CS FOR HOUSE BILL NO. 57(FIN) "An Act amending the manner of determining the royalty received by the state on gas production as it relates to the manufacture of certain value-added products." This was the first hearing for this bill in the Senate Finance Committee. Co-Chair Wilken stated this bill "allows the Department of Natural Resources commissioner to adjust the value of the State's royalty share for gas used by a manufacturer for agricultural chemicals." He noted a proposed committee substitute "Version C" was submitted to the Committee by the sponsor. He requested a presentation of the bill and a comparison of "Version C" to the House Finance committee substitute [referred to as "Version X"]. REPRESENTATIVE MIKE CHENAULT, Sponsor, explained this bill "adds certainty to in-State value-added manufacturing". Currently, he informed, royalty prices are calculated in four different ways which causes problems for manufacturers because the price of gas is uncertain, as well as the royalty owed on that gas. He explained that four years after the sale of product, an audit could determine that the price was considerably higher, costing the manufacturer $4 to $5 million in additional royalties. He stated this legislation would permit manufacturers to negotiate the price of the gas to allow the manufacturers to sell it at a price that allows for a profit. SENATOR TOM WAGONER clarified this legislation pertains to the "price of the State royalty share of gas". Senator Bunde commented that residents of the Kenai Peninsula oppose the level of State spending; however, this legislation proposes increased State funding. He understood the need to support viable industry. He asked the estimated cost to the State. Representative Chenault cited the fiscal note, which predicts the cost to be between zero and $11,5 million in lost royalty payments. He listed the factors, including the negotiations reached by the commissioner, employment opportunities and tangible benefits to the communities. Senator Taylor asked the version the sponsor supports. Representative Chenault responded that the proposed committee substitute, Version "C" mirrors Senate companion legislation and reflects a compromise agreed upon by the Senate. Senator Wagoner reiterated Version "C" is the preferred version. Senator Taylor moved for adoption of CS HB 57, 23-LS0303\C as a working draft. Without objection the committee substitute was ADOPTED as a working draft. Senator Taylor revisited the potential cost to the State. Senator Wagoner clarified the maximum $11.5 million predicted loss of royalty revenues would occur over a period of several years. Senator Taylor asked if this estimate is based on the provisions of committee substitute Version "C" or the House Finance committee substitute. Representative Chenault replied Version "C". Co-Chair Wilken noted a draft fiscal note, dated 5/5/03, addresses the provisions in Version "C". Senator Hoffman expressed concern that chemical fertilizing plants nationwide are currently failing because the methane gas used in stock feed is worth more than the finished product. He questioned therefore the benefits of this legislation to provide jobs. Representative Chenault could not speak to businesses elsewhere failing, but stressed the economic impact the loss of jobs on the Kenai Peninsula that would occur if the local facility failed. He informed that personnel layoffs are currently under consideration, although he attributed this to new ownership and because the plant is operating at 70 percent of capacity. Senator Hoffman asked if the sponsor would consider a shorter time period for a negotiated price to minimize the loss of royalty revenues. Representative Chenault indicated he would have to give the matter consideration before offering support. Co-Chair Wilken referenced page 2 of the draft fiscal note, which details the potential loss of royalties over the five-year period. Co-Chair Wilken asked for an explanation of the current process and why the royalty rate changes. He also asked for additional information on the impact on the State general fund. Representative Chenault remarked that this bill would not affect current contracts for gas supplies. He explained the existing process whereby the State and the producer negotiate a royalty amount without input of the manufacturer. He stated that upon review after four years, the State could determine that the negotiated royalty was not a "fair price". Co-Chair Wilken asked for an example of the producers in this context. Representative Chenault exampled Unocal and Marathon, noting that all gas producers are involved in the royalty negotiation. Co-Chair Wilken clarified the producer negotiates a long-term contract for the "price of that feed stock" with the State. Senator Wagoner told the Committee that the previous owner of the manufacturing plant also discovered and produced the gas. Currently, he said, Union Oil produces the gas, and Agrium operates as the manufacturer. Co-Chair Wilken next clarified the States receives 12.5 percent in royalty from Unocal, the producer, which sells that gas to Agrium. Representative Chenault affirmed and continued that the State could conduct an audit of the royalty price negotiated with Unocal and subsequently could determine that Unocal paid less than the worth of the gas. Co-Chair Wilken understood an agreement of the price was negotiated. Representative Chenault reiterated the existence of four different methods to calculate the royalty amount. As a result, he stated the State could determine additional payment is required, at which point, Unocal would collect the funds from Agrium. SFC 03 # 78, Side A 10:36 AM Co-Chair Wilken asked if retroactive price adjustments are a condition of the agreements between Unocal and Agrium. Representative Chenault affirmed. Representative Chenault reiterated this legislation would not impact current contracts, however in future contract negotiations Agrium, i.e. the manufacturer, would participate in negotiations and the royalty price would remain at the negotiated amount for the term of the contract. Co-Chair Wilken asked if Unocal were able to receive a higher price from the sale of gas to a buyer other than Agrium, whether the difference would be assessed to Agrium. Senator Wagoner told of the contract providing that Unocal would supply gas to Agrium at a negotiated price. He noted one exception is increased utility demand during winter months. Representative Chenault emphasized this legislation would provide assurances that under the terms of future contracts, the manufacturer would pay the negotiated royalty price. Co-Chair Wilken asked if new contracts would be implemented in FY 05 and FY 06. Representative Chenault informed that one long-term contract is in effect currently and that the remainder of the gas purchases are subject to "spot market". He stated that the manufacture is attempting to purchase an adequate supply of gas to operate the facility. Senator Wagoner furthered this legislation allows the commissioner to negotiate profit sharing with Agrium if determined to be in the best interest of the State. KEVIN BANKS, Division of Oil and Gas, Department of Natural Resources, testified via teleconference from an offnet location, that leases negotiated since statehood are market-value leases. He explained that the royalty value is subject to an evaluation using four different measures to determine the market value of the royalty. He noted that some leases in other states are gross proceeds leases, which provides that the royalty paid by the lessee is equal to the amount that the lessee sold the gas. He stated the sale price of the gas is one of the four measurements utilized for determining market value of royalty in Alaska and that the State is allowed to consider the price between the lessee and its customers compared to the market value as measured by other mechanisms. Therefore, he pointed out, the sale price and the royalty price could differ under the provisions of the lease agreement if the market value is higher. Mr. Banks stated that determinations of higher royalty amounts are often made after an audit and after the initial royalties have been paid. In these instances, he said, the lessee is required to pay additional royalty amounts two or more years later. Mr. Banks pointed out that gas supply contracts commonly allow the lessee and its customer to agree to an "excess royalties" term. He exampled contracts between gas producers operating in Cook Inlet and utility companies include this provision. Mr. Banks outlined the fiscal note estimates the amount of gas that would be sold to Agrium and other entities, such as utilities, in the future, not including gas currently under contract. He stated the fiscal note assumes that a royalty contract would provide for the State to collect additional royalties in the event the market value is determined higher. Co-Chair Wilken asked if an audit calculates the price of gas if it were sold to a utility company, compared to the price charged Agrium, and collects the difference from Agrium. He asked if this legislation eliminates this review and stipulates that the value of gas sold to utility companies has no bearing on the royalty amount due from Agrium. Mr. Banks affirmed. Co-Chair Wilken clarified that this bill establishes a procedure by which the royalty price is determined through negotiation, and asked which parties are involved in these negotiations. Mr. Banks replied the suppliers and Agrium negotiate and that the State has no involvement. Co-Chair Wilken asked if the State is therefore relinquishing the utility value, or alternative customer value of gas sold to Agrium, and for the benefit of fertilizer production on the Kenai Peninsula. Mr. Banks affirmed. He pointed out that Version "C" provides that the commissioner has the discretion to set a royalty price for between $2 and $2.43, as exampled in the draft fiscal note. He stated that under normal circumstances the value is $2.43 and the contract value is $2.00. Co-Chair Wilken asked how the commissioner would determine the actual amount. Mr. Banks replied the commissioner must ensure that the contract price is not unreasonable low, and that the prospective reduction in royalty receipts would be balanced by employment opportunities in the fertilizer manufacturing plant. Senator Hoffman asked how often during six-year term of the contract would the commissioner make a determination of the royalty amount, once or more often. Mr. Banks explained the process, whereby each lessee would submit an application to commissioner and provide the terms of a contract with Agrium listing the negotiated prices. He said this information would be used in calculating the royalty and would occur only once in the life of the contract. Co-Chair Wilken announced the bill would no report from the Committee during this hearing. MIKE NUGENT, General Manager, Kenai Nitrogen Operations, Agrium, testified via teleconference from an offnet location that this legislation is "one piece of a pie, which could provide producers in Cook Inlet with stability, and Agrium with certainty of what the are to manufacture the products we sell." He informed that natural gas is the major raw material used to develop products. Mr. Nugent asserted the nitrogen facility is one of few major value-added manufacturing operations in Alaska, is the second largest producer of nitrogen products in the United States, and that six-percent of the total nitrogen products are produced in North America. He listed the Pacific Rim countries that import Agrium products, including Korea, Taiwan, Mexico, and Thailand, and the need to be competitive in world markets. He remarked that the company currently is competitive because of the facility's location close to markets, the highly skilled workforce and the stable political climate; unlike the competitors located in Russia, Indonesia, Saudi Arabia and Venezuela. However, he pointed out these countries enjoy "extremely low" natural gas prices, which puts Agrium at a disadvantage. He stated this legislation would lessen the disadvantage. Mr. Nugent informed that this bill would allow the commissioner to accept the price negotiated by the producer and the manufacturer, Agrium, as the amount by which royalties would be calculated. Mr. Nugent pointed out the fiscal note does not reflect economic impacts provided by Agrium, including wages, purchase of goods and services, taxes and new development to Alaska, and instead only considers the price of natural gas. He stated that the analysis is based on forecasts, which involve several variables that are difficult to predict, such as volume, price and ownership. He furthered that the analysis assumes that the facility is operated at full capacity. Mr. Nugent shared that the facility is not operating at full capacity because Cook Inlet suppliers are unable to deliver adequate natural gas supplies. He stated the plant is currently operating at 75 percent of capacity, which results in lower revenue for the State of approximately $2 million if 2003. He warned that unless able to fund producer to supply a large quality of natural gas at a competitive price, Agrium could eventually fail as a business and the State and local communities would receive no revenues from the operation. Mr. Nugent told of repeated discussions with producers in Cook Inlet in which the primary concerns were the additional royalty charges the producer is subject to. He cited a letter to the City of Kenai from Aurora Power Resources, Inc. dated February 11, 2003, which reads as follows [copy on file]. Aurora Gas, LLC is aggressively pursuing the development of natural gas producing properties, primarily on the West side of Cook Inlet. Oil and gas exploration and development is a high cost, high-risk endeavor. As a producer looking for to market our natural gas there is a great hesitation to enter into a gas sales agreement with a purchaser, such as Agrium, because it adds yet another layer of risk to a producer. A producer selling gas to Agrium runs the risk, in fact the probability, that certain years after selling its gas to Agrium, the State will assert a claim that royalty needs to be paid on a higher value than the arms length negotiated contract price. This additional royalty, plus interest accrued at a higher-than-market rate, would have to be born by the producer and/or by the purchaser. It is for this reason that Aurora Gas, LLC and its natural gas marketing affiliate, Aurora Power Resources, Inc. strongly endorse this legislation and the concept that royalty should be paid on the basis of arms length negotiated contract prices. Accordingly, we salute and support the draft resolution in support of HB 57 and urge the Kenai City Council to adopt same. Mr. Nugent spoke of the increased difficulty of development of natural gas reserves caused by the unknown State royalty values. Senator Taylor noted he was absent during portions of the testimony asked why the chair intended to hold the bill in Committee. Co-Chair Wilken indicated questions related to the fiscal note. Senator Bunde referenced Mr. Nugent's testimony asserting that the fiscal note does not take into account taxes collected from Agrium in determining the cost of this legislation. He requested further information on this matter, specifically what taxes. Co-Chair Wilken instructed the sponsor to provide a detailed sponsor statement explaining the bill. Co-Chair Wilken ordered the bill HELD in Committee.