CS SSHB 28(FIN)-OIL & GAS ROYALTY MODIFICATION  REPRESENTATIVE NORM ROKEBERG, co-sponsor of HB 28, told members that HB 28 is a "tune-up" of AS 38.05.180(j). That section of statute pertains to royalty modifications of marginal fields. In 1995, the new Governor brought forth this legislation as a major centerpiece of his Administration to try to increase oil production in Alaska. That bill was crafted in such a way that it created impossible barriers for it to work. During that nine- year period, no grants of royalty reduction have been granted by the state. This bill modifies that statutory section to remove some of those barriers and it simplifies the language. He directed members' attention to the language on page 2, beginning on line 24. That particular language embodies, in one paragraph, the discretionary ability of the commissioner to grant a royalty modification under the terms set forward in it. It deletes language that indicates that if a royalty modification is granted, the state would have to ultimately recover. The intent was to increase oil exploration but it required that the state recover its money even though it was reopening a dry hole by royalty reductions. He said the provisions of the bill became almost unintelligible. TAPE 03-49, SIDE B  REPRESENTATIVE ROKEBERG said HB 28 removes that language and provides for a sliding scale royalty to be determined by the commissioner who, under the Constitution, must act in the best interest of the state. It provides that relevant factors be taken into consideration, such as a change in the price of oil and gas, in production rates, production ultimate recovery, development costs and operating costs. Therefore, if the price of oil increases, the state's share will increase on a sliding scale basis. It contains other provisions that remove some of the oversight. He said the Administration supports the legislation. CHAIR OGAN said he instantly recognized this legislation from his participation on the House Oil and Gas Committee years ago. He asked if there has been any use of the statute. REPRESENTATIVE ROKEBERG said there was one application from Unocal that did not go through. Although the public believes the legislature gave big incentives to the oil industry, the North Star modification was the only thing that occurred. He pointed out that other specific royalty bills targeted certain fields, particularly in the Cook Inlet area, that had to be enacted because the statute did not work. 11:30 a.m.  REPRESENTATIVE VIC KOHRING, co-sponsor of HB 28, told members the sliding scale would likely be between 3 and 12.5 percent. The general royalty rate has been 12.5 percent. The commissioner is granted discretion to determine the rate. The commissioner can make that decision based on an in-house evaluation, or through an independent contractor. The evaluation will consider operating costs, field recovery, production rate and volume. REPRESENTATIVE ROKEBERG commented that the fiscal note indicates program receipts at $150,000. He stated: I caution you - it's just program receipts because of the requirement of a maximum ceiling on any applicant where they can hire a third party consultant. Actually, I think the fiscal note's not correct. It should be a zero fiscal note. Only if there's an application would there be any program receipts generated. So I just wanted to point that out. This bill is not going to cost the state anything - only in foregone royalties that we wouldn't perhaps get otherwise if they're bringing a shut-in well back on production. MR. KEN BOYD, an oil and gas consultant, said he was testifying on behalf of the Alaska Oil and Gas Association (AOGA). He stated support for CS SSHB 28(FIN) and said he participated with Representative Rokeberg and Senator Ogan and a cast of hundreds seven or eight years ago who worked on the existing law. He said the current royalty reduction statute is awkwardly worded and very difficult to implement. SENATOR SEEKINS asked if a model already exists for the sliding scale or whether this bill will give the commissioner the discretion to set a sliding scale for each particular field. REPRESENTATIVE KOHRING said it is his understanding this bill gives the commissioner that discretion. He deferred to Mr. Myers for an answer about an existing model. SENATOR SEEKINS asked if a cap exists for the state's overall agreement with an oil company or whether there is a seller price. MR. KEVIN BANKS, Division of Oil and Gas, Department of Natural Resources (DNR) said, regarding whether a model exists, DNR uses fairly standard discount cash-flow models. DNR would more than likely tailor a sliding scale royalty provision to the specifics of each applicant. He said he can't say the bill contains a cap. DNR could conceivably trade a 12.5 percent royalty for a royalty modification that would allow for some sliding scale that could exceed, in rare instances, the 12.5 percent rate. However, that would depend upon the kind of project and the unknowns at the time of application. SENATOR SEEKINS asked if the oil companies will pay more during the "boon" years. CHAIR OGAN said as memory serves him, he believes there was an upside in the original legislation. MR. BANKS said the original HB 207 contained some complicated language that directed the commissioner to develop a system that would pick up on the upside. Unfortunately, it was written so that it removed any projected royalty modification benefits to the applicant. In CS SSHB 28(FIN), the commissioner can negotiate an upside but is not required to do so. He said he can think of cases where a sliding scale between 3 and 12.5 percent would provide sufficient incentive to get production on line. The state's reward for giving up some of its royalty on the front end would be to get more production out of the prospect. CHAIR OGAN said subsection (3) on line 24, page 2, seems to be the key to the legislation. It says "sliding scale royalty or other mechanism" so it provides broad latitude. He added that it provides for an increase or decrease and asked if it gives that discretion to the commissioner. MR. BANKS said that is correct. SENATOR BEN STEVENS asked if this legislation prevents or allows the commissioner to make rate adjustments to specific platforms [in Cook Inlet] without coming to the legislature for legislation. REPRESENTATIVE KOHRING said the answer is yes but this legislation does not apply to platforms. He noted that SB 185 pertains to platform royalty reduction and differs from this legislation. He explained that the intent of CS SSHB 28(JUD) is to encourage the industry to develop three types of fields because they are not profitable: new fields, existing fields, or mothballed fields. SENATOR BEN STEVENS said if this legislation is not enacted, separate pieces of legislation would be brought forward, such as SB 185, asking for royalty rate reductions for specific fields. He said instead, CS SSHB 28(JUD) defers all legislative authority for rate reductions to the commissioner. REPRESENTATIVE KOHRING said that is correct, for marginal fields only. He said the legislation is not specific to certain fields; it applies to any field in the state considered to be unprofitable. He said the commissioner will determine whether a field is profitable after doing an analysis of each field. SENATOR BEN STEVENS asked Mr. Myers to describe what kinds of fields fall under those three categories. MR. MARK MYERS, Director of the Division of Oil and Gas, DNR, told members this bill amends an existing royalty reduction statute. It does not create a new program; it fixes some problems in the existing statute. That statute was modified but the last set of modifications created unintended consequences that were problematic. CS SSHB 28(JUD) applies in three situations: to new fields that are not economic where reducing the state's royalty share would make the field go; to fields in a later stage of production where operating costs exceed the value of production; and to fields that have been physically shut in so there is no production flowing. Reducing the royalty would change the economics sufficiently to start up production of the field again. This bill gives broad authority to the commissioner to set terms to recapture upside. MR. MYERS said once a field is in development, a few things might improve its economics - operating costs remain the same but an increase in oil prices creates a dramatic increase in profits. Under this bill, rising oil prices can be structured into the royalty rates. Second, if production itself increases, which is only likely in a new field, the state needs a mechanism to capture the upside as more data comes in. This bill allows for all of the adjustments by giving the commissioner a lot of flexibility. However, the agreements still require legislative approval. He said an example of a field that is not yet in production would be the small field at Umiat; a field that is producing but is close to shut-in is Badami, which is currently producing about 1400 barrels per day. He said SB 185, the platform bill, addresses a unique set of circumstances in Cook Inlet where some fields are late in life with a 30-year production history. DNR was comfortable with the data about that area and did not feel it needed a mechanism to recover the upside. That legislation contains a customized approach for Cook Inlet platforms that do not require this same process. The advantage of that approach is to retain the infrastructure in Cook Inlet. SENATOR WAGONER asked how CS SSHB 28(FIN) will apply to abandoned oil wells. MR. MYERS said they could fall under all three categories, because of the term "field or pool." A deeper reservoir of oil under a shallow gas reservoir could be a separate reservoir. Depending on whether that gas had been produced before by field or pool, it could qualify under any of the three categories. He said the operator would have to justify that the economics did not support operation without the royalty reduction. He explained that the process for approving the royalty reductions would be a little different. The preliminary decision would be submitted to the legislature during the public comment period, however the legislature does not vote to approve royalty reduction under this bill. SENATOR BEN STEVENS asked if that provision is in Section 8. MR. MYERS said that is correct. CHAIR OGAN pointed out there is a $150,000 cap on the amount that can be paid by the lessees and asked whether that reflects program receipts. He also asked if that amount is appropriate or whether it will cost DNR more than $150,000 to administer. MR. MYERS said that money would come from the applicants so there should be no additional cost to the state if the program receipts are authorized. He said that amount was negotiated with the sponsor and he cannot say whether it is totally adequate. In the past, all of the royalty reduction requests have been handled internally. DNR recognizes that a lot of analysis will have to be done on new fields, where little data is available. DNR believes $150,000 is an adequate amount. CHAIR OGAN asked what fields this might apply to. He noted a bill just passed the Senate that deals with severance tax breaks for certain wells. He questioned how the two pieces of legislation dovetail and whether CS SSHB 28(FIN) is targeted toward heavy oil. MR. MYERS said it is targeted at any producing field. He said fields go through various stages. At a field's end stage, the operator and the state must determine when it becomes uneconomic. He said royalty reductions are truly effective at the very tail end of declining production. He expects this legislation to eventually apply to all fields in the state. He pointed out in the other cases, DNR will have to look at the individual economics of each field. He said with heavy oil, as the technology changes, the economics have vastly improved. DNR would have to take a serious look at the detailed economics, the engineering and the reservoir. He indicated the heavy oil reserves are just being tapped now and are in their initial stages of production. He pointed out the exploration incentive is specifically crafted to not include wells within units that are producing or any units that have a plan of development. SENATOR DYSON asked if anyone is opposed to CS SSHB 28(FIN). MR. MYERS said he is not aware of anyone. REPRESENTATIVE KOHRING said he was not aware of anyone either. The bill had three committee referrals in the House and he did not recall any negative testimony. CHAIR OGAN noted this bill is extensive and he has some angst about the short timeframe for study. He asked Mr. Myers if he is aware of any flaws that committee members' may not be aware of. MR. MYERS said he believes the bill improves the process. Although compromises are made in every bill, he believes the compromises are balanced and that the interests of the state are well protected. SENATOR WAGONER asked if Swanson River has any royalty incentives right now. MR. MYERS said he believes Swanson River is primarily a federal unit. SENATOR BEN STEVENS noted that Mr. Myers said that application is determined on the end of life determination of the field, which he believes is a trigger to the possibility of a royalty reduction. He expressed concern that any operator could say a field is at the end of production life. He asked how DNR would determine whether a field is at end of life. MR. MYERS said this bill allows those royalty reductions to occur at any stage of a field's life but, to determine the true economics of a field takes a lot of work and is more difficult the further it is from the end of field because later in the field life there are more well and seismic data and production profiles. He said the calculation is very technical, which is why the fiscal note contains funds for outside experts. CHAIR OGAN asked why the language on page 2, lines 5-9, is being deleted. He stated: I remember we had a lot of discussion with the bill that originally passed about delineation of the oil and gas field or pool and, instead of delineating it to allow the commissioner to conduct an analysis and make the findings required by the subsection, we're eliminating - we're just letting them delineate to the satisfaction of the commissioner and it doesn't say anything about findings. Why are we doing that? MR. MYERS said they wanted the delineation to be done on a technical basis. Representative Rokeberg was concerned about the level of legislative input and cleaning up the cumbersome nature of the mechanism. He said the original royalty reduction required two years of production. There was a push at that time, primarily by BP, to allow a reduction before production start- up. BP then asked for the royalty reduction. However, the reality is that some production is necessary to determine the economics of the field. The legislature at that time said as long as the reservoir was delineated, it was willing to grant a royalty reduction. He said this bill establishes the necessary level of data and who gets to decide whether a reservoir has been sufficiently delineated. CHAIR OGAN said the bill contains no sunset data or requirement to report to the legislature. MR. MYERS clarified that the commissioner's preliminary decision will be presented to the legislature. The House amended the bill to provide the legislature with access to confidential data. REPRESENTATIVE VIC KOHRING said regarding the potential Permanent Fund earnings that this bill will generate, this bill essentially deals with three fields. Two are not producing anything at all. One way to look at the economics is that the state could get 12.5 percent of nothing, or 3 or 7 percent of something, by virtue of the sliding scale. CHAIR OGAN asked if there is as much known heavy oil on the North Slope as has already been discovered. MR. MYERS said that is correct but the recoverability of that heavy oil will be much lower, probably 10 to 15 percent. MR. KEVIN TABLER, Manager of Land and Government Affairs for Unocal, stated support for CS SSHB 28(FIN). He said it is a substantial improvement to the 1995 legislation, in that it provides clarification and predictability for an applicant. CHAIR OGAN asked Mr. Tabler if Unocal applied for a royalty reduction but did not complete the process. MR. TABLER said Unocal pulled out after 18 months and a significant amount of cost. CHAIR OGAN commented this bill is extensive, however the policy decision to allow royalty reduction was already made by the legislature. SENATOR WAGONER moved CS SSHB 28(FIN) from committee with individual recommendations and its attached fiscal note. CHAIR OGAN announced that without objection, the motion carried. He then recessed the meeting to the call of the Chair at 12:10 p.m.