MINUTES JOINT MEETING HOUSE AND SENATE FINANCE COMMITTEES April 19, 1995 8:15 a.m. TAPES SFC-95, #35, Side 1 (420-end) SFC-95, #35, Side 2 (575-114) CALL TO ORDER Senator Steve Frank, Co-chairman, Senate Finance Committee, convened the Joint House and Senate Finance Committee meeting at approximately 8:15 a.m. PRESENT Senators Representatives Sen. Frank Rep. Martin Sen. Halford Rep. Brown Sen. Donley Sen. Phillips Sen. Rieger Sen. Sharp Representative Mark Hanley, Co-chairman, House Finance Committee arrived soon after the meeting began. Senator Zharoff and Representatives Foster, Grussendorf, Kelly, Kohring, Mulder, Navarre, Parnell, and Therriault did not attend. ALSO ATTENDING: Representative Gail Phillips, Speaker of the House of Representatives; Wil Condon, Commissioner, Dept. of Revenue; Annalee McConnell, Director, Office of Management and Budget; Dr. Charles Logsdon, Chief Petroleum Economist, Oil and Gas Division, Dept. of Revenue; Nancy Slagle, Director, Division of Budget Review, Office of Management and Budget; Mike Greany, Director, Legislative Finance Division; and aides to committee members and other members of the legislature. SUMMARY INFORMATION Spring Revenue Forecast Presentation by Dr. Charles Logsdon Department of Revenue Upon convening the joint meeting, Senate Finance Co-chairman Steve Frank invited Commissioner Wil Condon, OMB Director Annalee McConnell, and Chief Petroleum Economist Chuck Logsdon to join committee members at the table. WIL CONDON, Commissioner, Dept. of Revenue, advised that the department lowered its mid-case forecast for FY 96 general fund revenue by $184 million from the November forecast. The reduction is based on: 1. Present belief that North Slope production will be down 92,000 barrels a day from the fall forecast. 2. A 20-cent reduction in the destination price forecast from $16.72 to $16.52 a barrel. 3. Expectation that transportation costs that determine what the state receives at the wellhead will be 51 cents a barrel higher than in November. The Commissioner referenced the department's five-year forecast presenting high, medium, and low scenarios and acknowledged that in some years prices and volume would achieve the high case. However, the market is likely to decrease to the low level as well. The department thus plans around the mid case. At the present time, the price of ANS crude is over $18.50 a barrel. The department forecast for FY 96 is $16.52. While FY 96 may prove to be a high year, when projecting basic market fundamentals for the next few years, the department does not foresee a dramatic change. Market fundamentals call for a price, in 1995 terms, of $16.50 a barrel. Speaking to volume, Mr. Condon referenced a recent presentation by Cambridge Research. He noted that the presentation was perceived as optimistic in terms of production projections. Department projections through 2002 exceed those of Cambridge. ANNALEE McCONNELL, Director, Office of Management and Budget, next spoke to the relationship between projections and the upcoming FY 96 budget. She referenced the lowering of the expected oil price between the fall and spring revenue forecast and stressed need for a "much firmer fiscal plan for the state." She cautioned that in getting to that point it does not make sense to take hasty action which could have a negative impact on the overall state economy. However, the administration will be more closely tracking what occurs on a month-by-month basis. There is opportunity for mid-year course correction, if necessary. Mrs. McConnell stressed need to work closely with the long- range fiscal planning commission. She reiterated her caution against action that could drive state and local economies downward. The administration believes it is on track in terms of bringing the budget down from the amount originally proposed in February. It would not, however, be prudent to take drastic action. CHUCK LOGSDON, Chief Petroleum Economist, Dept. of Revenue, next spoke to members. Directing attention to a handout (copy appended to these minutes), Mr. Logsdon noted a projection of $1.885 billion for FY 95. Due to higher oil prices, the department will attempt to update that number by May 1. Mr. Logsdon estimated that revenues would amount to approximately $1.9 billion, if oil prices remain high. Figures for FY 96 evidence the largest adjustment from the fall forecast. The projection is $1.775 billion for FY 96 and $1.828 billion for FY 97. The department is fairly confident that, in nominal dollar terms, the state "can probably bring in something around $1.9 billion a year," if production and price remain close to the mid-case level. Referencing the second page of the handout, Mr. Logsdon explained that if the forecast were to be characterized by one assumption, it would be production. The department made a "fairly radical adjustment downward" in production estimates in the short term. For the last several years, the department held with a "fairly optimistic" projection from Prudhoe Bay in FY 95 and 96. The department felt that with commissioning of the GHX2 project, decline at Prudhoe Bay could be mitigated to a significant degree. More experience as the project progresses indicates that not all of the oil originally anticipated will be recovered. Changes in production numbers reflect a one-time downward adjustment compounded by weather-related down time and unplanned seasonal maintenance on the Prudhoe Bay oil field. The foregoing resulted in a 92,000 barrel decline in production estimates for the North Slope from the fall forecast. That is the bad news. The good news is that there is much additional activity on the slope. An aggressive plan would expand Milne Point up to approximately 50,000 barrels a day. Milne Point facilities will thus be moving oil to market at "something closer to what the original plans suggested they would be." That will be achieved because of discovery of new, producible pay made possible through technology and additional exploration. A large scale enhanced oil recovery (LSEOR) project will move natural gas liquids through the pipeline and enhance recovery at Kuparuk. Commencement of additional well drilling at both Kuparuk and Prudhoe Bay will extend production further into the future than earlier anticipated. End: SFC-95, #35, Side 1 Begin: SFC-95, #35, Side 2 The decline rate for the North Slope now appears to be closer to 4%. When the production curve is matched with that for revenue, it evidences a downturn for the next several years but subsequent upward movement over the next five or six years to around $1.9 billion a year in general fund unrestricted moneys. Adjustments in production numbers highlight changes in the tax rate. Mr. Logsdon noted that the severance tax is subject to the economic limit factor (ELF). The ELF is a direct function of the number of barrels produced and the number of wells that produce them. If the number of wells remains the same or increases, and production drops, on average that lowers the amount of oil coming out of each well. That is exactly what lowers the ELF. Page 3 of the handout reflects the fact that the tax rate is beginning to come down. It "takes a fairly good sized drop between 95 and 96." Also of importance is the fact that Pt. McIntyre is "incredibly productive" and is paying substantial severance tax. It is producing upwards of 140,000 barrels a day out of wells producing 7,000 to 8,000 barrels a day. The ELF is thus close to .9, the maximum rate. The forecast assumes that in order to keep production at those levels, producers may double the number of wells in the field. The resulting effect will be that production remains the same but the tax drops. Every 1% drop in the ELF at $10 a barrel at the wellhead costs the state "about $7 million." In 96, the state will face "nearly a 5% drop in the tax rate." That translates to $35 to $40 million. Referencing page 4 of the handout, Mr. Logsdon explained that the fall forecast used $16.72 as the base price for FY 96. That was rolled back approximately 20 cents for the spring forecast because of a serious push by Iraq to have the embargo lifted. The United Nations declined to do so with the exception of a limited sale of up to $2 billion worth of oil to fund war reparations and provide food and medicine which the United Nations would distribute to the Iraqi people. That arrangement was unacceptable to Iraq. The world view presented by Cambridge is consistent with that of the Dept. of Revenue. On the demand side, economic growth is expected to be relatively robust for the next five years, with the exception of Japan. The global increase in oil consumption is approximately 2 million barrels a day. Of that, OPEC picked up less than half, and non-OPEC benefited from the greater share. Speaking to supply, Mr. Logsdon noted that non-OPEC production continues to increase, and there are projections of another large increase from the North Sea next fall. That is anticipated to exert downward pressure on price, and it is showing "up only a little bit in the futures market" where contract prices for next fall are "just a few pennies lower than the cash price today." The key issue for OPEC is Iraq and its 3 million barrels a day which have been sitting on the sidelines for approximately five years. Although most feel this oil will not reenter the market while Saddam Hussein is president, it remains a cause for concern. The real area of potential growth continues to be the former Soviet Union, countries in the Middle East, and areas around the Caspian and Black Seas. The chief obstacle to development is getting the oil to market. In the long term, this represents a huge amount of oil that could enter the market. Mr. Logsdon cautioned that in not producing and selling its 3 million barrels a day, Iraq is banking 90 to 100 billion barrels in reserves. Those barrels will be available at some time in the future. When evaluating all of the foregoing, the Dept. of Revenue projects a tendency for mid-scenario oil in the $16.50 a barrel range. It further assumes that the mid-case price will keep pace with inflation. It is further projected that the price will be close to $16.50 per barrel purchasing power in the year 2005. Mr. Logsdon explained that for planning purposes, some oil companies focus on the low scenario, $15.00 oil. Market dynamics that move the price in that direction may always occur. He cautioned against reliance on the high projection of $18.00 and noted that an $18.00 year may be followed by a $13.97 year. Due to that volatility, a long-term planning price of $16.50 is more prudent. Speaking to pricing, Mr. Logsdon noted that Alaska experiences "some fairly big deductions from that sales price" in determining the wellhead value upon which taxes and royalties are based. He next referenced a graph entitled, "Transportation Costs to Lower 48" and explained that it rolls together both the TAPS charge and tanker costs. FY 95 reflected a "big jump" in the cost of moving ANS to market. The largest share resulted from the 1995 TAPS filing evidencing unanticipated operating expenses. Hundreds of millions of dollars were expended by Alyeska for electrical work, corrosion repair, etc. That caused the tariff to be 50 cents higher than anticipated. Most of the 20 to 30-cent increase in marine transportation reflects "increased . . . 90-type regulatory costs." These costs are allowed deductions against the severance tax. Mr. Logsdon referenced the next graph and noted decreases in tanker and pipeline costs between 1995 and 1998. The decrease for marine transportation indicates that fewer barrels of ANS will be transported to the gulf coast, and average transportation costs will thus drop. Further, depreciation on capital pipeline costs has declined but will again increase beyond the year 2000 as additional capital investments are needed. Projected declines in operating costs reflect a reduction in the number of barrels shipped through the pipeline. Decommissioning of facilities (pump stations) will also lower fixed costs. The department is projecting transportation costs of below $4.50 a barrel over the next five to six years. Mr. Logsdon next directed attention to the "Alaska State Revenue Matrix" and pointed to projected revenue of $1,948 million based on a price of $18.00 and FY 96 production of 1.50 million barrels. That number is approximately $200 million higher than the current base case. Responding to a question from Co-chairman Halford concerning the high and low range of production for FY 96, Mr. Logsdon advised of a single point estimate for production for the short term. The Co-chairman voiced concern that although production was a "big component of the last error" no potential range is shown. Mr. Logsdon concurred and explained that that is one of the reasons the sensitivity matrix was developed. Representative Martin voiced his belief that, at this time, Alaska's welfare depends more upon production than price. He then asked if it is possible to obtain additional information from producers and suggested need for a five- year production average. Commissioner Condon explained that the individual responsible for production estimates carefully reviews development plans submitted by operators and reviews production forecasts with pertinent companies. That results in "the best we can do" in terms of discussions with those responsible for investment of capital moneys in an attempt to "get the hydrocarbons out of the ground." In response to a further question from Representative Martin, Commissioner Condon explained that wells are not being shut down because they are not producing profitably. They are being shut down because, in the mix of oil and gas production, it is not optimum to produce from particular wells because of the high amount of gas produced with the oil. Facilities at Prudhoe Bay can handle only a certain amount of gas. As the field matures, the amount of gas produced per barrel of oil increases daily. The amount of oil produced is a function of ability to handle the gas that comes out of the ground with the oil. Representative Martin asked if the state would sustain a 3 to 4% production loss per year into the future. Commissioner Condon acknowledged there would be production loss each year. Responding to further questions from the Representative, the Commissioner stressed need to anticipate the range between the low and high-case scenario. The budget should be planned based on selection of the right mid case over the longer term. Senator Rieger referenced potential for development of Badami and the String of Peals fields. He then inquired concerning components of the department forecast that result in a future (1998-99) 300,000 to 400,000 barrel discrepancy when compared to Cambridge numbers. Mr. Logsdon voiced his belief that the two projections are "pretty close . . . through 2002." Beyond that, Cambridge speaks to liquid production capacity. The department has not been able to develop definitive numbers for that. He added that the department has not "explicitly included production from Badami." The department opted not to do so because it has not been well delineated. Information over the next several months should better define the number of barrels that might be available. Other production mentioned by Cambridge remains a mystery. The department has not estimated production from Hammerhead and other wells that have been drilled. The state forecast includes ability to produce from North Star, Seal Island, and West Sak. Those fields are not now in production because of large cost hurdles. Technological advancements may make them producible at a reduced cost. Alaska does not have, in either its reservoirs or known discoveries, sufficient barrels to justify Cambridge production numbers. Commissioner Condon clarified that through 2002, the department's forecast is higher than Cambridge. He reiterated that the department projection does not include production from Badami. The Cambridge projection does. At 2002, Cambridge "picks up two chunks." They include known fields for which no development plans have been announced as well as new discoveries which have not occurred. That is where volumes within the two projections diverge. At that point the Dept. of Revenue estimate begins to decline, while the Cambridge estimate increases. For producing fields, the department's projection is more optimistic than that of Cambridge. House Speaker Gail Phillips asked if the department requested detailed information on future numbers from Cambridge. Mr. Logsdon said the department received the actual numbers but not requested backup information underlying the numbers. Discussion followed between Senator Sharp and Mr. Logsdon reiterating earlier comments regarding increased operating costs that gave rise to the tariff increase in 1995. Mr. Logsdon explained that the state does not absorb "the entire blow." The state pays 25 cents for every dollar increase in cost through lower wellhead value and lower severance tax and royalties. The $300 to $400 million increase in unanticipated operating expenditures relates to the fact that the pipeline is getting old. Repairs must be undertaken to keep the system in tact. Senator Rieger advised of information from Cambridge indicating that future reserves relate to three areas with estimated reserves of 150 to 300 million barrels. ADJOURNMENT The meeting was adjourned at approximately 9:05 a.m.