry on workability of the changes. He voiced a greater comfort level in addition of parameters associated with modifications. Senator Zharoff next presented Amendment No. 4. He explained that the intent is to remove the requirement for final approval by the Governor. He suggested that the requirement represents an additional step that lengthens time consumption. Amendment No. 5, Senator Zharoff explained, removes the effective date. Speaking to Amendment No. 3, Commissioner Shively termed the proposed concept "what we want to do." He then voiced need for time to review the proposal to determine whether it fits correctly and will work. He reiterated that he was not uncomfortable with the concept but acknowledged that "It's not quite the way we would have done it . . . ," in terms of a mandatory schedule on price and optional provisions on other items. He concurred that price represents the biggest risk to the state in terms of "a deal going bad." He said the department could work within the concepts but could not commit to exact language at this time. Senator Rieger explained that current wording seeks to address the high degree of uncertainty rather than the economics of the field. In response to a question from Co-chairman Frank, Senator Rieger remarked that industry would probably not seek modification if the field appears to be economical. A modification would only be sought if there are sufficient risks in base assumptions to "make that kind of trade off." Jim Palmer suggested that ideas embodied in Amendment No. 3 have merit. He cautioned, however, that it appears that once capital costs are recovered, the rate would go up at a point when the field was starting to decline. An increased royalty at that point would not stabilize the situation. That impact would not be in the best interest of either industry or the state. Senator Rieger voiced his understanding that concern relates to "the optional modification based on total projection . . . not the modification based on the price of oil." Mr. Palmer concurred. Senator Sharp noted need to review Amendment No. 3 in terms of placement of Amendments 1 and 2 to determine if they would still be necessary. Senator Leman and Jim Eason again came before committee to speak to proposed amendments. Senator Leman said he had no problem with and would support Amendments 1 and 2. Amendment 1 requires that, unless directed to do otherwise, information would "go to the Legislative Budget and Audit Committee." Language therein provides for better working within the time line. Amendment No. 2 accomplishes Senate Resources Committee intent to have an agreement that spells out conditions. It provides greater comfort to those who raised concerns regarding a reopener. The redrafting clarifies the issue. Amendments 4 and 5 would remove provisions of importance to the Senate Resources Committee. Amendment No. 4 goes beyond deletion of need for the Governor's signature in that it also deletes Legislative Budget and Audit oversight. Amendment No. 5 removal of the sunset provision will be the subject of ongoing debate. Mr. Leman advised that he had only recently been provided a copy of Amendment No. 3. While it contains elements consistent with the Senate Resources approach, it may not be desirable or necessary to place in statutes. Jim Eason concurred in concern regarding placement of the provisions in statutes because they focus on one part of what is likely to be many parts that must be examined "in any deal that's proposed." Price is an important variable and one that will be examined in every agreement. However, it will not be the only variable. A situation in which prices remain high and there is additional volume and reduced operating and capital costs could produce an outcome where the state will do better than it would have under a standard royalty but not as good as it could have if the parties had agreed to operation of several variables and how to account for them. The proposed change is thus very limiting for both sides and could potentially reduce revenue that might flow to the state. It limits the Commissioner's flexibility to consider other things and limits legislative oversight of a deal that has more than one component. Senator Rieger referenced an earlier comment that language within the Senate Resources bill could be read as a possible reopener. The Senator attested to focus on price and production since other variables which describe a field "get much more complicated to verify and could lead to a possible dispute." Price and production are very clear. For other parameters (initial capital cost, production cost, etc.) which describe a field, the state should not exact a penalty for improvement in those characteristics. The Senator suggested the situation should not revert back to the original schedule and the royalty increase because "you did better than you said you could." Mr. Eason voiced need for symmetry so that both sides shared risks and benefits. The deal described in the findings would be a set of assumptions, or relevant factors, that include, production, ultimate recovery, price, and all variables. If the parties agree that a presumed level of investment of capital and operating spending would result in making the field uneconomical or less than desirable for the applicant, royalties should be reduced by a certain percent. Mr. Eason then voiced presumption that the legislature intended to set up a mechanism in advance that would react to changes in assumptions that present a different economic picture for both the applicant and the state. If the agreement has multiple components, it will be more difficult to describe, but it forces up-front description of the deal and action by both parties. Comments followed by Senator Zharoff regarding Legislative Budget and Audit Committee review and extension of the time frame for approval and granting of a reduced royalty. He further spoke against 5-year sunset provisions. Senator Leman attested to the 60-day process and stressed that obtaining the Governor's approval should not add to that time frame. At this point in the meeting, Senator Sharp offered Amendments 1 and 2 for consideration, saying that they appear to remain viable and have merit. In his closing remarks, Senator Leman voiced his belief that Amendment No. 4 would do disservice to transfer of information to the Legislative Budget and Audit Committee, including underlying assumptions and dates. He directed specific attention to page 5, lines 12-19, and he urged that the amendment not be adopted. Co-chairman Frank called for additional amendments, comments by members, or testimony from others. None were forthcoming. RECESS The meeting was recessed, subject to a call of the chair, at approximately 5:45 p.m.