HOUSE BILL NO. 207 "An Act relating to adjustments to royalty reserved to the state to encourage otherwise uneconomic production of oil and gas; relating to the depositing of royalties and royalty sale proceeds in the Alaska permanent fund; and providing for an effective date." Senator Rieger MOVED to adopt CS Work Draft, version "X", dated 5/11/95 by Chenoweth/Finley. No objection having been heard it was ADOPTED. Senator Rieger testified to the basics of the "X" version, compared to the Resources substitute. He stated that the focus of this version is on the economics of the field. The most important feature is on page 3, line 15-16, which speaks to a mechanism for adjusting royalty percentages based on price or value of the hydrocarbons produced. He read, "the mechanism must provide for an increase in royalty percentage resulting from an increase in price from the base assumptions that, at a minimum, fully compensates for any decreases in royalty percentage resulting from a decrease in price..." He stated that this was an effort to set forth the nature of the royalty modification, and that there would be an upside for the state to compensate for the downside risk the state assumes. Another change addresses the findings which did not speak to the financial aspects, and are no longer mandated in this bill. The focus is more on the financial impact of a royalty modification on the state. A significant change, one which Senator Rieger stated that the administration wants to change back, is in the amendment offered earlier to the committee. He stated that he could not see how a pool or field that had never been developed could clearly and convincingly be shown to be uneconomic. He therefore offered an amendment for deletion. It is currently in the work draft CS, but supports the administration's wishes. The last significant change from the Resources CS is the information provided for the justification of a royalty modification which could not be provided for legislators. He stated that the bill does retain the sunset and the governor's sign off. He recommended that Mr. Shively speak to the committee on the administration's amendments. John Shively, Commissioner, Dept. of Natural Resources was invited to join the committee. He said that he would go through the amendments and explain each one. Starting on page 2, line 3, technical amendment; line 8 and 9, recommended removal of the sunset date; line 15 (iii) reinsert, "oil or gas production from the field or pool would not otherwise be economically feasible;". He said that is the standard by which to judge the royalty reductions. Co-chair Frank inquired if the proposed insert (iii), was intentionally or inadvertently left out. Senator Rieger stated that in the first amendment offered to the committee, he had recommended taking the (iii) language out, because he could not see how a field would be economically feasible in speaking of a future undeveloped field. However, he supports the administration in replacing it in the bill if that is how they want it to read. Co-chair Halford asked if there is a point where the State of Alaska should say that our oil is worth $.50/bbl or $1.00/bbl or some figure that the state should never go below? Mr. Shively responded that there most likely is, but he felt that it depended on a variety of circumstances. He stated that there were three situations: marginal fields yet to be developed; shut-in fields, and fields that might be abandoned; and in the later two cases, there may be good argument to going down to a very small amount of money in order to keep certain facilities operating or jobs going. In terms of a marginal field that was just starting to develop, there would be a higher rate, which is what has been done in this bill. There is a higher floor rate for a marginal field, than for the shut-in or abandoned fields. The legislation does set that minimum. Discussion was had by regarding the bottom price per barrel. It was mentioned that at times there had been discussion in setting a floor in the value and working off of that. Co-chair Halford stated that it could work in the opposite direction regarding variability and taking risk from the industry, which are the arguments against doing it, but at some point the state should say there has to be some return or, no activity. Mr. Shively advanced to page 3, line 7: after the word "price", delete the rest of the line; lines 8-15, he stated that the language is more reasonable and intent language than actual law. If it remains in actual law, there are a few concerns on line 10, "fully compensates". The term is subject to difficulty in the interpretation. Line 14, the term, "negative risks". He asked Senator Rieger to explain his intent, as it may be helpful. Senator Rieger explained that it was language that the drafters came back with. He stated that his word was "downside" and the drafters came back with "negative risks". Mr. Shively stated that on line 18, he recommended eliminating the words, "ultimate recovery", and replacing them with the words, "production rate or volume". The term ultimate recovery would seem to be that we would go back at the end of the field and assess backwards on the oil or lessees, which is something that was not intended. It would make this section difficult to use. Most of the economics, if this is the way to assess, would be on production rate (monthly or daily base production) or the actual total volume. Senator Sharp asked if the rate of production could be manipulated for a more favorable rate? Mr. Shively responded that it could be. He gave a formula example with an average monthly production rate, and it went above a certain figure, which would grant an extra royalty. The cap could be managed. There is consideration in accounting for the cap, plus the total volume. There has been adequate testimony regarding a new field, generally the total volume is unknown. This is why both variables must be considered. The total volume cannot be ultimately manipulated, but the production could be managed. Co-chair Frank asked for a definition of volume. Mr. Shively stated that it was production over the life of the field. To determine the economics variable, the state would use the amount that the lessees have figured the field is worth, such as a base of 100 million barrels of unrecoverable oil. Anything over and above the 100 million barrels would be at an increased royalty rate. He stated that another way to figure the economics, would be to examine the daily or monthly rate. There is no way to achieve the figures up front, the analysis is based on certain economics. One, is the volume that is expected from the field. Co-chair Frank expressed his concerns. Mr. Shively stated that often once the development of the field starts, it becomes clear that there will be estimate changes. Co-chair Frank emphasized that he started out with the notion that if there were going to be variables, production would logically be one of them. However, he is now placing more emphasis on price expectation, and not so much on the production over the life of the field. In the case of field production, the return comes later; in the case of production, there is an opportunity for increases or decreases based on what the lessee would like to do. Mr. Shively responded that is why Senator Rieger's amendment mandates that price be used, with an option of using volume in adjustment. Mr. Shively continued through with the changes in the document and stated that the change made on page 5, line 31, Section 9, is an improvement. He stated that the last issue, is that of the governor's signature. The department recommends that the governor not sign. Currently, the law allows the commissioner to sign royalty reductions. Co-chair Halford stated that the previous Finance Committee Substitute removed the prohibition on legislators being able to review the information on which the decision was made. However, the language that is moved up into the other section, says, "the confidential data may be disclosed by the commissioner to legislators." He inquired if there was a problem in changing the word from "may" to "shall". Co- chair Frank MOVED to remove "may" and insert "shall" on page 4, line 17. No objections being heard, it was ADOPTED. Senator Zharoff inquired as to the price modifications, how cumbersome is it going to be to make adjustments as prices go up and down? Co-chair Frank suggested a fixed royalty. Mr. Shively stated that royalty adjustments are done in other places, and there are much more complicated scenarios such as: net profit leases; a direct sliding scale based on a time period; or step royalty (price agreement). Market baskets differ from company to company, but this is what is used as a price and adjust accordingly. In response to the committee, Mr. Shively noted that there was no reference made in the legislation to "net profits leases". When asked what bidding method was used, he responded that there were no precise leases. If related to straight base royalty, which varies in the state from 12- 1/2% to 20%, there are some leases which have a net profit aspect and a base royalty. Under this legislation, there could be negotiation on the base royalty, but not the net profit portion. He emphasized that the royalty is not used as a bid variable. It is possible, but it has never been used. In terms of net profit leases, there are 45. There has not been a sale involving a net profit with a big variable for some time. That was a concept that came out of the late 70's and early 80's, when everyone thought that the price of oil today would be about $75/bbl which would have solved a lot of problems that we have been facing in the last few days. It has been suggested for use by some of the remote fields. Mr. Shively noted that a complete analysis has not been done and the tax rates seem high. Information relating to the competitiveness of Alaska, some of which came from a report by Richard Feinberg, who has been a major critic of this legislation, indicates that North America, and Alaska in particular, has real problems in being competitive in the world market as it relates to marginal fields. Senator Phillips MOVED to adopt his amendment. He stated that this amendment would give the legislative oversight. He stated that he feels uncomfortable with a limited number of people approving or disapproving royalty contracts. It is a business proposition between the state and the companies. The companies have stated that they would have to go back to their board of directors for approval, and it is not just the chairman that makes the decision. In the state's case, the legislators are the board of directors for 600,000 residents in Alaska. He stressed that there is an obligation to represent the share holders of Alaska. The amendment was presented to the Senate Resources Committee. In speaking to the amendment, Co-chair Halford referred to another law which is not included in this bill. He inquired if that law is the same law that the State operates under when royalty contracts are approved? Senator Leman responded that this was a proposal that was offered in a work draft to the Senate Resource Committee. It was not adopted. The interest is to create a compressed schedule for legislative approval or disapproval. The concern was offered by some, that if the legislature is not in session it would cause delays. This will add 20 days on to the legislative process. Mr. Shively read from the "L" version, page 7, subsection (D). "transmit a copy of the final findings and determination prepared under (B) or (C) of this paragraph to the lessee or lessees making application for the royalty increase, decrease, or other adjustment:" Discussion was had on Senator Phillip's Amendment #1. End Tape #73, Side 1 Begin Tape #73, Side 2 Co-chair Halford asked the wishes of the committee. By a show of hands the Amendment #1 FAILED. Those in favor were Senators Frank, Phillips and Halford; those opposed, Senators Rieger, Zharoff and Sharp. Amendment #3 was discussed. It was noted that whatever the reduction, the apportionment shall be (until the revenue actually declines) below the amount that would have otherwise gone to the permanent fund. The apportionment of the royalty shall protect the permanent fund share. Senator Sharp MOVED to adopt amendment #3. Senator Zharoff asked for additional explanation. Co-chair Halford stated that if there is a royalty reduction, the apportionment of royalty between the permanent fund and the general fund shall be apportioned in such a way as to hold the permanent fund harmless as much as possible. For example, if the royalty goes below the 50% share provisions on some leases, then the PF would see a reduction anyway. Senator Rieger stated that he understood the intent of the language, but wondered if it was constitutional? He stated that it was dedicating revenues that are not dedicated by the constitution. Co-chair Halford said that the constitution only requires 25% dedication. The statute on leases is 78%, which increases the amount going to the PF to 50% statutorily. The PF is a constitutionally dedicated fund. Co-chair Frank stated that if there is a royalty reduction, the general fund will not receive funds since the PF will maintain its share. Under the leases, the PF gets 50% of the royalty revenue. With a 50% royalty reduction, there will not be a royalty from the development of a new field. He stated that in the hypothetical case given earlier, there would be a 3% severance tax. There are few, if any, fields providing severance tax, hence, the amendment means there will be no general fund revenues when a marginal field is developed. Co-chair Frank noted that it would allow for marginal fields that would not otherwise be in production at all. If it is good for the state, it would be good for the PF. It is a bill worth supporting because it will bring in net revenues to the treasury it will also bring in revenues to the PF that would otherwise not come in. Senator Zharoff stated that he liked the intent of the amendment, but could not support it. No further debate on the amendment was offered and by a show of hands the amendment FAILED. In support of the amendment were Co-chair Halford, along with Senators Phillips and Sharp. Opposed were Co-chair Frank, along with Senator Rieger and Zharoff. Senator Rieger MOVED Amendment #4, a technical amendment. No objections being heard, it was ADOPTED by unanimous consent. Senator Rieger MOVED Amendment #5, offered by the administration. placing back into the bill the words, "economically feasible determination". Co-chair Halford suggested that this implies that the only floor, is the absolute floor in the bill. If economically feasible is the determination of any tax policy, then all that needs to be done to prove the point, is to be uneconomically feasible. Mr. Shively was asked his understanding of this amendment. He stated that there is better direction with this amendment inserted in terms of getting to the kinds of mechanism that Senator Frank mentions in his other changes. He stated the purpose of the legislation is to test the feasibility of the field, otherwise, the royalty would be left alone. The language has been debated, in the final analysis, it strengthens the purpose of the legislation. Senator Rieger expressed the difficulty in defining marginal. This is the administration's bill. He supports the language. However, he asked how the administration determines if a field is economically feasible. Mr. Shively said that as he understands it, there will be an analysis on the rate of return of investment. There will be a determination on fair rate of investment, which is debatable. If the determination is made that it is under the fair rate, then it would not be feasible to develop without the royalty reduction. The reason for making the changes is, if the assumptions based on the rate of return change, particularly with price and volume, then there should be an upward adjustment. Senator Rieger stated with that approach, it might be that with a royalty modification, not a downward adjustment, the expected rate of return does not change. The threshold return that the company requires goes down. Taking a number of 14% rate of return, may be adequate, when there is a risk sharing arrangement, but not acceptable rate of return to induce an investment if there is too much downside. He noted that it was not absolutely clear that there has to be a downward adjustment as the base case of a modification. Mr. Shively responded that this is a way that some companies do business. This is not the intent of this legislation, though it is a concept worthy of further review. He stressed that this legislation is not meant to solve every possible potential situation. The Oil and Gas Policy Council will be analyzing other approaches as incentives over the next year. Co-chair Frank pointed to the rate of return. He read an analysis from the Dept. of Natural Resources: "A reasonable rate of return that is independent of the particular company financing involved should be adopted to avoid possible manipulation of an in-house economics simply for royalty reduction purposes." He asked what the policy would be on that statement. He brought out that it was in the Conoco findings, dated 12/28/90. Mr. Shively stated that it did come from Conoco, included in current law, which has been determined necessary to be place into this legislation. Some of the changes and amendments being considered is designed to give more flexibility. Co- chair Frank restated that the department is saying, "that under current law, the state cannot analyze a company's rate of return and analyze two difference companies and give one a royalty reduction." In the previous memo from the department, is states that there should be a consistent rate of return; nor should hurdle rates be considered. Mr. Shively stated that when that occurred, Conoco already had lost their investment costs. In this situation we will be looking at fields that may have different kinds of risks. Risks are what people look at when analyzing hurdle rate. Location, and size of capital investment may go into the risk analysis. If the department does not have the capacity to a determination, there would be outside experts hired. Co-chair Frank asked if the department should be striving for consistency in terms of analyzing? If rate of return is the variable for determination, should there be a policy covering this area of concern? Mr. Shively responded that a rate of return is a major issue. There should be consistency. Once there is experience, then the accuracy will be better. He pointed out that there are other risk factors. He also suggested that all companies do not look at investments in the same way. This legislation has language making it flexible to address the various situations. Co-chair Frank stated that the department should have a policy with consistent rate of return. Co-chair Halford asked the question, for adoption of Amendment #5. By a show of hands the amendment FAILED. Senators Zharoff and Rieger voted for the amendment. Co- chairs Halford and Frank, along with Senators Sharp and Phillips voted against the amendment. Senator Rieger MOVED to adopt a version of the drafted Amendment #6 which deletes on line 7, page 3, after the word "price", "or value of the hydrocarbons produced". Senator Zharoff OBJECTED. No further debate, and by a show of hands, the amendment was ADOPTED. In referring to the remains of the Amendment #6, he asked to have defined the terms "fully compensates" and "negative risks". Senator Rieger stated that Anne Finley, the drafter in legal services used the term "negative risks",to mean the downside potential be equal to the upside potential." The term, "fully compensates" means equal. Following the explanation and by a show of hands, Amendment #6 FAILED. Senator Zharoff voted for the amendment. Co-chair Halford, along with Senators Phillips, Rieger and Sharp were opposed. Senator Rieger stated that the language in Amendment #7 is permissive, but that the language was acceptable. He MOVED for the adoption of Amendment #7. Co-chair Frank asked to delete section (ii) on page 3, line 16, keeping the focus on the price. He said it is the one known element. If the price goes down, there would be relief. If the price goes up, it would be obvious. There would not be an opportunity to make changes in production rates driven by royalty effects. Senator Sharp asked if this section only applies to the original application for adjustment. Senator Rieger responded that the entire modification would be structured up front. It might be that on the ultimate recovery questions, there remain unknowns until later. How it is made to work, he does not know. The advantage of using only price for recovery, whether it is current recovery or total recovery is understandable. This is only an option. Mr. Shively stated that it is permissible. The department says that the volume is a variable that will always go up. This gives the state the opportunity to collect on the upside, which is always better. Collecting can be done in a variety of ways: it could be based on a daily, monthly, or annual production; or above a certain total amount. Any alternative would be part of the negotiation. It would be in addition to any adjustment as a result of price. The department wants the paragraph in question, to stay in. Co-chair Frank expressed concern regarding the amendment because, it could be, that the volume of oil is going to be greater than the company says it is going to be when they make application. He was fearful that the state could be put off for royalties to a later date, if ever. Mr. Shively said that if it is confined to production rate, the company can manage that rate. Therefore, they never have to go above it. He cited a company in Norway that managed under the volume to keep the royalty down. It is a potential problem. If, on the other hand, there is pay on volume, it might give more incentive to produce earlier. Combined to rate, it gives them a great incentive to stay under that rate. Senator Sharp expressed concern over production rates being manipulated. He stressed the possibility of never seeing the upside. Co-chair Frank said he is convinced that the focus should be on the price. He noted that what is heard, is the volatility of price being risky. Mr. Shively responded that they can delineate before the investment is made. Co-chair Frank stressed that if the emphasis were on the price, there would be risk sharing, which would eliminate the manipulation of the production rate or the ultimate recovery. Mr. Shively responded that in dealing with estimated volume and estimated rates, it is cause for disagreement for the lessees. When dealing with what is down the hole, one is dealing with different geological theories. One cannot make the analysis without the volume. If one is using it to make the initial analysis and it is ignored, and there is a considerable amount of oil, which there can be, then the state has lost an economic opportunity. Even if this happens 10, 15, 20 years down the line. Co-chair Frank stated that it is an inherent problem crafting law to make it work in the way it is intended. He stated he was not in disagreement, but he is also looking for a vehicle that will give them confidence. Co-chair Halford stated that in the section on information, "It shall be disclosed to legislators, legislative audit, legislative finance, employees of their divisions, or contractors of the auditor of finance division who is engaged to evaluate it." Mr. Shively pointed out that on page 4, line 24, Section 7, it states, "may require the lessee or lessees making application for the royalty modification to pay for the services of an independent contractor, qualified to evaluate hydrocarbon development, production, transportation, and economics, who is selected by the commissioner to assist the commissioner in evaluating the application and financial and technical data; selection of an independent contractor under this paragraph is not subject to AS 36.30;" Co-chair Frank stated that the royalty reduction that BP submitted on the Badami Project was turned down. Was that solely based on price, or did it have a production or field volume element to it? Mr. Shively stated that it was solely based on price. Co-chair Frank asked if it was turned down because there was not enough upside? Mr. Shively responded that it was withdrawn, not turned down. The state did not have the authority to grant it. It is in the marginal field category in terms of volume. Co-chair Frank asked if the methodology in a "price only" sliding scale was appropriate? Mr. Shively introduced Kevin Banks, Economist for the Division of Oil and Gas. Mr. Banks stated that in the Badami case, price would not have been a sufficient variable upon which to base a royalty percentage. He stated that it is entirely possible, without changing the total recovery in a field. In response to increases in prices, that the production rates could be increased in the field by drilling wells more quickly and stimulating the oil field, so that these production rates increase. The fact is, that revenue is, price times the production, at any given period of time. It has a dramatic effect on the economics of the field if one can begin to pull out oil much faster and sooner. The state would want to be protected to take advantage of those types of situations where that may arise. It is possible to produce more oil from a field. He cited the example of the Gulf War, when prices rose dramatically, but in Prudhoe Bay, production rose to over 200,000 barrels a day because of rapid stimulation in the field to take advantage of those high prices. Co-chair Frank offered an Amendment to Amendment #7. On line 17, delete, "as", insert, "which must meet the conditions...". Senator Rieger asked Ms. Finley about the language. She stated that it does not do harm and even without the language that is what it says. The administration expressed no objection to the amended amendment. The amendment was MOVED and ADOPTED. Co-chair Halford asked if there were objections to adopting the amended version of Amendment #7? No further objections being heard, amendment #7 was ADOPTED. Senator Zharoff MOVED to adopt Amendment #8, which is the sunset provision. By a show of hands the amendment failed. Senator Zharoff voted for adoption. Co-chairs Halford, Frank, along with Senators Rieger, Sharp and Phillips were opposed. Senator Zharoff offered a verbal amendment to amend the date on Amendment #8 to the year 2015. Those in favor: Senator Zharoff; Those opposed: Co-chairs Halford and Frank, Senators Rieger, Sharp, and Phillips. The amendment FAILED. Senator Zharoff amended Amendment #8 to a new date of 2010. Those in favor: Senator Zharoff; Those opposed: Co-chairs Halford and Frank, along with Senators Rieger, Sharp and Phillips. The amendment FAILED. Senator Zharoff amended Amendment #8 to a new date of 2005. Those in favor: Senator Zharoff; Those opposed: Co-chairs Halford and Frank, along with Senators Rieger, Sharp and Phillips. The amendment FAILED. Senator Zharoff WITHDREW Amendment #9. Co-chair Halford asked for a definition of a field or a pool. Mr. Shively responded that there is not an exact definition. A pool may be a different horizon or different area of oil that may underlay one or more leases. He cited an example of the Kuparuk field that is being developed and West Sak, a pool above it. This language allows at looking at the two pools separately opposed to all one field. Co- chair Halford asked if they can be producing from the same hole. Ken Boyd, Director, Division of Oil & Gas, responded that they can come from the same hole, but more often, they do not. Co-chair Halford asked if the administration needs the term, "or pool" in the legislation. Mr. Shively responded that it does give more flexibility. It has been debated in the House Oil and Gas Committee and the House Resources Committee, discussed in some detail in Senate Resources. All those committees were comfortable with the provision. Senator Leman stated that Resources deleted the phrase, "or a portion of a pool" because it was decided not to name individual wells in a field or a pool. Co-chair Frank asked how many producing pools there are. Mr. Boyd responded that there are a number of pools within a field. Co-chair Halford asked the wishes of the committee. Senator Rieger MOVED to adopt SCSCSHB 207 (FIN) with individual recommendations and accompanying fiscal notes. SCSCSHB 207 (FIN) was REPORTED OUT of committee with no recommendations and the following fiscal notes: Dept of Revenue (APFC), zero; Dept of Natural Resources, $105.8; and Dept of Revenue (Revenue Operations) Indeterminate amount. ADJOURNMENT The meeting was adjourned at approximately 11:30 p.m.