HOUSE FINANCE COMMITTEE February 13, 1996 1:42 P.M. TAPE HFC 96-34, Side 1, #000 - end. TAPE HFC 96-34, Side 2, #000 - end. TAPE HFC 96-35, Side 1, #000 - end. CALL TO ORDER Co-Chair Mark Hanley called the House Finance Committee meeting to order at 1:42 p.m. PRESENT Co-Chair Hanley Representative Martin Co-Chair Foster Representative Mulder Representative Brown Representative Navarre Representative Grussendorf Representative Parnell Representative Kelly Representative Therriault Representative Kohring ALSO PRESENT Representative Joe Green; Ken Boyd, Director, Division of Oil and Gas, Department of Natural Resources; Ed Behm, Occidental Oil and Gas Corporation (OXY) USA Inc.; Charles Logsdon, Chief Petroleum Economist, Department of Revenue; Bill Vandyke, Petroleum Engineer; Sara Hannan, Executive Director, Alaska Environmental Lobby; Patrick Coughlin, Division of Oil and Gas, Department of Natural Resources; Jon Tillinghast, Attorney, Occidental Oil and Gas Corporation (OXY) USA Inc. SUMMARY HB 325 An Act authorizing suspension of payment of a portion of the royalty due the state for initial production of heavy oil from wells on the Arctic Slope. HB 325 was HELD in Committee for further discussion. HOUSE BILL NO. 325 "An Act authorizing suspension of payment of a portion of the royalty due the state for initial production of heavy oil from wells on the Arctic Slope." 1 KEN BOYD, DIRECTOR, DIVISION OF OIL AND GAS, DEPARTMENT OF NATURAL RESOURCES testified via the teleconference network. He noted that he had supplied the Committee with three letters; one addressed to Representative Williams, dated 1/30/96; one addressed to John Morgan, BP Exploration, dated 2/9/96; and one addressed to Co-Chair Hanley, dated 2/13/96 (copies on file). He referenced his letter to Co-Chair Hanley, dated 2/13/96 (Attachment 1). Mr. Boyd observed that Attachment 1 was written in response to comments and questions expressed during the 2/08/96 meeting of the House Finance Committee. He emphasized that the Department welcomes discussion to determine the best way to develop Alaska's heavy oil reservoirs. He maintained that a royalty holiday is not the best way to develop Alaska's heavy oil. He asserted that a level of scrutiny, not provided by HB 325, is needed. Representative Brown referred to Attachment 1. Mr. Boyd noted that the operators have not had time to formally respond to his letter. Co-Chair Hanley agreed that the operators have not had sufficient time to respond. Representative Martin questioned why the Committee should request more information from the operators. Mr. Boyd maintained that the information requested is the same as that required for other royalty reduction requests. He added that if the companies can demonstrate their case absent some of the requested data that the Division will listen. He stressed that if the operators do not want to supply requested information that they need to respond in writing and provide the reasons the data is not necessary. He stated that the requested data is the same data that is used by companies to reach developmental decisions. He could not see any reason why the State should not have the same level of scrutiny for its decision process. He emphasized that the State is prepared to give away a portion of its resources. He added that the Division will be able to make a decision when the data is available. Representative Martin asked how long it would take the Division to make a decision after the data is available. Mr. Boyd responded that their decision would be a matter of weeks or months but not years. Representative Brown referred to item 4 in Attachment 1. She pointed out that the Division states that there are some good reasons to define the legislation by "pool" or "reservoir" as opposed to "well". She summarized points made by item 4. WILLIAM VANDYKE, PETROLEUM ENGINEER, DEPARTMENT OF NATURAL RESOURCES responded to questions by Representative Brown. 2 He noted that infrastructure sharing arrangements exist among operators at Milne Point. He stated that economics differ between a field where there are no arrangements for surface facilities and those that share facilities. PATRICK COUGHLIN, DIVISION OF OIL AND GAS, DEPARTMENT OF NATURAL RESOURCES added that an operator could place wells to take advantage of the incentives. He observed that incentives offered by the Bureau of Land Management are based on pools. He clarified that federal incentives will be implemented through regulation effective March 11, 1995. He explained that federal regulations refer to property which is defined as a segregated unit. Representative Brown referred to item five in Attachment 1. She noted that item five suggests that "well" be defined. She asked that the Division prepare an appropriate definition. Representative Grussendorf asked for clarification on items 2 and 7. Mr. Coughlin noted that these points were raised during debate on HB 207. He stated that the question was raised if a zero royalty combined with zero tax would be constitutional. He noted that the Constitution requires that state resources be managed for the maximum benefit of all the people of the State. Mr. Boyd cited item 7. He noted that a wellhead value of $15 dollars would equate to a market price of $21.50 dollars. He pointed out that $21.50 dollars is approximately $5 dollars higher than current market prices. He added that this price would inflate each year. He questioned if this is the right number. Representative Brown requested elaboration of item 11. Mr. Coughlin stated that item 11 provides an example based on 500 barrels a day and a wellhead price of $10 dollars per barrel. The equation demonstrates that if the royalty rate were 12.5 percent the State would lose $228,125 thousand dollars a year from the royalty suspension. Representative Brown referenced item 6, page 3 of Attachment 1. She summarized that the Division believes the appropriate value should be the value determined at the appropriate LACT meter for all current North Slope royalty payors pursuant to royalty settlement agreements. She asked if reference to "field cost deductions" should be eliminated. Mr. Coughlin responded that royalty payments are not based on the value at the well head. He observed that the royalty value for each company varies. He added that many 3 fields are not eligible for field costs. Some fields are under negotiation regarding field costs. Representative Brown asked the sponsor's intent regarding field costs. Representative Green explained that the intent is that the cost of doing business, "to get it clean and ready for shipment" are excluded. He stressed that the intent is to provide an incentive to pilot heavy oil. He clarified that the legislation would opiate any prior cost agreement. He stated that the intent is that no royalty is paid on anything of value on 20 degree gravity or less oil. "Any agreement that there may have been, as far as treating, cleaning and all that, on this lease, that lease, old leases, new leases, is not considered." Representative Brown noted that the State pays field costs on some North Slope leases which are deducted from the royalty paid. She asked if the State would pay the field cost if the royalty is zero. Mr. Coughlin stated that if the intent is to have the State pay field costs it would violate AS 38.05.180(f) which states that the State will not issue any leases which permit the deduction of field costs from the royalty share. Representative Brown asked if there are situations were the State pays field costs. Mr. Coughlin noted that the State pays a $.40 cent fuel cost on Kuparuk and a $.79 cent fuel cost at Prudhoe Bay. He acknowledged that the State may have to pay $.40 cents for fuel costs against a zero royalty share. Mr. Boyd noted that this is not reflected in the fiscal notes. In response to a question by Representative Brown, Mr. Boyd added that West Sak overlies the Kuparuk fields. Representative Brown asked if the intent is that the State would pay field costs on situations, such as Kuparuk, where the State has a settlement to pay the fuel costs. Mr. Boyd did not know the answer. SARA HANNAN, EXECUTIVE DIRECTOR, ALASKA ENVIRONMENTAL LOBBY (AEL) stated that every drop of oil drilled in the State is an environmental concern. She noted that the Alaska Environmental Lobby has 10,000 members. She asserted that AEL wants to see a healthy oil industry in Alaska that is also a good neighbor and partner. She stressed the importance of maintaining an ownership interest. She noted that the Constitution prohibits the State from giving away its resources. She stated that the environmental community is not opposed to incentives that provide for an economic benefit to the State. She noted that they are opposed to giving away the resource at the expense of Alaskans who would not benefit from their resource extraction. She 4 maintained that there is no guarantee new jobs will go to Alaskans. She maintained that it is bad public policy to craft a broad solution to a very narrow problem. She asserted that if the legislation is designed to help OXY stay a producer on the North Slope it should be crafted so narrowly that only OXY benefits. She added that if the legislation is designed to set policy about heavy oil, the Committee should be cautious about basing a decision on the arguments that OXY provides. She acknowledged that there are problems with OXY's ability to operate. (Tape Change, HFC 96-34, Side 2) Ms. Hannan urged the Committee to pursue long and deliberate discussions. She maintained that the owner state must be protected to assure that there is a healthy oil industry in Alaska during the 21st century. She stated that if agreements and terms of contracts are changed subsequent to leasing then companies holding contracts are given an unfair advantage over those that did not win the original lease. Representative Mulder asked if AEL has supported oil industry incentives. Mr. Hannan stated that AEL worked with the House Resource Committee on HB 207. She noted that AEL supported the final version of HB 207. Representative Martin maintained that AEL is an outside group looking in. He questioned Ms. Hannan regarding the makeup and function of AEL. Ms. Hannan noted that AEL is a coalition of environmental groups. She observed that AEL has been active in Alaskan politics for many years. In response to a question by Representative Martin, Ms. Hannan compared the legislation to joint risk and long term profit in the film industry. She maintained that an incentive can be given to assure that the capital risk investment is returned, but over the life of a 30 year well the State's royalty of 12.5 percent is paid in full. She observed that royalty payments could be graduated from a low to full percentage. She maintained that the capital risk would be shared. She asserted that no one in the environmental community is saying that the risk should not be shared. Representative Martin stressed that the oil industry has taken risks by investing in Alaska's resources. He questioned if other countries have tried to develop heavy oil. Ms. Hannan replied that AEL is an Alaskan organization. She observed that the state of Alaska employs experts in cold weather oil production. Representative Navarre thanked Ms. Hannan for her testimony. He pointed out that heavy oil production has to compete for other investment decisions in Alaska. He questioned if the 5 incentive is the best way to encourage additional production and revenues in the State. JON TILLINGHAST, ATTORNEY, OCCIDENTAL OIL AND GAS CORPORATION (OXY) USA INC. spoke in support of HB 325. He clarified that the House Oil and Gas Special Committee's intent regarding "eligible field costs" relates to the lessee's reported royalty price under whatever settlement agreement the lessee has with the State. He stated that it was not the House Oil and Gas Special Committee's intent to enter the eligible field cost debate. He suggested that page 1, line 14 could read "only to the portion of the lessee's reported royalty value". ED BEHM, HEAVY OIL TEAM LEADER, OCCIDENTAL OIL AND GAS CORPORATION (OXY) USA INC. testified via the teleconference network. He discussed the logic behind the $15.00 dollar per barrel price ceiling. He provided members with a chart demonstrating the rate of return with and without the royalty (Attachment 2). He noted that without the royalty holiday the rate of return with a wellhead price of $10.00 dollars per barrel would be below 5 percent. The rate of return would rise to 11 percent with a wellhead price of $12.50 dollars per barrel. He noted that current wellhead value is $10.00 dollars per barrel. At a $15.00 dollar per barrel wellhead price the rate of return without the royalty suspension would be approximately 18 percent. He noted that with the royalty holiday a wellhead price per barrel of $10 dollars would result in a rate of return of 7 percent; $12.50 dollars would raise the rate of return to 15 percent; and a wellhead price of $15.00 dollars would result in a rate of return of approximately 25 percent. He stressed that in order to make a 15 percent rate of return with the royalty holiday the wellhead value has to average $12.50 dollars per barrel. He pointed out that the company needs a wellhead value of $15.00 dollars a barrel to average $12.50 dollars per barrel. He added that the federal government has initiated a $15.00 dollar wellhead price cut ceiling. Representative Navarre asked how many barrels a day are projected for production. Mr. Behm stated that OXY's assumptions are based on per well production of 430 barrels a day. He noted that production declines at a 10 percent rate. Representative Brown referred to language suggested by Mr. Tillinghast. He suggested that page 1, line 14 could read "only to the portion of the lessee's reported royalty value". She asked if the wellhead value is above $15.00 dollars would the exemption be lost completely. Mr. Behm stated that it was his understanding that the suspension would only be lost on revenues above the $15.00 dollar a 6 barrel level. In response to a question by Representative Brown, Mr. Behm maintained that it would not be practical to limit production. He stressed that it is in the operator's best interest to maximize production at all times. He explained that the 10 year forgiveness period was chosen to allow facilities to be expanded in order to handle heavy oil production. He emphasized that development would begin in the best areas and move to poorer areas. He asserted that to prematurely cut off the royalty suspension would leave areas that are too marginal to develop. Representative Brown asked the justification for basing incentives per well as opposed to reservoir or pool production. Mr. Behm pointed out that operators are not requesting the royalty suspension on existing production. He stated that the per well approach emphasizes new capital drilling. Mr. Tillinghast noted that Bureau of Land Management regulations are not intended to spur additional capital investment. They are intended to restore shut in production and continue production that is reaching its economic limits. He quoted the preamble to the federal regulations. He stressed that the goal of HB 325 is to encourage the development of new wells. In response to a question by Representative Martin, Mr. Behm noted that Canada and Venezuela are promoting heavy oil production. He maintained that royalty on new development in Venezuela is near zero. Representative Green referred to the map on page 12 of "An Opportunity to Develop Alaska's Heavy oil Resources", by BP and OXY, dated 1/22/96 (copy on file). He pointed out that oil viscosity changes with the degree of API gravity. He stressed that a per pool suspension would work against the State since operators could remain in areas of lower viscosity. Representative Green noted that if fluids are not kept moving there is a tendency for oil to settle back. He stressed that pumps can be ruined and tubing prevented from being removed if production is stopped. He emphasized that a production stoppage would increase operating costs. He emphasized that operators would not want to stop production. In response to a question by Representative Mulder, Mr. Behm stated that the economic focus would be on marginal wells. He added that OXY provided the Department of Natural Resources with the data they used for their critical assumptions. He asked for the Department's response. 7 Representative Grussendorf noted that most State's that provide royalty incentives also collect property or sales tax. He pointed out that the state of Alaska does not collect a state property of sales tax. Mr. Tillinghast questioned if it is likely that Alaska's heavy oil reservoirs are going to be developed without an incentive, within the relatively short window of opportunity. He noted that heavy oil must be developed before the pipeline either closes down or per barrel tariffs becomes so high that heavy oil will not be economic regardless of incentives. He added that heavy oil production must occur while an infrastructure remains for its production. He noted that the Department of Natural Resources has projected that Milne Point will shut in, absent change, between the years 2006 and 2011. He emphasized that industry has spent more than $270.0 million dollars in the past 15 years to develop heavy oil. He stressed that it is not economic to recoup these costs under the present economic environmental. He maintained that heavy oil will not be developed absent an aggressive state partnership. He asserted that the State will receive considerably more from a partnership. He noted that the Department of Natural Resources predicts that the State will receive $60 million dollars in royalties from the 3,000 barrel a day pilot project at Tract 14, Milne Point. He alleged that if the field is developed according to BP's development scenario with a five year royalty suspension the State would receive $425.0 million dollars in royalties from Schrader Bluff. He pointed out that the State would receive an additional $60 - $80 million dollars from other North Slope production due to declines in the Taps Tariff caused by extra heavy oil in the system. He added that jobs will also be created. Representative Grussendorf reiterated that other states have other revenue mechanisms. He stressed the need to carefully consider the issue. Representative Navarre questioned OXY's total capital costs. He estimated that using an assumption of $10.0 per wellhead X 230 wells X 300 barrels a day that the return would be $250.0 million dollars a year. He stated that at five years operators would receive $1.25 billion dollars on an investment of $600 million dollars for the estimated 41 year life of the field. Mr. Behm could not verify his numbers. He emphasized that total expenses could approach $1.1 billion dollars including expenses and capital costs. Representative Navarre asked what percentage of a well's production is obtained in the first five years. Mr. Behm estimated that one third of the well's production would 8 occur in the first five years. He observed that estimations vary. (Tape Change, HFC 96-35, Side 1) Representative Navarre asked if it would be to the operator's advantage to load development toward the end of the 10 year cycle in order to gain the advantage of new technology. He pointed out that any well developed before the year 2006 would receive the royalty holiday for 5 years. He estimated that there would be a reduction of development cost over the next 10 years. He pointed out that the benefit of technological advances which result in lower development costs would not be shared with the State. Mr. Behm stressed that a deferment of development would send the project to the end of the project line. He questioned if costs saved by delaying development would offset the cost of inflation. Representative Navarre suggested that the suspension be enacted for five years with subsequent review by the Legislature. Representative Martin questioned how much more information the Department of Natural Resources needs to make a decision. Mr. Tillinghast stressed that the legislation was not crafted based on the micro economics of one particular lessee. He observed that the challenges of developing heavy oil is a matter of statewide concern. He stressed that OXY's economics can be used by the State as a generic bench mark. He stated that OXY used state oil prices and the Department of Revenue's spring 1995 base case price forecast. He stated that it is not reasonable for the Department to request the type of comprehensive audit that would be required under HB 207. He added that one of the purposes of HB 325 is to send a message that independent operators are welcomed in Alaska. In response to a question by Representative Martin, Mr. Behm pointed out that Attachment 2 shows that the project will be difficult to make economic with the current $10.00 dollar wellhead price. Representative Martin stated that the state of Alaska will receive millions of dollars in corporate income tax. Mr. Tillinghast noted that the University of Alaska estimated that the additional tax income to the State would be substantial. Mr Boyd stated that the life of the Milne Point field cannot be estimated. He added that economics change for different operators. He maintained that better analysis is needed. 9 Representative Green referred to the life of the pipeline. He noted that there is concern among operators. He observed that the pipeline was estimated to decline around 1987 or 1988. He pointed out that the use of the pipeline has been extended through new discoveries and technology. He maintained that a date can not be identified for the end of the pipeline's activity. Representative Navarre presented a scenario of a 230 well field producing at an average of 300 barrels per well per day. He requested a comparison of state revenues including income tax for the scenario with a royalty of 12.5 percent and with the royalty suspension, allowing for full production costs, in order to determine what the State would be offering under HB 325. He added that BP's concerns differ from those of OXY's. He noted the competition within Alaska for developmental money. He observed that existing fields might have a better rate of return even if the royalty suspension is applied. He emphasized that other approaches may generate more activity in existing fields. He noted that incentives on heavy oil may not be enough to generate increased activity. He expressed concern that a significant portion of the resource would be depleted in the first five years. He observed that investment opportunities could be traded off. Projects with like economics could be deferred while investment occurs in projects where a royalty suspension is offered. Representative Grussendorf asked if OXY's development of heavy oil could be accommodated under HB 207. Mr. Boyd noted that OXY could not be accommodated under HB 207. He stressed that BP, the 91 percent share holder, could be accommodated under HB 207. Representative Grussendorf observed that the State faces the dilemma of trying to take care of small operators while opening windows for larger operators. In response to a question by Representative Kelly, Representative Green maintained that operators will find the money if projects are economic. Representative Navarre stated that there is a finite number of investment dollars worldwide that must be competed with. He estimated that the best rate of return will receive limited investment dollars. Representative Green agreed that there is worldwide competition for projects but asserted that there is enough capitalization dollars for all economic projects. ADJOURNMENT The meeting adjourned at 3:38 p.m. 10