HOUSE & SENATE SPECIAL COMMITTEES ON OIL & GAS November 4, 1994 9:30 a.m. MEMBERS PRESENT Representative Joe Green, House Chairman Representative Pete Kott, House Vice-Chairman Representative Gary Davis (via teleconference) Representative Jerry Sanders Senator Loren Leman, Senate Chairman Senator Judy Salo Senator Bert Sharp (via teleconference) MEMBERS ABSENT Representative Harley Olberg Representative Joe Sitton Representative Jerry Mackie Senator Rick Halford Senator Al Adams OTHER LEGISLATORS PRESENT Representative Con Bunde Representative Brian Porter Senator Drue Pearce Senator Jim Duncan COMMITTEE CALENDAR Briefing on "Perceptions of Alaska: Alaska Oil & Gas Market Research Report," by Gaffney, Cline & Associates WITNESS REGISTER PAUL FUHS, COMMISSIONER Department of Commerce & Economic Development P.O. Box 110800 Juneau, AK 99811-0800 BILL CLINE Gaffney, Cline & Associates Energy Advisors 16775 Addison Road, Suite 400 Dallas, TX 75248 PETER GAFFNEY Gaffney, Cline & Associates Energy Advisors 16775 Addison Road, Suite 400 Dallas, TX 75248 LARAINE DERR, COMMISSIONER Department of Revenue P.O. Box 110400 Juneau, AK 99811-0400 CHARLES LOGSDON Chief Petroleum Economist Oil & Gas Audit Division Department of Revenue 550 West 7th Avenue, Suite 570 Anchorage, AK 99501 MARTY RUTHERFORD, DEPUTY COMMISSIONER Department of Natural Resources P.O. Box 107005 Anchorage, AK 99510-7005 GEORGE FINDLING, MANAGER Government Relations ARCO Alaska, Inc. P.O. Box 100360 Anchorage, AK 99510 ACTION NARRATIVE TAPE 94-13, SIDE A Number 002 CHAIRMAN JOE GREEN called the meeting to order at 9:30 a.m. He noted that the House Committee did not have a quorum. Number 020 CHAIRMAN LOREN LEMAN introduced the members of the Senate Committee. He noted that the Senate Committee had a quorum. Number 039 PAUL FUHS, Commissioner, Department of Commerce & Economic Development, explained that Gaffney, Cline & Associates was hired because of the importance of the oil and gas industry to the state of Alaska. He said that in a recent commerce department input/output model of the state, about 83 percent of the state's income comes from oil and gas revenues annually. He said Gaffney, Cline & Associates was hired to give an analysis of how Alaska compares to the rest of the United States and the rest of the world with regard to tax structure, leasing, permitting and regulation. He also asked them to work with the oil industry to determine its perceptions of Alaska. He said after reading the report, he believed state government and industry needed to do better to work together. Number 074 CHAIRMAN GREEN recognized the Chairman of the State Oil & Gas Commission, Dave Johnson, and Commissioner Russ Douglas. Number 075 BILL CLINE, Gaffney, Cline & Associates, gave a background of the firm, Gaffney, Cline & Associates. He said the firm was formed in 1962. It provides technical and management advice to the oil industry worldwide. He said the scope of work the firm undertook was basically to assess and summarize the general industry conditions and to compare Alaska to other environments with respect to how effectively it competes for the investment capital of the oil companies. The firm also sought to identify the strengths and weaknesses of Alaska's competitive position and to comment on potential competitive strategies to improve or enhance Alaska's position in the rest of the world. He said Alaska has become increasingly less competitive due to the high cost of operations, what the industry perceives as difficult fiscal terms, and what industry perceives as difficult regulatory conditions. Number 169 PETER GAFFNEY, Gaffney, Cline & Associates -- (tape inaudible). Number 229 MR. CLINE stated that since 1983, there has been a steady rise in world oil demand. He referred to the report's three separate scenarios with respect to future world oil demand: High demand, medium demand, and low demand. He said there was a measurable increasing slope in terms of total world oil demand despite a huge detraction that is occurring in Eastern Europe and the former Soviet Union. He referred to the non-OPEC oil supply and said the price was going to decline in the future. He said OPEC is a very important factor in the oil demand scenarios. He predicted that oil prices will go up to $25 per barrel, although he did not know when it would happen. He said although oil companies are looking forward to the future, they have to live with the price as it is now. He said there is an industrywide consensus that the industry is facing flat prices in nominal terms and declining prices in real terms. He said governments are also facing these dilemmas. He said governments are reacting proactively to the changes by trying to adjust their legislation, fiscal conditions, and regulatory policies in order to offset this scenario. He stated currently the integrated companies are enjoying an emergence from the recession in the U.S. and Western Europe. He said governments are still concerned with how to deal with the former Soviet Union, how to reenter Latin America, and the ongoing process of cutting costs. He referred to independent oil companies and said they are focusing on areas where they have competitive strength and they are enjoying better U.S. gas prices. He stated a continuing issue the independents face is whether to keep their operations in the U.S. or whether they should pursue projects abroad. He addressed national oil companies and ministries. He said their current problem is competing with the former Soviet Union for the industry's attention. He said nationals are refocusing on natural gas and the current trend worldwide is to move from offshore projects to onshore projects since companies cannot control price, but can control cost. He said opportunities have risen because of geopolitical changes. He said the key locations for onshore production are Latin America, the Middle East, Russia, and the former Soviet Union. He referred to the geopolitical changes that have occurred in the 1990s . He said many places that were formerly inaccessible were now accessible. He discussed drilling trends. He said companies are moving away from the Arctic International/U.S. balance, which are high cost. He said natural gas was a growing business and environmentally attractive to the industry, but as a viable substitute for fuel, it competes with coal and requires large increments of investment. He said in the current environment there is a pressure for high cost or low value production. He stated there are also pressures on the companies to fund OPEC, and to loosen fiscal terms wherever they can. He said industry is looking for ways to insulate itself from the effects of oil prices. He said industry is shifting away from traditional reserves replacement to a cash flow focus. He referred to the countries that Alaska competes with for exploration funds. He said Alaska not only competes with countries that do 2 million barrels per day, but also much smaller countries in Latin America and Asia. He compared the exploration and drilling activity of Norway (average 20 exploration wells per year) and Indonesia (average 16 exploration wells per year) to Alaska (average 16.5 exploration wells per year). He said that Asian-Pacific offshore drilling activity averaged 204 barrels in the first quarter of 1994 compared to 100 for the first quarter of 1974. The United States averaged 16.5 exploration wells per year. TAPE 94-13, SIDE B Number 003 MR. CLINE said Alaska competes with the United Kingdom for exploration activity. He said the United Kingdom was a "legislation-led" province. He referred to 1989 and the dramatic drop off of exploration activity in the North Sea. He said the government recognized the decline and in May 1993 shifted from encouraging exploration activity to encouraging development activity. Number 013 MR. GAFFNEY said the drop off in drilling in the North Sea in 1989 has cost the United Kingdom about 500,000 barrels per day over the last three to four years. Number 046 MR. CLINE discussed the oil industry's perceptions of Alaska. He said it was perceived that Alaska is for major companies only because it is an ultra-high cost environment. He said the fiscal environment in Alaska is tough under low price conditions. He said a fiscal environment is especially difficult in a more regressive environment, one that is revenue, as opposed to profit-oriented, taxation. He stated that Alaska is seen by the industry as having significant environmental hurdles, more so than anywhere else. He said the geology in Alaska is good but not spectacular. He indicated that Alaska has more competitors and those competitors are getting even more competitive. Number 067 MR. GAFFNEY discussed the concept of progressive legislation. He said oil companies agree that what helps most is to have legislation which does not kill off exploration drilling incentive. He said it is best to keep the industry working and developing when the price is down and the cost is high, then when things get good, cream off a higher proportion at the top. Number 081 MR. CLINE addressed exploration and production decision criteria. He said companies look for adequate geology and the size of the economic opportunities. He stated they also look at logistics and cost and legislative and political risk. He said industry also looks at how difficult it is to conduct business in the prospective environment. Number 108 MR. GAFFNEY -- (tape inaudible). Number 113 MR. CLINE referred to charts which compared perceptions of Alaska against perceptions of Norway, the United Kingdom, Venezuela and Russia. He indicated that the charts were based upon one person's perception of the countries used in the graphs. He addressed fiscal barriers and incentives. He said the economics for projects in Alaska are highly leveraged to costs and prices. He referred to graphs and discussed the Niakuk field costs and imported legislation from the United Kingdom, Norway, Indonesia and Australia and plugged it into the Niakuk scenario. He stated the graphs illustrated that Alaska is very sensitive to costs and oil prices. Number 211 MR. GAFFNEY stressed the elimination of regressive legislation given the Niakuk scenario. Number 237 MR. CLINE said that unless the tax burden is fairly sensitive to the economics afforded a project, once a company goes into a low price/high cost environment there will be a huge barrier to reinvestment in the area. He referred to graphs of economic models to illustrate his point. Number 379 MR. CLINE addressed regulatory barriers and incentives in Alaska. He said there was a labyrinth of regulatory agencies and bodies, as well as powerful environmental groups. He said there was extensive judiciary involvement in the regulatory process, which was unusual. He said the ANS Export Ban is significant because it impacts markets negatively. He addressed Alaska's advantages. He discussed the state's political, legislative and currency stability. He said prospectivity comes at a big price because of the cost of operating in Alaska. He addressed the transparency of the process and mentioned that it was easy and clear to understand. He addressed current industry initiatives such as the large block concession proposal and exploration incentive credits. He said other areas such as the United Kingdom, Venezuela, and Indonesia are competing aggressively for the industry's investment and risk capital. He said in Alaska high geologic promise is offset by the high cost/low value production, the powerful environmental groups, closed industry structure, the regressive tax system, and the litigious reputation of state government. He said there has been an improvement in the relationship and cooperation between state and industry as well as a growing awareness of the competition for industry capital. He recommended broadening the appeal of Alaska to both new and older oil companies by participating in road shows. TAPE 94-14, SIDE A Number 005 MR. CLINE encouraged the development of Alaska's natural gas resources. He observed that regardless of the future of oil prices, now is the time to initiate changes that will lower the economic threshold and retain higher levels of economic rent from a larger number of projects and developments. He recommended creating an industry administrator for the state. He encouraged the state to pursue a wider participation with the industry as a whole so it is aware of what is going on in other parts of the world. He recommended the state reassess fiscal and licensing terms and regulatory processes. He encouraged the state to obtain and keep contact with federal officials. He recommended the industry and the state create a project where the goals are the same. Number 093 MR. GAFFNEY recommended the state encourage development by finding common ground with the industry. Number 112 LARAINE DERR, Commissioner, Department of Revenue, said the project to change the oil and gas production tax regulations began in the fall of 1992. She said the project grew out of the general dissatisfaction and frustration with existing regulations, which had been in effect since 1981. She said those regulations are complex and they often result in significant disagreements over the correct amount of production tax. She said the regulations were the main reason the state has such a large amount of taxes receivable. She said taxpayers wanted revised regulations with more certainty so they could file a more complete and accurate tax return. She stated the state wanted revised regulations to speed the tax collection process and reduce the lengthy and expensive audit process. She said on November 16, 1993, Governor Hickel announced the proposed revisions to the oil and gas regulations, which would bring stability and certainty to the state's biggest taxpayers. She stated the revisions were not well-received by the oil and gas industry. She said that while the regulations were drafted to be revenue-neutral in total, and to provide taxpayers with certainty, that was not what the industry perceived. She explained the major changes in the regulations that were in the process of being adopted. She said one section involves the value of oil and gas. She said the new regulations allow for transportation deductions from value. She stated there was a significant clarification of return on investment calculations. She said there was a clarification of when a new field is in commercial production and when it goes to a higher tax rate. She stated there was a new clarification for how a well day is counted for the Economic Limit Factor. She emphasized that there were a lot of people involved in the creation of the new regulations and that it has created an open, healthy dialogue between the Department of Revenue and the oil and gas industry. She said currently the regulations are in the Department of Law and should go to the Lieutenant Governor by November 15, 1994. CHAIRMAN GREEN asked who the new regulations would benefit. Number 192 COMMISSIONER DERR said there would be a better working relationship between the oil and gas industry and the state, which would benefit both sides and be revenue neutral. Number 197 SENATOR JUDY SALO asked if someone could elaborate on the method of transportation costs. Number 201 CHARLES LOGSDEN, Chief Petroleum Economist,Department of Revenue, said the statute calls for actual transportation costs to be deducted from the price at the point of sale to determine "Alaska value." He said a fixed dollar amount per million dollar investment has been established as a deduction against the sale price. Number 237 REPRESENTATIVE CON BUNDE asked if there were people in the Department of Revenue with experience in the oil and gas industry and if the Department of Revenue perceived that Alaska is a difficult place to do business for the oil and gas industry. Number 247 MR. LOGSDEN said the accountants are primarily from the public accounting sector but that some have worked for oil companies. Number 259 MARTY RUTHERFORD, Deputy Commissioner, Department of Natural Resources, said she had some concerns about the report because she felt it contains little quantitative data and appears somewhat anecdotal in nature. She stated the report does not lay out a clean path toward making improvements. She said the lack of reference material to support some of Gaffney, Cline & Associates' observations makes it difficult for agencies to analyze how they might make improvements. She felt the state should focus more specifically on details, like how Alaska specifically compares to its competitors. She said it would be helpful to develop a long term fiscal plan in order to provide a very clear picture for the industry about how the state will address its financial realities. Number 319 COMMISSIONER FUHS said there has been an oil and gas caucus formed in both houses of Congress. He said the work of the National Energy Council was very important. He stressed the importance of a national energy policy. Number 370 SENATOR DRUE PEARCE stated that Alaska is a member of the National Energy Council. She said its members represent 85 percent of energy production in the United States. She said when the state of Alaska did the tax study in 1990, it discovered that people do not know about any of the opportunities in Alaska. She stated the legislature has an opportunity to sell oil and gas prospects. She said the legislature has to take a more active role in pursuing that opportunity. Number 494 GEORGE FINDLING, MANAGER, GOVERNMENT RELATIONS, ARCO ALASKA said ARCO finds the Gaffney, Cline & Associates report to be an incisive, good analysis. He said it fairly reflects the perceptions about Alaska. He said he felt that Alaska is not in the near-crisis stages, as the report would lead the committee to believe. He said the Gaffney, Cline & Associates report is a good starting point for both the state and industry. He said ARCO encourages other industry competitors to come to Alaska. He said that ARCO feels strongly about communicating with the state. Number 564 REPRESENTATIVE BRIAN PORTER asked if the current statutory structure was such that regulations could be developed that would reflect the recommendations of the Gaffney, Cline report. Number 575 COMMISSIONER FUHS -- (response inaudible). Number 581 CHAIRMAN LEMAN asked if the positiveness reflected in the report was symbolic or real. Number 605 MR. CLINE said the steps that the state makes now, towards more projects, will not manifest themselves for five to seven years.... (end of tape). TAPE 94-14, SIDE B Number 018 REPRESENTATIVE BUNDE said he was interested in hearing specific recommendations for demonstration projects. Number 022 MR. GAFFNEY -- (response inaudible). Number 026 SENATOR PEARCE asked if there was any other country which had a better experience in trying to get those companies already in the country to come to the table to help come up with incentives and demonstration projects. Number 049 MR. GAFFNEY -- (response inaudible). Number 057 SENATOR PEARCE asked if Alaska would be better off trying to "string the pearls" or trying to get even more new exploration. Number 060 MR. GAFFNEY said he was biased towards protecting the discoveries already in place. Number 069 CHAIRMAN GREEN referred back to the Niakuk operation. He asked if it was representative or was there a more representative 75,000 - 100,000 barrel field that would steepen the slope between the three different crude prices. Number 076 MR. CLINE said he expected the relationship to remain along the lines published in the report. Number 081 CHAIRMAN GREEN said several times the point was made that there may be a different method of sharing the benefits from development. He wondered if the industry, which is going to be payout conscious, and the state, which is more in tune with a longer period project, are headed for a collision. Number 089 MR. GAFFNEY said payout has become an issue. He said the state should be looking for what fits the requirements of Alaska, yet is still attractive to industry. Number 105 SENATOR SALO asked what was meant when Mr. Gaffney said exploration credit was not enough. Number 107 MR. CLINE said on its own, exploration incentive credit is not enough. He said it does not do anything towards going after undeveloped discoveries. Number 120 CHAIRMAN GREEN indicated that another hearing would take place on the Gaffney, Cline report, although he was uncertain as to the date. Number 127 CHAIRMAN LEMAN said the next hearing would be before the 19th Legislature convenes on January 16, 1995. He said he would like the industry to come with suggestions as to the projects discussed at this hearing. Number 136 CHAIRMAN GREEN adjourned the meeting at 12:03 p.m.