HOUSE SPECIAL COMMITTEE ON OIL AND GAS May 6,1999 5:09 p.m. MEMBERS PRESENT Representative Jim Whitaker, Chairman Representative Fred Dyson Representative Scott Ogan Representative John Harris Representative Allen Kemplen Representative Tom Brice Representative Harold Smalley MEMBERS ABSENT Representative Gail Phillips Representative Brian Porter COMMITTEE CALENDAR HOUSE BILL NO. 170 "An Act establishing the Alaska Gas Corporation, a public corporation, and providing for its structure, management, responsibilities, and operation." - HEARD AND HELD (* First public hearing) PREVIOUS ACTION BILL: HB 170 SHORT TITLE: ALASKA GAS CORPORATION SPONSOR(S): SPECIAL COMMITTEE ON OIL & GAS Jrn-Date Jrn-Page Action 3/31/99 625 (H) READ THE FIRST TIME - REFERRAL(S) 3/31/99 625 (H) O&G, RES, FIN 4/22/99 (H) O&G AT 5:00 PM CAPITOL 17 4/22/99 (H) 4/29/99 (H) O&G AT 5:00 PM CAPITOL 17 4/29/99 (H) HEARD AND HELD 5/06/99 (H) O&G AT 5:00 PM CAPITOL 17 WITNESS REGISTER WILSON CONDON, Commissioner Department of Revenue PO Box 110400 Juneau, Alaska 99811-0400 Telephone: (907) 465-2300 POSITION STATEMENT: Discussed the economics of HB 170. ROGER MARKS, Petroleum Economist Department of Revenue Anchorage, Alaska Telephone: (907) 343-9257 POSITION STATEMENT: Discussed his analysis of the Alaska Gas Corporation as established under HB 170. KEN VASSAR, Attorney Wohlforth, Vassar, Johnson & Brecht 900 West 5th Avenue, Suite 600 Anchorage, Alaska 99501 Telephone: (907) 276-6401 POSITION STATEMENT: Discussed the bonding and financing aspects of HB 170. BRIAN ANDREWS, Financial Consultant Merrill Lynch One Sealaska Plaza, Suite 301 Juneau, Alaska 99801 Telephone: (907) 586-4102 POSITION STATEMENT: Discussed the "five C's." MARK PRUSSING, CPA Public Finance Seattle-Northwest Securities Corporation 1000 Southwest Broadway, Suite 1800 Portland, Oregon 97205 Telephone: (503) 275-8309 POSITION STATEMENT: Discussed the bonding and financing aspects of HB 170. ACTION NARRATIVE TAPE 99-16, SIDE A Number 0001 CHAIRMAN JIM WHITAKER called the House Special Committee on Oil and Gas meeting to order at 5:09 p.m. Members present at the call to order were Representatives Whitaker, Dyson, Ogan, Harris, Kemplen and Smalley. Representative Brice arrived at 5:19 p.m. Representatives Phillips and Porter were excused. HB 170-ALASKA GAS CORPORATION CHAIRMAN WHITAKER announced that the only order of business before the committee would be HOUSE BILL NO. 170, "An Act establishing the Alaska Gas Corporation, a public corporation, and providing for its structure, management, responsibilities, and operation." CHAIRMAN WHITAKER reviewed the April 29, 1999 meeting which mainly discussed the revenue sharing aspect of HB 170. He noted that now it must be established that indeed there is revenue to share. Chairman Whitaker directed the committee's attention to an Alaskan map which was utilized in the discussion of up-line processing in Prudhoe Bay, energy distribution, down-line processing and the possibility of petro-chemical industries. He commented that a spur line to Anchorage will clearly be needed. Number 0447 WILSON CONDON, Commissioner, Department of Revenue, indicated that policy makers will wish to explore and pursue the question of the bill providing a vehicle to restructure the fiscal system in a manner making the project economic. Of the total costs the owners and operators of the project would pay over the life of the project, 40 percent of those costs are taxes of which 80 percent would be federal taxes. He noted such would occur under the current fiscal system, if that fiscal system was applied to a privately owned and financed project. Commissioner Condon stated that under the bill as proposed, as a state-owned project, that may be achieved such that the project is exempt from federal tax. Therefore, the economics of the project would change enormously. Furthermore, avoiding federal taxes might just be enough to improve the project enough to make the project economically feasible. COMMISSIONER CONDON emphasized that there is one basic issue to which he did not know the answer, that is being tax exempt. The entity owning the project needs to be a lot like state government. Therefore, he believed that an entity must be established with close ties to the state in order to placate tax people. On the other hand, investors in bonds who would pay for the project would insist on a sound, independent entity that makes its decisions based upon good business, not on politics. Establishing such an institution is the challenge. Commissioner Condon informed the committee that investors might have pause with the project's requirement that the project terminate in Prince William Sound. In summary, Commissioner Condon explained that the issue is whether there is a suitable institutional arrangement that is both eligible for federal tax exemption and independent enough of the political process to satisfy investors. Commissioner Condon acknowledged that over the years, there have been a series of legislative steps to commercialize North Slope gas which led to the enactment of HB 393 and the current sponsor group. He urged that if HB 170 moves forward that it be crafted in such a manner to take advantage of the work done by the sponsor group. CHAIRMAN WHITAKER commented that nothing is being done to preclude the sponsor group from participating. In fact, the sponsor group is encouraged to participate. Number 1012 REPRESENTATIVE OGAN referred to page 14, line 30 of HB 170 which refers to "Credit of the state not pledged." He inquired as to how it could be made to look like a state entity, if the state does not have any obligation for the debt. COMMISSIONER CONDON stated that a number of state entities have been established which are clearly state entities that borrow money and whose obligations are not obligations of the state. A few such entities are the Alaska Student Loan Corporation, Alaska Housing Finance Corporation (AHFC), the Alaska Industrial Development and Export Authority (AIDEA), the Municipal Bond Bank, and the Alaska Energy Authority. Commissioner Condon was quite certain that the general credit of the state would not be desired to be pledged. REPRESENTATIVE OGAN asked if there is enough of a state entity that the bonds would be considered tax free by the Internal Revenue Service (IRS). COMMISSIONER CONDON said that he did not know. In further response to Representative Ogan, Commissioner Condon noted that the Alaska Railroad Corporation (ARRC) is tax exempt. He indicated that the ARRC is tax exempt, perhaps, because the Congress specifically granted an exemption. He pointed out that the memo from Legal Research and Services provided the committee with an example of the liquor store owned by the City of Bethel which was not found tax exempt. REPRESENTATIVE OGAN surmised then that a gray area exists with regard to whether the corporation established under HB 170 is tax exempt or not. Perhaps, an act of Congress would be required. Number 1334 COMMISSIONER CONDON discussed Norwegian Statoil as an example of the type of entity that would be desirable. Norwegian Statoil is owned by the government, but is run like a private business. "If you set up a business that operated that way and you simply had a board and it could choose to pay dividends or not, that even though that was state owned, that an entity like that is going to be a taxable entity." He posed another scenario in which the project would be run under the Department of Transportation in the same manner in which Alaska's international airport system is run as an enterprise. Under such a situation, Commissioner Condon indicated the enterprise would be tax exempt. He said that investors would probably not like to see an enterprise this large run as is Alaska's international airports. REPRESENTATIVE KEMPLEN said that he was intrigued by the notion of a hybrid corporation which evoked thoughts of the Permanent Fund Corporation. It seems possible to create a quasi-governmental entity that is managed by a sponsor group, which is paid a fee for management, and has incentives for dividends to be paid to the state. He asked if that would fall between the two examples given by Commissioner Condon. COMMISSIONER CONDON agreed that Representative Kemplen's scenario would fall between the two examples already discussed. He commented that the permanent fund is different than what is encompassed in HB 170. The permanent fund is managing assets that are clearly state assets. Furthermore, the permanent fund is not an enterprise in the sense of buying or selling something. REPRESENTATIVE KEMPLEN asked if an entity managed by a private sector team would fall within the model of a tax exempt entity. Could it be possible for the state to engage in a contract with the sponsor group to serve as managers of the Alaska Gas Corporation, if the sponsor group could illustrate that they are capable of managing the project. COMMISSIONER CONDON imagined that could occur, but he was reluctant to speculate about what may or may not work. He informed the committee that he was not present to offer a suggestion to the resolution. With regards to management, private people can be hired for a variety of services which may or may not be called management. "The question of how the entity fits into the state institutionally maybe goes beyond what we normally think of as the decision to paint the facility red or green next year." Commissioner Condon emphasized that lenders will want assurances that the enterprise will be run in a manner to get the money lent back. If the lenders think the enterprise will be micro-managed by the governor or the legislature in an inappropriate manner, the lenders will be concerned about getting their money back. Therefore, the question is to determine how to establish an institution that will run in a business-like manner giving the investors confidence. REPRESENTATIVE KEMPLEN inquired as to how the committee could receive models of how such an entity would work. COMMISSIONER CONDON said that other examples from around the country could be utilized, however he did not believe there was anything that resembled what is proposed here. Commissioner Condon noted the possibility that the legislation, as drafted, may be adequate. CHAIRMAN WHITAKER concluded then that this project would have to provide for the satisfaction of the IRS and the investment community; the overlapping of the two must be discovered. Furthermore, he surmised that there is not an exact model that could be followed, although the goal is worthy of the time to make it work. COMMISSIONER CONDON agreed. Number 1943 ROGER MARKS, Petroleum Economist, Department of Revenue, noted that he was present to discuss the results of his analysis of the Alaska Gas Corporation as established under HB 170. He reiterated the two main aspects of state ownership which are the tax-free financing and the state being exempt from federal income taxes on the profits. With regard to tax-free financing, Mr. Marks pointed out that tax-free financing does not always mean that the interest rate will be low. The interest rate is related to the risk an investor associates with a particular project. Mr. Marks said, "The question why would tax-free financing, to the extent it's available and the extent interest rates are low and why would exemption from federal income taxes be important? If you look at the common picture that most folks have of this LNG (liquefied natural gas) project, that is the sale of 2 billion cubic feet a day or 14 million tons a year of gas to Asia at a cost of roughly $12 billion by the private sector. In our judgement, that probably is not economic at this time or won't be economic for awhile." He cited two main reasons why the project is not economically feasible. Firstly, the pipeline is very expensive and it would require much gas to be marketed in order to decrease the per unit cost to a competitive level. The sponsor group has been working to reduce the cost or utilize a smaller project that would not require the sale of as much gas to start. Secondly, the project is also economically challenged because the competition is cutthroat with other competing jurisdictions containing lots of gas who would like to sell under the same finite market. Mr. Marks echoed Commissioner Condon's comments that the large portion of taxes under the status quo is huge. If that could be removed, that would economically be the same as cutting the cost $3.5 billion from the capital outlay. Therefore, it would be a large economic advantage to eliminate the taxes. MR. MARKS directed the committee to his series of spreadsheets which illustrate the possible numbers under this proposal. He said that the spreadsheet labeled 1 would be utilized as a representative case. Spreadsheet 1 represents state ownership of the facilities which would include, per Chairman Whitaker's instructions, the conditioning plant, the pipeline, and the liquefaction facilities. He noted that the state ownership would not include the ships. Also there would be no taxes on the profits of the sale of the gas as well as tax-free financing for the conditioning plant, the pipeline, and the liquefaction plant. The ships would be financed privately. He explained that Spreadsheet 1 illustrates the state's revenue stream, cost stream, and the difference which is the net revenue to the state. The revenue stream would be the sale of gas in the Far East. Spreadsheet 1 utilizes the price of $3.50 per million Btu which represents approximately $17 ANS in energy market prices. He noted that Spreadsheet 1 keeps the $3.50 constant in real terms, or inflated at a three percent rate of inflation. Historically, forecasting energy prices has not been a real success of economists and therefore, would be a risk to be considered for those financing the project. He pointed out that the first three columns illustrate the gross revenue realized by the state; volume multiplied by the price results in the gross revenue. Number 2223 MR. MARKS continued with the next set of six columns which illustrate the state's cost. Mr. Marks assumed that the state would pay a third party to operate the project which is illustrated under the heading of "total operating cost." The next heading, "total principal + interest to pay off $9 billion capital cost" represents the pay off of the principal and interest on the conditioning plant, pipeline, and liquefaction facilities. Currently, it is estimated that the state will finance $9 billion of the $12 billion total project. He noted that $3 billion of the $12 billion is ships. In this case, the interest rate was assumed to be six percent which a normal rate of inflation. Mr. Marks explained, "As I have structured it, the state does not begin to pay off the bonds, the principal and interest, until gas sales commence in 2007 and they pay them off over 30 years. And what I've done is set this up what we call levelized payments where you look at on a per mcf (million cubic feet) basis, you start at a certain rate and those payments increase at the rate of inflation such that the bond holder, at the end of the day, has earned six percent on their bonds." He commented that this is different than a home mortgage under which you would pay the same each year. This would utilize a low amount that would increase with the rate of inflation such that the net effect would be the same as a mortgage. The next column illustrates the financing of the ships in the private market at an interest rate of 10 percent. He noted that the 10 percent interest rate was suggested by Dr. Pedro Van Meurs' report suggested. The final set of costs for the state would be the purchase of the gas from the working interest owners at Prudhoe Bay. Per Chairman Whitaker's instructions, the purchase was started at $0.50 per mcf which is increased with inflation. He pointed out that the price would ultimately result from the negotiated price between the state and the working interest owners. Therefore, summing the operating cost, the sate's capital, the ship's capital, and the purchase price of the gas result in the total cost. MR. MARKS stated that the difference is called the state's net revenue. Under this scenario, this really represents the state's cushion to remain competitive. If the state had difficulties entering the market, the state could reduce the selling cost of the gas in the Far East or utilize a smaller project that would cost more on a per unit basis. He recognized that there could be many sensitivities a few of which he reviewed. If the price of gas received in Asia was 20 percent less, the state revenues would be reduced by half. If there was a 40 percent cost over-run, the state revenues would be reduced by half. If the financing cost was 10 percent rather than six percent, the state revenues would be reduced by half. Mr. Marks informed the committee that Spreadsheet 2 is identical to Spreadsheet 1, except Spreadsheet 2 utilizes a starting price of $2.50 in 2007 which could be considered a low price scenario. A $2.50 starting price represents $12.00 oil. Spreadsheet 3 is identical to Spreadsheet 1, except Spreadsheet 3 utilizes a starting price of $4.50. A $4.50 starting price represents $22.00 oil. TAPE 99-16, SIDE B MR. MARKS continued discussion regarding Spreadsheets 4, 5, and 6 which are predicated on the idea that there are a number of surplus LNG tankers. If there were enough LNG tankers, only the operating costs would have to be paid. The figures with that scenario are provided by Spreadsheets 4, 5, and 6. He said that it is currently unknown if there are enough surplus LNG tankers. He offered to entertain any questions. Number 2441 CHAIRMAN WHITAKER asked Mr. Marks to describe an S-curve contract as it relates to historical LNG sales. MR. MARKS commented that LNG is a very capital expensive endeavor and most will not undergo the risk of spending such capital without a secure contract in place. However, consuming countries have other sources of energy besides natural gas heating oil. In order to protect consumers, the consuming countries do not want to pay on a Btu basis more for energy than the competing price of energy. He informed the committee that generally, the energy market moves with oil prices. In general, the price received with LNG contracts varies with the amount of oil, however to protect the consumers and the producers there is the S-curve. The S-curve places a ceiling and a floor on the price, within the ceiling and the floor the price of LNG varies with respect to oil. CHAIRMAN WHITAKER asked if the range in gas prices from $2.50 to $4.50 would be reasonable to construct a S-curve. MR. MARKS noted that traditionally S-curves have been the way contracts have been structured. Generally, the S-curve has an inflation component, although it does not accommodate inflation 100 percent. Therefore, if oil prices were flat for 30 years, very little of the gas price, maybe a quarter, would increase with inflation. Mr. Marks informed the committee that in the past few years the Katarese(ph) have become very active in the LNG market, particularly in Korea. The Korean government has been fairly cutthroat in contract negotiations and have refused to negotiate a price floor. Mr. Marks said that in the last five years, prices have been set without floors or ceilings. He agreed with Chairman Whitaker that in those contracts the market is at work. Number 2293 REPRESENTATIVE BRICE expressed the need to have discussion regarding the rationale behind the $0.50 per mcf purchase price. He inquired as to how Mr. Marks adjusted for state royalty. MR. MARKS informed the committee that he assumed that it would be passed through in the price, if royalties and severance taxes stayed in place. He felt it made sense that if the state purchases the gas, the royalties and severance taxes would be passed through. Therefore, under this type project it would make sense to remove royalties and severance taxes from the scene. REPRESENTATIVE KEMPLEN asked if the $9 billion capital cost included local property taxes. MR. MARKS clarified that local property taxes were also removed from the scene. In further response to Representative Kemplen, Mr. Marks said that the pipeline would amount to between $4.5 and $5 billion of the capital cost. He explained that the model utilized was one which was developed by the Administration's gas commercialization team that provided a report to the governor in 1998. That model was developed in conjunction with the three major working interest owners at Prudhoe Bay and Yukon Pacific. The original cost of the pipeline was determined, almost 10 years ago, to be $15 billion. The working interest owners were optimistic that the price could be reduced to about $12 billion including everything. The notion was that if the price could not be reduced to $12 billion, there would be no project anyway. REPRESENTATIVE KEMPLEN inquired as to how one could best achieve a sense of the sensitivity for this capital cost if there was a desire to integrate advances in pipeline construction technology. MR. MARKS suggested waiting until the middle of next year when the sponsor group reports on just such questions. Mr. Marks understood that the sponsor group would complete its report in a little over a year from now. CHAIRMAN WHITAKER summarized that Mr. Marks' model is based on the Van Meurs study, significant industry input, and state assimilation. Chairman Whitaker indicated that the committee should have copies of the January 1998 report to the governor. REPRESENTATIVE BRICE inquired as to where the $0.50 per mcf was derived. CHAIRMAN WHITAKER said that he chose an astronomically high number which the producers could not turn down in order to start negotiations. He commented that negotiation is under the purview of the administration. Chairman Whitaker announced that the committee would now turn its attention to the legality of the bonding and financing of this. Number 1970 KEN VASSAR, Attorney of Wohlforth, Vassar, Johnson & Brecht, informed the committee that his career began with four years, 1976-1980, of drafting legislation for the legislature. During that time he was the drafter responsible for all the legislation related to state lending and bonding activities, including the legislation which laid the foundation for the current programs of AHFC, AIDEA and the Alaska Municipal Bond Bank Authority. After that time, Mr. Vassar was in the Attorney General's office for two years during Commissioner Condon's tenure as the Attorney General. For the past 17 years, he has been in the aforementioned firm working as bond counsel for the same agencies for which he drafted legislation. MR. VASSAR echoed Commissioner Condon's comment regarding the dynamic tension between maintaining the essential governmental function of this entity versus providing this entity with the financial independence and powers to attract interest in the bond market. He identified the two separate, but related issues of whether the income earned would be taxable, which he noted was not his expertise, and tax exempt bond financing. The financing proposed has certain challenges because the project would necessarily involve the sale of gas to private companies or at least to non-governmental entities as referred to by the IRS code. The code describes governmental entities as being state governments and municipal governments, anything else is a non-governmental entity. Such a situation presumes that it is an area involving private activity bonds rather than governmental obligations. "Governmental obligations are the kinds of bonds that people typically think of that municipal bonds are issued for." Such bonds finance roads, schools, and state and municipal office buildings. He pointed out that governmental obligations begin with the presumption of being tax exempt. When private parties are involved, the presumption is that the bonds are taxable. He noted that the IRS code does create exceptions that allow certain types of bonds to be tax exempt, although the bonds are private activity bonds. MR. VASSAR said that the challenge in this project is to determine which portions of this financing would be categorized as governmental obligations. For those portions that are private activity bonds, the challenge would be whether those bonds would be eligible for one of the exemptions allowed by the IRS code to maintain being tax exempt. Mr. Vassar commented that at this point there seem to be many questions with fewer answers for this project. For example, docks and wharves can be financed with tax exempt funds in the private activity bond category. Perhaps, that will be a part of this project. He pointed out that facilities for the local furnishing of gas and electricity could be financed. He understood that a portion of the gas in this proposed pipeline would be diverted to local governmental use. In all likelihood, a percentage of the overall facility can be taken based upon the percentage that would be used by local governments to qualify for the local furnishing exception. He noted that there are a couple of other financing possibilities and there should be time to review those. Mr. Vassar related that there is a better possibility of taking advantage of available exemptions under the IRS code as well as the best possible financing structure to the extent that flexibility can be maintained in the underlying enabling legislation for the responsible financing entity. Therefore, he suggested that any legislation created to pursue this financing needs to provide flexibility while keeping in mind that this is a state project. MR. VASSAR referred to Representative Ogan's earlier question regarding the state's pledge to disclaim liability for the bonds. He emphasized that no indebtedness should be created through this mechanism that anyone could mistake for a general obligation of indebtedness for the state. If that occurred, the indebtedness would be invalid. It is a common practice for governmental entities to issue debt that is secured by something less than the governmental entity's full faith and credit general obligation. That merely makes the security for that debt come from a particular source. Similarly, Representative Kemplen mentioned questions about the management team to which the same types of considerations apply. If there are private management teams, one must take care that the essential governmental characteristic is maintained. The regulations of the IRS code provide specific rules for management teams. However, the IRS recognizes the ability of states to create private corporations to accomplish financing of governmental purposes. Therefore, the existence of private managers does not eliminate the governmental aspect of the function being served. Mr. Vassar concluded by saying that this is an excellent opportunity to review a number of options available to accomplish this financing function. Number 1312 REPRESENTATIVE KEMPLEN noted that Mr. Vassar mentioned that it is easy to publicly finance ports, harbors, and electrical distribution facilities. Are there examples of quasi-public entities financing pipelines or similar infrastructure? MR. VASSAR said there are not examples in Alaska, but there are in other parts of the country. He cited the New Jersey turnpike as an example. In further response to Representative Kemplen, Mr. Vassar explained that a nonprofit corporation can be created that would own the facilities. He noted that this is all premised on the initial determination that all of this is an essential governmental function. The nonprofit corporation can be established to own the facilities and can be given the power to issue bonds itself on the state's behalf. The proceeds of those bonds could finance the construction and acquisition of the facilities and then lease the facilities to the state with the lease payments utilized to repay the debt. At the end of the debt term, the facilities would automatically become state property and the 501C4 corporation would be eliminated. That is basically the IRS code 6320 approach. Mr. Vassar informed the committee that there is also an allowance for the issuance of tax exempt bonds to finance the activities of 501C3 corporations. In this case, the state agency would issue the bond and make a loan to a 501C3 nonprofit corporation. The finance structure would be similar to that described above. Mr. Vassar pointed out that the difficulty is that in both of these situations, the corporation would be performing an essential governmental function. He noted that a presentation must be made to the IRS who would determine whether the project would be eligible for one of the aforementioned corporations to perform. REPRESENTATIVE KEMPLEN commented that he was interested in more information in the essential governmental function. What type of criteria is utilized to determine if a project or entity qualifies for such a designation? Would the construction of a pipeline to move a public resource from the North Slope qualify as an essential governmental function? MR. VASSAR said that there is a spectrum of financing, ownership, and leasing arrangements. He commented that he liked the introductory portion of this legislation which walks through the state constitutional provisions which mandate the utilization of the state's natural resources for the benefit of the people of the state. Such statements present the state's case and is helpful in that way. Number 0932 REPRESENTATIVE BRICE inquired as to the benefits and drawbacks to the two approaches mentioned by Mr. Vassar, assuming the IRS sees this as an essential governmental function. MR. VASSAR clarified that the 6320 and the 501C3 are similar in that both involve a private corporation performing what the state might do for itself. When a private corporation is involved, a certain amount of the possible liability of the state is taken away. At the same time, that introduces another entity controlling an essential governmental function. He pointed out that is why many of Alaska's bond-issuing entities as well as this legislation, include language creating the entity as public corporations of the state with separate and independent legal status. He explained that the notion is that if the debt of these corporations is not paid, the people who purchased the bonds know they cannot come to the state expecting to be paid back. REPRESENTATIVE OGAN acknowledged that there is a gray area with this project, but how can the pitfalls be avoided? MR. VASSAR said that part of the art of developing any bond issuance is to work with a financing team of experts with a significant background in preparing such financing. Such would include underwriters, financial advisers, counsel to the underwriters, and trustees. The working group would meet to make the best determination possible and often there is a way of doing things which is well within the state IRS code, regulations, and rulings. Unfortunately, there are many gray areas. If that point is reached and satisfaction that the project is well within the financing spectrum cannot be obtained, the financing group is incumbent to say to the issuer that the IRS must first make a ruling. Mr. Vassar noted that the IRS has procedures regarding formal responses to questions about bond financing. He likened the procedures to an administrative appeal. The IRS also gives out private letter rulings to issuers with questions. Those private letter rulings have precedential value and are applicable only to the particular project. In further response to Representative Ogan, Mr. Vassar explained that there is an appeal process. One could request that the Department of Treasury overturn an IRS ruling. In response to Representative Kemplen, Mr. Vassar said that the process usually takes about six months. However, the timing depends upon the complexity of the issue and how busy the IRS is. He noted that the IRS never provides a time specific. Number 0412 BRIAN ANDREWS, Financial Consultant, Merrill Lynch, informed the committee that all credit transactions are evaluated on what he called the "five C's." The "five C's" are as follows: capacity - ability of debtor to repay the creditor; collateral - value of assets that secure a loan in case of default; credit - historical indication of how a debtor has handled prior obligations; character; and coverage - diversification of capacity and collateral risk to a third party such as an insurance company. If those can be satisfactorily negotiated between a creditor and a debtor, a transaction can be struck. He acknowledged that what is being discussed here is a sizable credit transaction and would peak the interest of the global banking and investment community. However, he felt it important to note that AT&T just successfully raised $42 billion for its Media One bid. In Mr. Andrews opinion, if the "five C's" can be satisfied such a financing could be accomplished. Number 0279 MARK PRUSSING, CPA, Public Finance, Seattle-Northwest Securities Corporation, informed the committee that he had been a resident of Alaska since 1974 until his move to Portland last year. Prior to his move he served in the Department of Revenue. He said that he understood the impact of oil revenues and royalties on state finances as well as the importance of such a project for the state's future. He pointed out that the Public Finance portion of Seattle-Northwest Securities Corporation specializes in the issuance of bonds as an underwriter and in a financial advisory capacity. The financial advisory position would be similar to what would be performed in this case. He noted that Seattle-Northwest Securities is the number one underwriter of municipal bonds in the Northwest in 1998 as well as a number of years prior. He also noted that he currently serves as the financial advisor to the City of Seattle on all of its municipal bond transactions. Mr. Prussing commented that he has a personal and professional interest in Alaska. MR. PRUSSING stated that the team that would be desired for this project would be include someone like Mr. Vassar's bond counsel; a financial advisor to act in the state's interest in order to sort the proposals from various underwriting firms. With a project of this size, the underwriting firms would be those such as Merrill Lynch, Goldman Sax, Solomon Smith Barney, et cetera. He explained that typically, he would help select the underwriting team for the State of Washington. He indicated that the project would be better with more flexibility. TAPE 99-17, SIDE A Number 0044 MR. PRUSSING commented that a project of this nature should not rely on the nature of the taxability of its debt to make the project feasible. If the project cannot be achieved on its own merits, Mr. Prussing indicated that the project would not be a good candidate for issuing bonds. The tax exempt status simply enhances the profitability of such a project. He noted that this relates to the ability to borrow in the municipal bond market versus the taxable bond market. In such a project, it is likely that there will be a combination of tax exempt and taxable bonds. There are many investing and financing vehicles available and the goal is to find the best mix to meet the requirements of the project. MR. PRUSSING provided the committee with the following point of reference regarding how the tax exempt status of debt figures into the profitability for the state's purposes. He explained that he ran some numbers assuming a differential in taxable versus tax exempt rates. He predicted that it would represent between $125 to $200 million annually if the bonds are tax exempt. That is in debt service cost. According to Mr. Marks' spreadsheet for the year 2015, if the income were subject to federal income tax that would amount to almost $554 million. That illustrates the magnitude of the two issues. The tax exempt status of the bonds is important and although it will make the project more feasible, it will not drive whether the project will work or not. He reiterated the likelihood of portions of the project being taxable and others being tax exempt. Mr. Marks commented that the ability to not pay federal taxes on income is an order of magnitude greater than the tax exempt financing. This would be considered a revenue backed financing which is common. MR. PRUSSING acknowledged that there are many challenges ahead for this project. If this is a project that proves to be feasible economically, the capital markets will come and meet the need of the financing. In closing, Mr. Prussing encouraged the committee to explore, identify, and seek solutions to the challenges of this project. Number 0431 REPRESENTATIVE BRICE inquired as to what would result if the state up-front capitalized a portion of the project with maybe the $3.5 billion from the capital budget reserve and would only need to bond for $8.5 billion. MR. ANDREWS noted that any credit transaction is a negotiated process. Therefore anytime additional collateral value can be added or the risk reduced, the stronger the credit and the lower the rate can be negotiated. In other words, the better the deal. MR. PRUSSING agreed with Mr. Andrews and likened it to borrowing money to purchase a house. If the home buyer puts down money, the bank will probably give a better interest rate. It is a credit rating question. REPRESENTATIVE OGAN utilized a triangle to illustrate the components necessary for this project. There is gas, financing, and the market. He noted that those present dealt with the financing aspects which would have to have some comfort with the market. Representative Ogan indicated the need to hear about the market at some point beyond mere speculation. MR. PRUSSING agreed with Representative Ogan that the state would have to demonstrate that there is a market for the gas to make investors more comfortable to meet the debt service. Typically, the projected revenues would be reviewed with regard to what percentage the projected revenues would be of the debt service. MR. ANDREWS commented that of the elements he mentioned, the capacity to repay the debt probably carries the most weight. That is the element the creditors will strip down. The creditors will want to ensure that those purchasing the gas have the capacity to continue with that obligation. REPRESENTATIVE OGAN requested that Mr. Andrews expand on the character and coverage elements of his "five C's." Number 0767 MR. ANDREWS explained that coverage is the element of shifting risk, typically to a third party. Usually in a municipal bond or tax exempt financing, an insurance company will come in with its credit worthiness and assets to protect the underlying creditors to the obligation. It is a credit enhancement situation. He noted that another way to view coverage is to obtain an assuridity, a third party that may not put up assets, but would sign for the obligation. Mr. Andrews explained that character is an intangible concept to some extent and it folds into credit. Is the debtor capable of making the debt whole? He pointed out that sometimes tax exempt financing carries with it moral obligation which may or may not be worth anything and would necessitate returning to the character of the issuer. MR. PRUSSING commented that another way to view coverage is to review the projected revenues and how well does that cover debt service. How many times over does it cover the debt service? With regard to the moral obligation of the state, some issuers rely upon that, but that would not be an assumption. He believed that Mr. Vassar would agree that it would not be appropriate to have people believe that the state is morally obligated. Therefore, this would have to stand alone and the coverage would be from a third party guarantee or generally stand alone with regard to how the projected revenues compare to projected debt service. REPRESENTATIVE KEMPLEN recalled that there was mention that the legislation's language should be broader to ensure flexibility in financing. He guessed the reference was in regard to Article 2 of the legislation. He asked if the language was restrictive. Number 0953 MR. PRUSSING replied no. He clarified that his comments were directed to underscore Mr. Vassar's comments. To have flexibility in establishing the entity, as the borrower, will provide more flexibility in the future. "As far as the instruments that are authorized under the legislation, I just made the assumption that as we get further down the road we'll refine that and make sure that any options we would want to explore would be covered in there." He reiterated that it does not appear to be restrictive. CHAIRMAN WHITAKER commented that the instruments are all subject to change. He echoed his comments at the previous hearing that this legislation is an idea in search of a better idea. Chairman Whitaker announced that there will be other hearings and that there will be the need for two subcommittees, one to examine financing options and mix and the other to examine the tax status of income. He indicated the need for those interested to come forward. ADJOURNMENT There being no further business before the committee, the House Special Committee on Oil & Gas meeting was adjourned at 6:55 p.m.