SB 30-APPROVAL: ROYALTY OIL SALE TO PETRO STAR  3:31:13 PM CHAIR GIESSEL announced SB 30 to be up for consideration. She said this bill cannot be amended since it is ratifying a contract for royalty oil between the Alaska Department of Natural Resources (DNR) and Petro Star. Last year this body considered and ratified the contract between the Alaska Department of Natural Resources and Tesoro. She explained that Alaska's Constitution mandates developing the resources for the maximum benefit of the people of Alaska and when the state takes its royalty oil in kind (RIK) it needs to prove that it is getting more money than it otherwise would taking royalty in the traditional means of in value (RIV). JIM SHINE, Commercial Manager, Division of Oil and Gas, Department of Natural Resources (DNR), Alaska Department of Natural Resources (DNR), said he would first provide a brief overview on the contract ratification process and then review the contract. ED KING, Special Assistant to the Commissioner, Alaska Department of Natural Resources (DNR), introduced himself. MR. SHINE noted that DNR Deputy Commissioner Mark Wiggin was available on line as well as other members of the Commercial Team who were involved in the negotiation with Petro Star. He explained that when the state takes royalty it has a choice to receive it in kind (RIK) - physical possession - or in value (RIV). When it elects to receive its royalty in value, the producers ship, co-mingle, and sell the state's royalty share with theirs and remits the state's value to it by way of a check. When the state elects to receive RIK, the state assumes ownership over the actual oil and the DNR Commissioner disposes of it through sale procedures described in statute. The state has regularly sold RIK to in-state refiners dating back to 1979 with Mapco/Williams. The contract that is before them in SB 30 for ratification has gone through a thorough public review; the preliminary best interest finding (BIF) was out for a 30-day public comment and no comments were received. A revised BIF was presented to the Royalty Oil and Gas Development Advisory Board (Royalty Board) in August and it considered the contract, the presentation, and the BIF and recommended unanimously that the legislature approve it. 3:35:01 PM MR. SHINE clarified that there are two contracts, and the one that is currently in place is a one-year contract commencing on January 2017 for the sale of royalty oil to Petro Star, which does not require legislative approval. Following the termination of that contract starting in January 2018, the four-year contract in SB 30 would commence. The state will receive a combined benefit from the two contracts of $29 - $37 million more than if it had received the same barrels over those five years in value. SENATOR COGHILL joined the committee. CHAIR GIESSEL asked who is on the Royalty Board. MR. SHINE replied that the Royalty Board consists of eight members: three commissioners from the Department of Natural Resources (DNR) who is a non-voting member, the Department of Revenue (DOR), and the Department of Commerce, Community and Economic Development (DCCED), as well as five public members: Bruce Anders (Chair), Dana Pruhs, Kathryn Dodge, Lawrence Gaffaney, and Steve Selvaggio. SENATOR WIELECHOWSKI asked if the lower tariffs are factored into the $29 - 37 million in savings from the increased production in the pipeline that would result in more revenue to the state. MR. SHINE replied the $27 - $37 million figure is spelled out in the BIF. The real benefit is the difference between the marine transportation deduction, which is present in the RIV net back formula versus RIK net back, which is an in-state location differential, which he would describe later. SENATOR WIELECHOWSKI asked again if that savings figure takes into account the lower tariff that would result in slightly higher taxes to the state. 3:38:12 PM MR. SHINE answered that both RIK and RIV formulas have a tariff reduction as part of the net back formula. If the royalty volumes are coming from Prudhoe Bay, the tariff is from Pump Station 1 to the Valdez Marine Terminal. Tariffs from any fields upstream of Prudhoe Bay would include transportation to that point. 3:38:32 PM However, before taking RIK the commissioner must find it is in the state's best interest. The state can dispose of its RIK through a competitive bid process or a non-competitive, negotiated sale process. The DNR issued a solicitation of interest in January 2015 to five refineries - Petro Star, Tesoro, Flint Hills, BP, and ConocoPhillips - within the state to determine market interest in purchasing the state's royalty barrels. The two responses it received were from Tesoro and Petro Star, and last year the Tesoro negotiated sale contract was ratified. This year the Petro Star negotiated sale contract is before them. Based on the responses, it was determined that there was not enough competition for a competitive sale, Mr. Shine said, and while Tesoro agreed immediately to the price terms in the solicitation, Petro Star was seeking a different pricing mechanism that is not as advantageous to the state. At that point the DNR commissioner determined that a competitive bid sale was not in the state's interest and entered into separate negotiated sales. The first contract in effect right now is less than one year in length to relieve market conditions and allow Petro Star to secure its feed stock for refineries in Valdez and North Pole in the near term while also negotiating a long term contract to provide a secure source of supply for the refineries over the next four years. He explained the reason for having both contracts terminate near the same time in 2021 is because at that point the department will have a better sense of what royalty volumes are available. Historically, the state has been able to enter into 10-year RIK sale contracts, but with declining throughput and uncertainty of what volumes would be available, it's been determined that five year contracts are more accurate at this point. 3:41:26 PM MR. SHINE said AS 38.05.183(e) states that the commissioner must sell the state's royalty oil to the buyer who offers "maximum benefits to the citizens of the state," and in making this determination, the commissioner must consider: 1. The cash value offered, 2. The projected effects of the sale on the economy of the state, 3. The projected benefits of refining or processing the oil in state, 4. The ability of the prospective buyer to provide refined products for distribution and sale in the state with price or supply benefits to the citizens of the state, and 5. The eight criteria listed in AS 38.06.070(a), as reviewed by the Royalty Board. 3:42:08 PM For approval of an RIK sale the DNR must make a Best Interest Finding (BIF) in support of the sale. In this case, the preliminary BIF was issued in July 2016 and the final was issued in September 2016. DNR presented the proposed sale to the Royalty Board on August 31, 2016, and it unanimously voted in Resolution 2016-2 that the proposed disposition of ANS royalty oil to Petro Star meets the requirements of AS 38.06.070. Prior to finalizing the RIK contract, the legislature must pass a bill ratifying the contract with Petro Star (HB 70; SB 30). 3:42:58 PM The Royalty Board's decision criteria was listed on slide 6. Slide 7 had the actual contract terms: 1-year contract: from 18,800 bpd to 23,500 bpd for Jan. 2017 -Dec. 2017 4-year contract: from 16,400 bpd to 20,500 bpd for Jan. 2018 -Dec. 2018 from 13,200 bpd to 16,500 bpd for Jan. 2019 -Dec. 2019 from 10,800 bpd to 13,500 bpd for Jan. 2020 -Dec. 2020 from 8,400 bpd to 10,500 bpd for Jan. 2021 -Dec. 2021 MR. SHINE explained that the range is a minimum nomination per day and the high number would be the maximum. The numbers decline over the next five years, whereas the Tesoro contract last year had a static number of 20,000-25,000 barrels per day. The Petro Star contract is meant to give them as much royalty volume as the state can project to not exceed in the next four years. Typically they don't nominate more than 95 percent of expected royalty volumes and so the Tesoro contract combined with the Petro Star contract is about 95 percent of expected royalty volumes under contract to local refiners within the state. The net back formula provides a higher revenue to the state over RIV that uses a marine transportation deduction, which is basically the price to ship a barrel of oil from Valdez to its destination on the West Coast. The in-state location differential is a deduction in the net back formula meant to represent the cost of a barrel of oil within the state. 3:45:26 PM MR. SHINE explained that the flexibility of quantity provides for a three-month consecutive turnaround clause in which either refinery may nominate below its minimum range for planned service interruptions for factory upgrades, de-bottlenecking, and efficiencies, which is customary in the refining and the upstream oil and gas industry. The reason the state doesn't want to keep 5 percent of expected royalty oil is to keep markers on what the marine transportation deductions are and what the net back formulas look like to ensure the department is meeting its statutory mandate to meet or exceed royalty in value when the it elects to sell the state's royalty in kind. If more royalty is available than projected, additional volumes will be offered to both Petro Star and Tesoro on equal terms consistent with the pricing mechanisms in each contract. He said that Petro Star has filed a $46 million surety bond with the state as provided in the one-year contract in the event an in-state refiner or royalty purchaser defaults (or denominates) on its obligations to pay the state for royalty already delivered. Both contracts encourage commercially reasonable efforts to manufacture refined products within the state and promote local hire of Alaska residents and contractors. All communications with Petro Star have indicated that they have no intent to do anything but refine the products within the state for local use as jet fuel, home heating fuel, and ultra-low sulphur diesel, to name a few. 3:48:31 PM MR. SHINE said the RIK net back formula is: ANS Spot Price - $1.95 -Tariff Allowance +/-Quality Bank Adjustments -Line Loss. He explained that the ANS spot price is a monthly average of the daily average of the two reporting agencies, Platts and Reuters. The in-state location differential is deducted from that $1.95 as well as the TAPS and upstream tariffs to Pump Station 1. Then there are Quality Bank adjustments and a small percentage of line loss. Line loss is a .09 percent, industry-standard deduction from net back formulas that is meant to represent small differences in measurement between meters upstream and downstream as well as any loss in product due to evaporation, friction, ice build-up, or paraffin as is the case in the TransAlaska Pipeline System (TAPS). 3:50:00 PM SENATOR WIELECHOWSKI said if you take 20,000 barrels out of TAPS he understands that the tariff will go up slightly for everyone else who put oil in the pipeline. Then that in turn is able to be deducted from the production taxes that are paid to the State of Alaska, which ultimately causes a small loss for the state. He asked if that is factored into this. 3:50:44 PM ED KING, Special Assistant, Alaska Department of Natural Resources (DNR) answered that the oil that is being delivered to Tesoro is presumed to have already been produced and shipped through TAPS through the Petro Star refinery, so it would already be calculated into the tariff calculation. If the state weren't selling oil to Tesoro the assumption is that they would be purchasing the same volumes of oil from someone else and it wouldn't have any net effect. SENATOR WIELECHOWSKI said that didn't answer his question, but they could discuss it afterwards. SENATOR COGHILL asked who puts the calculation together and what value that adjustment means at the end of the line. MR. SHINE answered that the Quality Bank administrator makes those determinations, which is meant to measure the difference in value of the oil streams into the co-mingle point and the stream of oil coming out in Valdez. So, adjustments are made to those entities who are contributing a lower quality of oil that result in a benefit to the upstream producer who has a higher quality product. Those adjustments can be made as far back as eight years in this contract when the Quality Bank administrator or FERC makes a determination. SENATOR COGHILL said that is interesting, because this contract has a huge variable. MR. SHINE said that is the reason for the eight-year tail in the contract. Even though it is a five-year contract having that tail move out eight years provides the state with a little bit more certainty that if adjustments were made that they would benefit the state, too. MR. KING noted that the Quality Bank adjustment is also in existence if they were to take RIV as well as RIK. So this contract has no actual effect on the value in that regard. 3:53:36 PM MR. SHINE continued that the contract will yield $29 - $37 million in additional revenue to the state over what it would have received taking the same barrels in value. The real benefit between RIV and RIK is really realized in the in-state location differential and the RIK net back formula as opposed to the marine transportation deduction, which is present in the RIV net back formula. The marine transportation deduction for FY17 is somewhere in the $3.30-$3.40/barrel range and is expected to move up by about 10 cents per year until 2021 when it will be about $3.70/barrel. The static $1.95 RIK differential in the current contract as well as the Tesoro contract is where the state is getting the most benefit from the sale of royalty over RIV. The value realized by the different contracts is: 1-year contract (Jan. -Dec. 2017): from $7.6 to $9.5 million 4-year contract (Jan. 2018 -Dec. 2021): from $22.3 to $27.9 million 3:55:04 PM He explained that some of the criteria that the commissioner and the Royalty Board consider are the impacts to local economies and local hire; and Petro Star provides benefits to the state in terms of employment, its in-state refining capabilities, as well as providing ultra-low sulphur diesel, jet fuel, and asphalt to local economies. He presented a comparison of the volumes of the two contracts on slide 10 and said he was available to answer questions. CHAIR GIESSEL asked if he had any objections to this contract. MR. SHINE answered no and no public comments were received; no adverse comments were presented at the Royalty Board. 3:56:09 PM DOUG CHAPADOS, President & CEO, Petro Star, Inc., Anchorage, Alaska, thanked the DNR Division of Oil and Gas for their efforts and past and present commissioners for the work they had done in getting this contract in place. These are critically important contracts for their company, because without oil they are out of business. With the decline of TAPS throughput they have found it more and more difficult to source crude oil from producers on the North Slope. Being a consistent source of crude in the future, the state has brought Petro Star back and they look forward to refining this oil and making products for Alaska consumers. SENATOR COGHILL commented that the investment Petro Star had made was immediately beneficial to the North Pole area and he is very grateful. 3:57:59 PM SENATOR MEYER asked if it matters to him or the refinery if the oil is heavy or light, or what the gravity or sulphur rate is. MR. CHAPADOS said they like to see higher quality crude oil and Petro Star refineries are designed to process a barrel of crude in a very simple way. They like to see lots of middle distillate materials in the crude: kerosene, jet fuel, and diesel fuels. That allows them to retain more from each barrel they process. Typically they retain 25-30 percent of each barrel that they process and the balance is returned back to the pipeline. That is where this Quality Bank liability is generated, because the oil they return is considered to be of lower quality than the balance of the oil that is being shipped through TAPS. Crude from the Alpine Field is an example of a lighter crude oil that has a high concentration of jet fuel range material in it. SENATOR MEYER asked if he gets to choose which oil he gets. MR. CHAPADOS answered he wished he could, but they are subject to whatever is being shipped through TAPS, which is a co-mingled stream from all the fields. Over time the quality of the oil increases and decreases; it's at a good point now between those that are coming on line and those that are declining. 4:00:20 PM SENATOR MEYER said he had heard that pipeline oil is becoming heavier, so it is encouraging to hear that CD-5 and the Willow discovery have high gravity rates. MR. CHAPADOS responded that he believes that the new fields are of reasonably good quality. 4:01:13 PM MR. CHAPADOS said Senator Wielechowski questioned whether or not the sale of this royalty oil to Petro Star would increase the tariff rates for the remaining barrels that are being shipped through TAPS, and the very quick and simple answer is no. He explained that prior to the state royalty oil contracts, Petro Star was buying oil from another North Slope producer. Those barrels were being shipped through TAPS just as these barrels will be. So, at the end of the day, it's really a zero net gain in terms of how many barrels are being shipped through TAPS and where it's being shipped to. 4:02:20 PM CHAIR GIESSEL opened public testimony, and finding none, closed it. SENATOR COGHILL moved to report SB 30, labeled 30-GS1873\A, from committee with individual recommendations and attached fiscal note(s). There were no objections and it was so ordered.