SENATE RESOURCES COMMITTEE April 11, 1996 8:03 P.M. MEMBERS PRESENT Senator Loren Leman, Chairman Senator Drue Pearce, Vice Chairman Senator Steve Frank Senator Rick Halford Senator Robin Taylor MEMBERS ABSENT Senator Georgianna Lincoln Senator Lyman Hoffman OTHER MEMBERS PRESENT Representative Joe Green COMMITTEE CALENDAR SENATE BILL NO. 318 "An Act authorizing, approving, and ratifying the amendment of Northstar Unit oil and gas leases between the State of Alaska and BP Exploration (Alaska) Inc.; and providing for an effective date." PREVIOUS SENATE COMMITTEE ACTION SB 318 - See Resources minutes dated 3/29/96, 3/30/96, and 4/3/96. WITNESS REGISTER Jim Baldwin, Assistant Attorney General Department of Law P.O. Box 110300 Juneau, AK 99811-0300 POSITION STATEMENT: Commented on SB 318. Patrick Coughlin, Deputy Director Division of Oil and Gas Department of Natural Resources 3601 C Street, Ste. 1380 Anchorage, AK 99503-5948 POSITION STATEMENT: Commented on SB 318. Ken Boyd, Director Division of Oil and Gas Department of Natural Resources 3601 C Street, Ste. 1380 Anchorage, AK 99503-5948 POSITION STATEMENT: Commented on SB 318. Bill Van Dyke, Lease Administration/Royalty Department of Natural Resources 3601 C Street, Ste. 1380 Anchorage, AK 99503-5948 POSITION STATEMENT: Commented on SB 318. ACTION NARRATIVE TAPE 96-50, SIDE A Number 001   SB 318 NORTH STAR OIL & GAS LEASE AMENDMENT  CHAIRMAN LEMAN called the Senate Resources Committee meeting to order at 8:03 p.m. and announced SB 318 to be up for consideration. The following is a verbatim transcript: CHAIRMAN LEMAN: ...In the Department of Law's legal brief. It said the Northstar amendments can withstand challenge by virtue of their positive statewide significance. Then you noted that the "reduction in net profit sharing is tied to promises of local manufacture and assembly of facilities to develop the leases." My question is would it be your opinion that these promises of local manufacture and assembly of facilities must be binding terms of the agreement in order to meet the statewide significance test. JIM BALDWIN, Assistant Attorney General: I think what you're quoting from is the part of the opinion which deals with the local and special legislation issue that we were dealing with and we were merely pointing out there that there needs to be a record made here in the legislature of the State interests that are behind this very narrowly focused piece of legislation. As far as the promises to be binding I think it's enough that there's some good and sound reason for this kind of legislation. What we're getting at is there must some reasonable basis to make a piece of legislation that's so narrowly focused as far as the territory it applies to being the Northstar unit leases or the railbelt area of the State where the manufacture may take place of the facilities that are going to be used in connection with the development of the unit. And so it's enough that there be some reasonable basis that the legislature has for being so narrow in its focus. Whether the agreement bears fruit I don't think is as important as the fact that you are doing it with in good faith belief that it will happen. I don't know if I can tell you that it has to be binding. That's not a condition of our opinion. It's merely a fact that there be some sound reasonable basis for making this legislation as narrow as it is. CHAIRMAN LEMAN: What I heard you say is that it doesn't have to be binding to meet that statewide significance test that you said needed to be met. MR. BALDWIN: That statewide significance test is one that was announced in a case known as State v. Lewis and it involved a land trade and it was attacked on the basis of the land was local legislation because it applied to only a specific amount of land in a single location of the State and the court decide there that because the land trade was of statewide significance - of importance to the entire State - that it met the local and special interest test and did not violate the constitution. That's where the state-wide significance comes in. We think this transaction has state-wide significance because of the amount of revenue that's involved, the fact the major population center of the railbelt area would be the beneficiary of some of the economic activity connected with the development of the Northstar unit, the fact that petroleum revenues form such a large percentage of the total revenues of the State. It makes this a very good case for being a matter of statewide significance. CHAIRMAN LEMAN: The next question is along the same lines. In your opinion regarding the test of whether the expenditures meet with public purposes under the public purposes tests under Article IX, Section 6, of the Alaska Constitution, you referred to the test as being "similar to a determination whether there is adequate consideration to support a contract." You indicate that if there is valuable consideration received by both the State and the lease holder, the benefits to the State may be characterized as direct. The question is in the same vein as the preceding question, must the State be assured of the receipt of the consideration for which it bargains in order to meet the public purposes test. MR. BALDWIN: That part of the opinion you're referring to deals with a question that was raised by Senator President Pearce as to whether or not this made an invalid appropriation of public resources and it was my conclusion that what she was basing that question on was whether or not it was a violation of a public purpose doctrine in the constitution which says that State property or money may not be expended except for a valid public purpose. It's been our opinion in the past that the courts will generally find a public purpose if the legislature declares it to be a public purpose. That's been the reasoning of the courts. From our side, analyzing it even further than that, because we don't like to stop there sometimes being the executive branch. We also analyze it as this mutuality of consideration that there has to be some equal exchange in order for there to be a public purpose. So if the State is giving up something in the form of, say, royalty revenues or a net profit share, but to be something received in return. It appears that there is some consideration here in return for that and the analysis that has been provided to you by the Department of Natural Resources and was provided to us at the time we wrote this opinion seems to indicate there was some mutuality consideration. Whether it's valuable consideration or whether inequality there I'm not so sure I'm capable of judging, but it appears to be some valuable consideration on the side and perhaps time will have to bear that out. CHAIRMAN LEMAN: My final question in that area - they're kind of all interrelated - so excuse me if they overlap a little bit. In concluding your analysis regarding the public purpose test you again appear to focus on the question of consideration. You note that we believe that a compelling case can be made that there is adequate consideration to support a finding of a direct and substantial public benefit flowing the reduction of the net profit share. Two questions. As a matter of contract law in determining what is adequate consideration would potential consideration be the same as actual consideration. MR. BALDWIN: That's a law school question. I guess I learned in law school even a pepper corn can be enough consideration for a contract. The point we're trying to make here is that there should be some fair exchange here to satisfy the public purpose doctrine to get too fixated on contract law and considerations in connection with contract law is probably not the correct way to approach this. But there has to be, in order to satisfy the public purpose doctrine, a direct public benefit and not an indirect public benefit - when you're giving up public revenues or foregoing some debt that's owed you by some third party. There has to be a direct public benefit and not an indirect benefit. The direct benefit cannot only flow to the other interest and there appears to be direct public benefit here in connection with the way this agreement is structured. SENATOR LEMAN: Can you give me an example of what an indirect public benefit would be. You used that in your example and I'm just trying to figure what you were meaning. Director public benefit I assume you mean there is money flow, employment, tax base, development sooner rather than later. MR. BALDWIN: Those things would be in the direct category. CHAIRMAN LEMAN: What would you put in the indirect category. MR. BALDWIN: I'm trying hard. In the context of other situations - it's hard for me to figure how it would work in this one - but in the context of other situations you often times see in the context of an appropriation to a grantee where a grantee is getting money to develop a mineral resource and the benefits to the State from that is maybe the grantee will develop the resource and maybe the State will benefit somehow in the future. It's not certain how that's going to happen, but the grantee develops directly by getting money to help it with its exploration program and we have in the past questioned appropriations of that nature, using that kind of reasoning. Saying that it appears that the benefit here is very indirect to the State. It's not something you can put your finger on directly here. You can't point to a tangible benefit. It's purely speculative. CHAIRMAN LEMAN: My final question in this area is the bottom line of all of this line of questioning is in other words would it make a difference if expected consideration never materializes. Some of the consideration we would have to put in that category. I don't have the actual agreement words in front of me. I remember there's a few caveats - best effort and things like that. My question is would it really make a difference if that consideration never materialized. MR. BALDWIN: No, I don't think so, not under the public purpose doctrine. The public purpose doctrine is the one legal issue that worries me the least. I think this transaction easily passes the public purpose doctrine test. The courts have been very deferential to legislative determinations of what is in the best interests of the State to expend its money on or to forego its revenues on or to receive additional revenues on. The courts have been very deferential in that regard and I don't see that as being a major factor influencing the validity of this particular transaction. CHAIRMAN LEMAN: What is the term of most unit agreements when they are approved by the Department. PATRICK COUGHLIN , Deputy Director, Division of Oil and Gas: I don't know....years would be before automatic contraction, but some are five and some are ten. CHAIRMAN LEMAN: Even the first term some are five? To your knowledge were there specific reasons the Department approved only a five year initial term for Northstar. KEN BOYD , Director, Division of Oil and Gas: I don't understand the question, I guess. MR. COUGHLIN: When the Northstar unit was first approved - when Amerada Hess was the operator. Is that what your question is directed to? I wasn't here so I didn't hear. CHAIRMAN LEMAN: We'll clarify and get it to you in writing. MR. BOYD: That would be great. If you're going back to the original unit with Amerada I'd have to look it up in the unit files. I'm sure there's a reason. BILL VAN DYKE , Royalty Lease Administration: Mr. Chairman, a unit such as Northstar to start out in the exploratory stage - most of those have a three to five year term while exploration and early delineation is under way. The three to five year term usually will match the commitment that the lessee is willing to make. We usually push for shorter terms. The lessees want longer terms and it's usually matched to the number of wells as to the amount of exploration they are willing to commit to at the time. And it's usually somewhere between three and five years. CHAIRMAN LEMAN: Has the Department ever conditioned its approval on a proposed unit agreement on conditions similar to those required for its initial approval of the Northstar unit agreement. MR. VAN DYKE: Mr. Chairman, those terms you were referring to were those the drill or pay terms. I can't remember all the terms that were in the initial approval. CHAIRMAN LEMAN: I tell you what, we're going to expand the questions so we can make sure we get the answers we wanted. It's probably unfair to reach bach that many years. I appreciate your willingness to at least help us out. Did BP ever inform the Department before the Department approved the current plan of development for the Northstar unit that it was unwilling to proceed with development unless the net profit share provisions were removed from the leases. MR. BOYD AND MR. COUGHLIN: Not to my knowledge. Not to me. CHAIRMAN LEMAN: Was it a surprise to you? MR. BOYD: Well, we approved a plan of development that went on for three years and we're looking at the logical progression of things and as we discussed in previous testimony, they came to the commissioner - the legislature, I believe, early last year during 207 and talked about removing NPSL terms. I don't recall them using that terminology then - that we won't do it without removing those terms. I don't think surprised is the right word, but I don't know what the right word is. CHAIRMAN LEMAN: Let's try one more. We may put this on the list of to be renewed. What was the Department trying to accomplish in its imposition of the "in lieu of drilling" payments and the requirements for the unit to conduct the detailed engineering, geological, geophysical, and other studies in such a compact time frame. MR. BOYD: I simply don't know the answer. I don't remember the reasoning behind it. I remember the outcome. CHAIRMAN LEMAN: O.K. we'll go to the NPSL accounting procedures and I think we'll take your ten minute version. Were there other questions of these gentlemen before we move on? Thanks. MR. VAN DYKE: Mr. Chairman, my name is Bill Van Dyke and I work with the Division of Oil and Gas. I have a handout and I'll be speaking to some of the figures in that handout. On the second page there's a generalized flow chart of how the net profit share system works. It uses the month of April as an example. The general procedures are established in regulation and the regulations are for the most part fixed for a given net profit share lease once that lease goes into affect. The lease is issued, the regulations are in effect the day the lease is issued are the regulations that apply. You can't, except in a few instances, change the rules down the road on a net profit share lease. It's more or less a fixed system. I'll give you a general overview of how the accounting flows on this flow diagram and then I'll show you two specific examples from the North Slope. The numbers are meant to flow from month to month. It's an accounting system. If capital or operating costs haven't been recovered in a particular month, you can carry forward those negative numbers and recover them next month, hopefully, or the month after - using production revenue from later months. Again, using April as an example. Beginning with step one, if you haven't recovered capital in the month of say March, the prior month, you begin with a negative balance in April. You add to that this new capital cost and that would include pipelines and facilities, wells, roads, things you've built that month, installed that month. So those are new capital costs including taxes that you pay to the State. Those come in basically as a negative number. You add as a positive number your net production revenue once the lease is on line. That's simply oil volume times oil value of gas volumes times gas values. But you've got to subtract your day to day out of pocket operating costs from net production revenue. So you have basically negative capital costs and positive production revenue numbers. You simply add those numbers together and it can either come out positive or negative at the end of the month. We've invested a lot of money, a lot of capital costs, it's going to come out negative that month. If you've had a lot of production and the price has been high and you didn't bring forward a lot of negative numbers from previous months you're going to have a positive number that month. Month's where you do get a positive number, those are the months where you owe a net profit share payment to the State. So you take that positive number, if the net profit share rate on that lease is 65 percent, the State would get 65 percent of that positive number that month. If at the end of the month when you add all your costs and revenues together and your number is negative still, then you can carry that number forward to the next month. You're also going to carry some interest forward. So in step two it's real simple. If it's positive, we get a payment. If it's negative, you go down to step three, you add some interest to that negative number and carry it on, then at that point, to the next month and start the process all over again. It's the same process month in and month out. The text boxes on the right hand side have some example of what generally are included in some of the cost categories. How you calculate interest is set forth in the regulations and it's a fixed procedure also. CHAIRMAN LEMAN: Does that interest apply a monthly rate no matter when during the month that expenditure is made or is calculated on a daily basis or do you know? MR. VAN DYKE: The interest is calculated daily and the capital balance the average of the beginning and ending balance for that month. So you come into the month with a capital balance if you have a negative balance. You have a number at the end of the month. You take the average of those two and use a monthly average - prime from three different banks - and those banks are set out in the sale notes. SENATOR FRANK: On your new capital tax, are you talking about severance tax there - property taxes, corporate income tax? MR. VAN DYKE: As far as I can tell the income taxes are not included, but once production started it would be severance tax and prior production you could have property tax. And you would as you begin to install facilities, even prior production you would start paying property tax. SENATOR FRANK: Why do you call that a capital cost. It seems like it would be an operating cost. MR. VAN DYKE: Prior to production it's up there in the development part and then once you begin production actually the taxes fall down into the production revenue block. And that's not clear from the handout. SENATOR FRANK: And what about federal taxes... MR. VAN DYKE: As Far as I know they are not allowed. I couldn't find them anywhere. SENATOR FRANK: Because the thing we saw from last year, 207, they showed that they had to pay federal tax like only about $1.79 per barrel before they got up to their bottom line and I said that's kind of silly because how would you get enough to pay federal income tax if you weren't making any money. And they said that based upon their world wide average and this sort of thing. So I'm just wondering about whether there was any provision for paying a share of their world wide or any share of federal taxes comes into the picture at all. MR. VAN DYKE: As far as I know it doesn't come in - those types of taxes don't come in. And there isn't any other than federal corporate income tax. SENATOR FRANK: Are there any other federal income taxes that come in play in this situation. MR. VAN DYKE: Not that I'm aware of. Maybe when someone comes up later and knows they can inform the committee. SENATOR FRANK: And what about local taxes. Would those be included. Is there just a property tax. There's a corporate oil and gas property tax, right? And the locals get to rake off most of it. It seems to me and the rest a little bit of the rest goes to the State. So the full 20 mills is included in this probably? MR. VAN DYKE: Mr. Chairman, that's correct. The system allows for most local taxes to be a deduction and I'm not aware of any additional local taxes right now they would pay. If there were, I think they would be generally allowed as a deduction. SENATOR FRANK: How far off the field do expenses - as far as either the capital or the operating - do they get to assign costs. Do they get to assign some overhead under these or do you get into that sort of thing. MR. VAN DYKE: There are fixed overheads allowed and those fixed overheads are in lieu of fighting about costs coming from Los Angeles or Houston or Dallas or Cleveland. They're to cover those off site costs as well as some miscellaneous on site costs that would be hard to account for otherwise or to audit. CHAIRMAN LEMAN: Is there a certain multiplier to the direct salary costs that get applied... something that has been audited in the past as an accepted rate. MR. VAN DYKE: Mr. Chairman, there's a three percent overhead generally allowed on capital expenses and about a nine percent overhead allowed on operating costs. The next few pages of the handout are text and it's more or less a formal description of what we just went through. So why don't we just skip those and go to the examples in the back. It's really just a description of what' on that first chart. If you go to the examples in that back...This first graph is a real development count for a lease at Duck Island unit at the Endicott oil pool. It shows how the development expenditures increase over time. Production started in that field late 1987. You can see the development expenditures on that net profit share lease continue grow through '88 and '89 and then finally started to decrease as the production revenues started to basically pay off those development costs. So the overall concept works. Development costs are accumulated and then they begin to decline as production starts. They don't decline real fast because this particular lease at Duck Island has about 25 percent of the reserves allocated to it. It has a 20 percent royalty rate. This oil has a severance tax associated with it. So royalties and severance taxes are basically taken off the top before you begin to pay off the development account so you're paying it off with 70 cent dollars in effect or even less than that when you take out operating costs. So it takes a while for the account to pay out. Probably, in this particular case there were some added investments in '94 and '95. You can see the account flattened out in those years. The payoff was not too great in those years, but it should pick up again through '96, '97. It's going to take a couple more years to get to $0, though, probably five or seven years. This lease has a 79 percent net profit share rate on it. So hopefully, ten years from now we'll be seeing some net profit share payments off of this lease. CHAIRMAN LEMAN: Do you really expect to see net profit share leases off of Duck Island. MR. VAN DYKE: I do, yeah. CHAIRMAN LEMAN: I hope you're right. MR. VAN DYKE: The next example which is the second to the last page in the handout is a lease at Northstar. There's been no production on that unit. So there's no production revenue coming in that's attributed to that lease. So the account balance hasn't started in the downward direction, yet. There's five leases in this unit. The amounts shown here are not the entire development account balance for Northstar. They are just expenditure attributed to the one lease. There were quite a few expenditures in '85 and '86, exploration expenditures. Since then there's been lease rentals, taxes, additional seismic, some engineering studies, as well as the interest accumulated. So the account balance continues to grow year to year, month to month. SENATOR FRANK: I was just looking at this and seeing it flatten out. It looked like it was getting awfully flat, but you already told me that. MR. VAN DYKE: There have been some substantial additional investments at Endicott back in '94 and '95. Those get added back into the system. Every time you invest additional money you get put that into the development account. So the account can begin to grow again later in field life. The last page of the handout is...Mr. Chairman, it is growing because additional investments are being made and hopefully those investments will recover additional oil or increase production rates. So that affect will hopefully push it back in the other direction. SENATOR FRANK: What we want to hope for is no more investment so you can finally get some profits, huh? MR. VAN DYKE: The last page of the handout just shows some net profit share account balances by field and these fields all have a mix of net profit share leases and fixed royalty rate leases. It indicates how many net profit leases are in each unit or each field and then what the account balance is for that unit or that field. The grand total is about $828 million in development account balances for those units and fields. There are no terminated or expired net profit share leases included there - only active leases. CHAIRMAN LEMAN: It's growing at about $5 million per month, right? MR. VAN DYKE: Oh, the prime rate right now is around eight and a quarter for February, anyhow. SENATOR FRANK: I don't see anything here on like a barrel analysis. You know, like you start with a $16 barrel and then you take off your transportation, right? No, actually you take...How does it work. You take off your ship transport and then your tax and then your gathering line tariff, if there is one, probably. Then that gets you back...is that what you call net back. MR. VAN DYKE: To the ...that's correct. SENATOR FRANK: And that's around 10 or something. MR. VAN DYKE: Ten to twelve, in that range, yes. SENATOR FRANK: And then you take off your operating expenses and those would be considered lifting costs? Do I have the terminology right? MR. VAN DYKE: That's close enough. SENATOR FRANK: And they told us before the total of transportation and lifting is around seven in this case. Is that right? MR. VAN DYKE: If you're starting at the West Coast... SENATOR FRANK: I'd just like to understand the operating costs on a per barrel basis. MR. VAN DYKE: You can do that and get to a per barrel amount on a lease you would apply. SENATOR FRANK: And then you'd have to aggregate your capital costs and your other taxes and all those other things. I recognize that. I'd just like to look at it on a per barrel cost just so I understand it. MR. VAN DYKE: Because the capital costs just accumulate as a gross number, not a per barrel number, so... SENATOR LEMAN: That's something we could have by Saturday if not from you, from BP...have something as an example so we can... SENATOR FRANK: I'd like to see how the State views it on a per barrel cost or on a per field cost, for that matter. I don't really care. It would be helpful to have both those so we get a working knowledge of this sort of thing. MR. VAN DYKE: Mr. Chairman, we can do an example, maybe, for Endicott, because we know what the tariffs there are. SENATOR TAYLOR: On that subject, when you come with that, are we looking where we've got already capital costs accumulating at $828 million on these fields, on these leases. We would have to recover somewhere in excess of, if it was a dollar a barrel, $828 million barrels, wouldn't we, before this thing would get to a net profit. MR. VAN DYKE: Mr. Chairman, Senator, that's correct. Luckily it's a lot higher than a dollar a barrel to recover the capital investment. It's probably in the range of $4 or $5. SENATOR TAYLOR: It seems to me in the years I've been here we have, one, accumulated debt after another that we have legislation around here this year to try and streamline some of the appellate processes and the administrative hearing processes. So that we can get to a resolved and final number on disputed taxes. For net profit share you're accumulating interest in the benefit of the company at prime rate, but if the company fails to pay taxes that it owes, it begins to accumulate interest. When you get to the place where you're supposed to be net profit share... TAPE 96-50 , SIDE B and the State is to be receiving something. Why not just keep the whole thing stirred up in litigation and arguments over various hearings for another eight, ten years and when somebody comes along and wants to settle with you for fifty cents on the dollar. We never know what amount anything settles for around here. SENATOR FRANK: Yeah, sometimes we don't. MR. VAN DYKE: Mr. Chairman, Senator, I think luckily our interest rate's higher than the prime so at least delay is on our side in that way. SENATOR TAYLOR: I guess what I was getting at was are these things somewhat self enforcing... to take advantage of it, don't they have to somehow apportion the credit back as against what they would be paying. In other words you never get into a true taxing situation. You're really talking about a division of quote, "profit" and for them to get to that stage they've got to account for their costs to the extent they are willing to dispose of them so as to get the credit for it. MR. VAN DYKE: Mr. Chairman, Senator, that's true. The lessees initially have to report that cost. That reporting is subject to audit and have gone out and done audits and this year are doing quite a few more. It's a full blown audit of their costs. SENATOR TAYLOR: I'm just trying to compare net profit leases with other methods that we're currently using and the other methods haven't been all that successful. MR. VAN DYKE: Mr. Chairman, Senator, if they don't report the costs, they have to start paying the profits sooner because they have no negative balance out there. SENATOR FRANK: You know we've heard from the company that the reason they like this net profit share situation is because there's no incentive to invest as the field ages. But yet it occurs to me as you look at this balance kind of leveling off here that there's almost an incentive to invest. I mean because if you invest - I wish I got to write, you know, my investment off in the first year of expenditure. And I know they have other taxes to pay. But as regards the net profit situation, if they do invest an additional dollar, that goes into their capital account so it almost kind of looks like if they invest, they prevent the payment of ninety whatever it is, eighty nine percent taxes and so there might, I haven't figured it out, yet, but I'm wondering if there isn't some incentive to invest so that they don't have to pay taxes. I don't know how it appears on their accounting and how they report that for their books and their public accounting presentations, but that just kind of occurs to me that there might be some incentive because it looks like it would prevent them from paying tax if they invested. Now maybe visa vi paying no additional net profits tax I guess they'd be better off if they didn't have to pay that after all, but it still seems like it would be an incentive to invest. MR. VAN DYKE: Mr. Chairman, Senator, the way the system works, they don't get to save a dollar by investing a dollar. They would save less than that. Plus it's their dollar they have to invest so I don't believe they're going to spend a dollar to save a dollar in taxes. SENATOR HALFORD: I'm not sure who to ask this. It may be Ken Boyd, but the estimate of the reserves - what is the basis of the information on that. Do you have wells, there's what, four wells. There's - what's the extent of the seismic data that's currently available that defines the size. KEN BOYD: Mr. Chairman, Senator Halford, yeah, we have the wells and I don't remember exactly how many miles of seismic we have, but we have all the seismic data that's there. I don't remember the number of miles, but I can certainly find out. SENATOR HALFORD: Do you have 3-D seismic? MR. BOYD: There's no 3-D seismic. I think there's a piece of 3-D seismic on the southern end of the structure just over that southern lease and part of the plan development is to shoot a 3-D seismic program this summer - of '96. I think BP may have presented something to you about using bottom filing cables and a bit of new technology with the 3-D, but most of the structure - when I was with Marathon, we mapped the structure with 2-D seismic in the 1970's. It's not a difficult structure. It's like a little, tiny Prudhoe Bay. It's a three way dip closure with a fault on the north side. You can get the aerial extent fairly quickly. I know most companies overestimated the amount of oil early on and the problem is when you're dealing with seismic data, you're dealing in time. How long it takes a sound wave to go down and bounce back and from that you have to guess what the velocity is and guess what the thickness of the rocks are. Until you drill a well to calibrate your seismic, you don't know what that number is. I know we had it wrong at Marathon. I know Amerada Hess had it wrong, too, for that matter. But as you drill wells, you refine that velocity model and you're able to move that knowledge around the structure and you keep refining the structure and as is often the case, the structure tends to get smaller. Actually, the section tends to get thinner. SENATOR HALFORD: What I'm trying to figure...is the accuracy of the estimate of $130 million barrels of oil recovery and what the high range/low range for the economic model to just double it. The information says that doubling it is beyond any possibility. So they went to the high side of 180 million barrels. MR. BOYD: Mr. Chairman, Senator Halford, looking at it with our folks at Anchorage, we think 180 is kind of high. I think we'd really put the upper limit around 160 or 165. The doubling 260 number really looks like what all the oil in place would be and if you use a very high recovery factor and I guess 160 with maybe a 70 percent or a 65 percent is a very high world wide recovery factor. Between the wells and the refinements of the seismic and refinement of the velocity you can get pretty close. SENATOR HALFORD: What's the 3-D seismic shot this summer going to do. MR. BOYD: The 3-D seismic, I hope, will further refine the structure, but the real purpose in my view of 3-D seismic is to help you not drill stupid wells. In a reservoir that's even somewhat structurally complex it really is the fault pattern, how the fault patterns work. With 2-D seismic you're always constrained to be shooting, how can I say this....In 2-D seismic it's like each one of these blinds - pieces here - is a seismic line. And you're constrained to just look at this piece in that line. With 3-D seismic you have a whole series of points on this. You can imagine this thing covered with graph paper with a whole bunch of intersections of points. I can create a seismic line to go this way and that way. If there's a fault that's going this way, I can create a line to go across it and get a much better idea what the reservoir looks like. I think it not only helps determine the size of the reservoir, but it helps determine where the fault patterns are and you understand you don't drill on the wrong side of the fault. You just don't drill stupid wells. I think the 3-D will help the velocity model, also. It will help you to figure out what the velocity structure is of the earth and from that velocity depth times time you can get the depth. You can get the depth once you know the velocity field and the 3-D will help you get to the velocity field and you will refine this picture whether it goes down 230 or up 265, I expect it to be in that range. I hope I've answered your question. SENATOR HALFORD: It just seems from the model there's a huge difference in what the State's change is from the supplemental royalty versus a net profit share. If it does go to 180 million barrels, then the difference to the State on the supplemental royalty vs. the net profit share is almost 300 million '96 dollars. So it would seem that the size of the field may be a bigger variable in the difference in return to the State than the oil price. MR. BOYD: Mr. Chairman, Senator Halford, I think at least a fair amount of that uncertainty has to do with how much...It's not with the oil in place; it's how much of that oil ultimately gets recovered. If there's a real high quality oil recovery project somewhere at Northstar somewhere down the road, maybe we'll get closer to the 180, but that's going to take some additional wells and quite a bit more additional capital which will also affect the net profit share payment. SENATOR HALFORD: Did the model take that into account - when the model went to 180 million barrels in place. MR. BOYD: We'll have to ask Kevin when he comes out. KEVIN BANKS: For the record, Mr. Chairman, my name is Kevin Banks. I'm the Petroleum Economist at the Division of Oil and Gas at DNR. I think I'll begin by answering Senator Halford's question. The assumption that I made in the particular run of this model with the 180 million barrel recoverable oil assumed essentially that that would be acquire for free. I made an estimate that an additional $28 million in capital expenses would be made in the first few years of the development of the field to drill new wells only and that would then lead to an additional 50 million barrels of oil. I have to say that in BP's representation of their high side estimates which are currently in their proposal 160 million barrels...I think they estimate that will cost them for the additional 30 million barrels...another $91 million. That additional $91 million of capital expenditures has to do not with simply drilling more wells, but for the cost of additional gas recycling. Tertiary recovery of the field. And even that number doesn't include the fact that in order to do that gas recycling prospect it may require the purchase of gas from somewhere else on the North Slope. There's not enough gas in the structure at Northstar to pump the oil out of the ground at those kinds of recovery rates. And as Mr. Boyd stated it was a recovery rate in the order of 65 - 70 percent to reach that which would be indeed an abnormal situation for most oil fields in the world. So the interaction there, if you assume that there's simply more oil there, yes, you do get a fairly large and dramatic change in the net profit share that would come to the State, but it doesn't come for free. If anything I probably underestimated what that cost would be. SENATOR HALFORD: A 180 million barrel model shows the 300 million difference in net value to the State in 1996 dollars. MR. BANKS: That's right. SENATOR HALFORD: You didn't use any increased investment or you used what number for increase investment. MR. BANKS: I only assumed that that would be achieved with another $28 million in investment. SENATOR HALFORD: You assumed $28 million. BP's assumptions are $91 million. MR. BANKS: That's correct. Something on that order. SENATOR HALFORD: If you plug $91 million into your model, what does it do to the $300 million loss. MR. BANKS: I don't know the answer to that. Obviously, I would be able to take care of that for you. Obviously, the number would go down. I think the point, tho, is you've made the salient observation that if there is an upside, because you're at the cusp of what the development account and the net profit share will pay out, that the upside does come to the State. All 90 percent of the upside comes to the State once it starts paying. So, yes, the State revenues under the NPSL in a high side case, depending on investments, will be considerably higher. SENATOR HALFORD: I guess to ask somebody else in the negotiation if a variable were considered instead of oil price production level as the kicker for the supplemental royalty. That's not your.... MR. BANKS: Mr. Chairman, I'd like to, I realize the hour is late, so I would like to go through this fairly quickly. Today, as you see, in your packet here I have a ...I'd like to discuss the assumptions in the Northstar model. I think that's of considerable interest to people. I've also included just for the sake of explanation a very simply discounted cash flow model and suppose if we would like to call the base case model that BP uses the most likely case, this would certainly be the most unlikely case of an oil field on the North Slope. But I think it illustrates in the most simple way just what a discounted cash flow model has to do. And if there is time, go into some detail on the spreadsheet itself. What we've been referring to as a model is simply an excel spreadsheet and I'll walk you through those several pages in as much detail as you care to. If there's time, I would like to discuss the Monte Carlo features of the model, a way of dealing with risk and the statistical treatment of the possible outcomes that we've been trying to capture in our discussion today. CHAIRMAN LEMAN: If I can just interrupt. That'll keep Senator Taylor awake. He thinks Monte Carlo analysis are similar to video gaming. MR. BANKS: I have some interesting anecdotes to tell you about it. I have to admit that I used to teach economics at 8:00 in the morning and I hope I have better luck at 9:00 at night. First of all, the assumptions in the model. This is what I would have to call an illustrative Northstar model. There are subtle differences made in this model than the one the spreadsheet that was used to produce the results we have been sharing with you so far. As you can see, on these two pages there's a couple of places where we have in bold type indicated assumptions that appear in this spreadsheet that we calculated, or assumed, and they are different than what we have from BP in the model on which we based the discussions and the results we have been providing to you. Now that may be the subject for an executive session, perhaps, if you wish to know what their numbers were. We have come to an agreement with BP to share what you have here and I think it's been my experience that you have here more information than most people are ever given. Usually when talking about a prospect, they'll talk about reserves, perhaps, but they won't get into production rates or they'll talk about inflation rates, but not mention anything about oil forecasts and that sort of thing. CHAIRMAN LEMAN: BP has requested a view that you not use those numbers as part of this public discussion tonight. MR. BANKS: That is correct. CHAIRMAN LEMAN: Before you start, let me interrupt there. BP has requested of you that you not use those numbers as part of this public discussion tonight. MR. BANKS: That is correct. CHAIRMAN LEMAN: Okay, just so committee members know that I sent a letter, and you've probably got copies of it, to both BP and to DNR saying that our procedure in this committee as we have to follow the law for public meetings is that if BP requested that any information be confidential, DNR would review that and would have to concur, and then we, as a committee, would decide if we wanted to go into an executive session to view it. And we would have to vote as a committee on, and if we voted to do it, then we could go into executive session and follow the procedures for that. So far, I have not received such a request directly to the committee, although it has been intimated that such a request would come on certain information, but I have not received any specific request. I'm aware that you've had those discussions. Okay, please proceed. MR. BANKS: Just very quickly, and you can read along with me, but the production life or the project life is presumed to produce oil from late in the fourth quarter of 1998 and produce through 2012. Fifteen wells are producers -- that's a number that we need to use in order to calculate the ELF in the spread sheet. Other wells are drilled as injectors and service wells. We look to the mean or the base number in each one of these categories to develop the most likely case reserves of 130,000,000 barrels with peak production rate achieved very early on in 1999 of approximately 50,000 barrels a day, and then staying at a peak rate for a couple of years and then beginning to decline after that. Facility costs -- these would represent full-cycle facility costs including the appraisal costs that are currently being spent by BP for the development, engineering and the seismic that is underway this year. These numbers by the way, come from the proposal that BP has distributed among members of the Legislature and represent the same numbers that we were using all along in the discussions about the supplemental royalty versus NPSL question. Initial abandonment cost I put here at an estimate provided to us by Mr. Bill Van Dyke. BPXA has 98 percent of the working interest of the oil field. Murphy owns a 10 percent share of the one of the tracts in the federal lease -- I believe that's correct -- which gives them overall approximately two percent share of the oil field. And it would be my presumption that Murphy will participate in the costs and what have you in developing the field, simply write the checks and then take home the revenues as it comes their way. I think their relationship to BP is to let BP operate the field. Their position is such a minority position that I don't think the economics of Murphy are terribly important in how this works. On the following page we talk about the tract allocation between the state and the federal government. Approximately 23 percent of the oil is presumed to underlie the federal tracts -- there's more details about that in the model. State royalty rate: 20 percent. As proposed, supplemental royalty is the sliding scale that triggers at $17.35 and caps at 7.5 percent. Federal royalty rate is 16.67 and there is sliding scale feature to it, although that was set in 1979 as an inflation adjusted number. My preliminary calculation is -- I think it was something in the order of $14 in 1979. The wellhead price would have to be in excess of $28 or $30 now in order for that sliding scale to trigger at all, so, basically, we never tried to model the sliding scale royalty in this spread sheet. Net profit share, again, is 89 percent. You certainly have heard before. That represents the weighted average of the profit shares weighted by the amount of oil allocated to each tract. The development account balance is $262,000,000 -- that's a bit off of the number that Bill Van Dyke shared with you at $259,000,000, but I think it's pretty good that we got it that close. This number has been used all along in our estimate of the development account. Severance tax, calculated just according to law, 12.25 percent for the first five year of production and 15 percent thereafter. The ELF -- obviously, these numbers are subject to ELF -- the ELF is at its highest at about 0.7 percent in the first year of full production and it goes down after that. So, at best, the field won't pay much more than 9 percent or so. CHAIRMAN LEMAN: Time to break. Senator Halford. SENATOR HALFORD: One of the questions I had asked before was how the ELF applied to the severance tax. You're saying the effective severance tax is never going to get above 9 percent? MR. BANKS: Well, I think that's off the top of my head, Senator Halford. The 0.7 ELF factor would be applied in the years where you're still at a 12.25 percent severance tax rate. CHAIRMAN LEMAN: It's 8.6, and do you remember how fast it drops? MR. BANKS: I'll just look at the model, I'm turning to page 4. In the middle of that box on page 4, you see Tax($m, mod), and that's where the production taxes are calculated. The oil ELF is the second row of that part of it, and you see in 1999 the ELF is 0.71, and then it falls 0.6, 0.58, 0.43, the year 2003 it is 0.27. SENATOR HALFORD: So by the time you get to 2005, the severance tax is gone totally? MR. BANKS: That is correct. It's largely because the production rates by then have fallen considerably. SENATOR HALFORD: So there will be zero rate of return on severance tax from 2005 on. MR. BANKS: That is correct, Senator Halford. Without belaboring it, the state income tax rate -- the number that we had available to us was BP's actual number, however, in the spread sheet a 2 percent number is assumed. That is a number that I know that DOR has used in their feasibility modeling, and that's the one we used here. CHAIRMAN LEMAN: Senator Frank. SENATOR FRANK: So, for income tax purposes, you use a different methodology to establish profit than you do for net profits leasing, and the income tax is deductible as to the net profit share calculation. MR. BANKS: I don't believe so. I think the net profit share calculation is before income tax. And, in fact, if I may digress, Mr. Chairman, the question about federal income tax. One of the advantages of the net profit share system is that when the net profit share begins to be paid, it's written off of the federal income tax, so, in a sense, the federal government is contributing to the state's take in net profit share. SENATOR HALFORD: The models that we'll get later on production show that as the state's take goes down by the adjustments, the federal take goes up. The federal government is the beneficiary of the adjustment proposed in the bill. MR. BANKS: On the margin they get 35 cents on the dollar as we remove the net profit share. That is correct, Mr. Chairman. CHAIRMAN LEMAN: We need to go to Congress and get a little tax code adjustment. SENATOR TAYLOR: The last time we went to Congress we lost from 90/10 down to 50/50. SENATOR HALFORD: Well, it just look like the federal government gets over $100,000,000 out of the change. CHAIRMAN LEMAN: Yeah, we could spend it more wisely. MR. BANKS: We used the Department of Revenue's oil price forecast and also their forecast for tanker transportation, marine transportation and TAPS tariff, and we used their inflation rates as indicated here. The real prime rate as I picked out of the newspaper on Monday is 8.25, and that's the number we used in the illustrative model here. CHAIRMAN LEMAN: All of the way through the model? MR. BANKS: This is the prime rate that would be used to calculate the net profit share development account. That's where this number is applied. CHAIRMAN LEMAN: I know, but did you use that rate throughout the model for all years. MR. BANKS: Yes, Sir. CHAIRMAN LEMAN: Is that a reasonable assumption, in your opinion? MR. BANKS: Yes, Sir. I think so. I think a fixed prime interest rate is certainly -- I mean, obviously a model is some sort of simplification of reality, and, at this, you might say that it isn't simple enough. But the model is really intended to kind of watch what your assumptions are doing. SENATOR HALFORD: Well, I was going to go back to the state oil and gas corporate income tax rate. Is it 2 percent. MR. BANKS: The income tax rate is actually 9.4 percent. That is the state statutory marginal tax rate, but because of the proportional tax mechanism that oil companies are permitted to use in this state, the average effective tax rate is 2 percent according to DOR. SENATOR FRANK: Two percent of what? MR. BANKS: It is calculated in the same way that federal income taxes are, so it's 2 percent of the net income, after depreciation and costs and expenses. CHAIRMAN LEMAN: Further questions for right now? Please continue. SENATOR FRANK: So on that, in the case of net profits, you get to put all these capital costs in there, but then when you're calculating the income tax, you use a federal income tax depreciation schedule, or may it's a depletion. Do they have a depletion any more? MR. BANKS: No, I don't believe so, Mr. Chairman. SENATOR FRANK: Oil depletion allowance thing is no longer ... MR. BANKS: That is no longer, it's my understanding. Lastly, I'd like to point out what is read as nominal discount rate, that should be in bold type. We, in fact, used a 10 percent nominal rate based on the Arthur D. Little study and other sources of information that frequently a 10 percent number is used as a discount rate. That's to calculate the present worth of the prospect. CHAIRMAN LEMAN: Just so I understand -- the numbers then that are not public information right now are the three that are in bold, plus the 10 percent, the nominal discount rate. Those four variables are -- you put in dummy numbers to create this model. MR. BANKS: That is correct. SENATOR TAYLOR: Well, I figured that when I saw the Anchorage Daily News was cited as authority. CHAIRMAN LEMAN: Did that with a dummy number? They were just publishing somebody else's number. SENATOR TAYLOR: That doesn't mean they'll get it right. SENATOR FRANK: Now how do you [indisc.] nominal discount rate in the model, what purpose does it serve. MR. BANKS: The discount rate is used in the calculation of present value and particularly [indisc. - microphones being interrupted] you get a cash flow of say state revenues from net profit shares. If you want to know what the present worth of those are, this is the number that we use ... CHAIRMAN LEMAN: Go ahead. MR. BANKS: I can go through this simple discounted cash flow model, but I don't wish to belabor it. If you want to go right into the model, I'll be happy to do that. The point here is only that there is sort of the sublime and then maybe the ridiculous in terms of how complicated you can get about modeling the future. Recognizing that even as complicated as you can be, chances are you're not going to be right anyway. You can be precisely wrong, I suppose would be the outcome of 10 pages of calculations. But, basically, what a discounted cash flow model is attempting to do is show what kind of cash goes to the state, to the federal government, to the operator, and then what value does that have, or what kind of profit does that create for the operator. For each year, it's a simple matter of calculating revenues and deducting royalties and costs and other taxes in order to establish what that cash flow number is. SENATOR FRANK: For purposes of comparison, I could get easily confused on the effects of the discount rate -- I know that's always a big discussion point -- what is the appropriate discount rate. But it would seem in this case like you might take some confusion out of it if you assumed a discount rate that was equal to your prime rate on your capital account. Why would you use a different rate? MR. BANKS: I think I can answer that in a couple of ways. The purpose of a discount rate -- and I would agree that any number is probably as good as another -- but the main point is that it presumes that it handles the concept of the time value of money. That someone would rather have money than wait to get it later. It also presumes that you can take funds that you're accumulating each year and invest them in some way for some kind of return elsewhere. In fact, if you don't invest it -- if you just put in a pillow somewhere or under you mattress -- it would be incorrect to apply any kind of discount rate to a stream of cash flows. So, I believe that the -- for example, for the state of Alaska, the permanent fund I think in their annual report shows a number like 10.6 percent, or something like that, as the rate of return that we've earned over the average 17 years or so of the permanent fund, so it's a number. I may also respond -- you might have touched on an area about net profit shares that I think is an issue. We may get into it later, but where the prime rate or the rate that is applied to the development account differs from the operator's hurdle rate, then some distortions occur in the investment strategy or incentives for the operator. Mr. Chairman, I'm prepared to plow ahead with the model itself. SENATOR LEMAN: Please, please do. MR. BANKS: Basically, the model is divided into three parts, perhaps, like Ceasar's Gaul. We have a place in the model where we can adjust some of the assumptions. That's the several little boxes at the top. A couple of these boxes are intended as switches to turn off and on the net profit shares. We can... TAPE 96-51, SIDE A MR. BANKS: and as you can see in the very bottom, the supplemental royalty rate calculations are illustrated. You see the trigger price, as inflated through time, starting at $17.35, inflated at half the rate of inflation. By 2011, the last year of production, the trigger price rises to about $21.99. For each dollar increase in the price above the trigger price, an additional one and one- half percent in the supplemental royalty rate is paid, and that is not a step function: that's a linear function, so it rises smoothly. So 50 cents will get you 75 percent - .75 percent increase in the supplemental royalty and so on. Of course, as we've said the cap is at 7.5 percent for a total royalty take of 27.5 percent. CHAIRMAN LEMAN: That was the agreement - I didn't see that in the agreement, or at least it wasn't that obvious to me when I read it, but it's your understanding that it's a linear function, not a step function? MR. BANKS: Yes, sir. The calculation is as it is. CHAIRMAN LEMAN: That's your understanding Eric? MR. BANKS: In some of the boxes in the top - in the one in the top left, are some of the main assumptions you should recognize that the prime interest rate, 8 1/4, the real discount rate plus the inflation rate gets you a nominal discount rate of 10 percent: seven plus three here. I'm sorry - I'm still on the first page, here in the box up on the top left. You'll note that we've estimated a state income tax rate of two percent. Because of the way the model calculates federal income tax, that reduces the federal income tax to an effective rate of 34.3 percent in the model. That's why that is not a 35 percent number. CHAIRMAN LEMAN: It's 35 percent minus 2 percent ... MR. BANKS: Correct. CHAIRMAN LEMAN: ... of the 35 percent? MR. BANKS: That is correct, sir. I might also add that perhaps if we go ahead to page 6, the model was very organic. We've gone through several versions and things were added as our need - basically through discussions with us about what the state felt like we needed to be able to see and make sure that we were correctly assessing what was going on. In the middle box on the top in the front page is the state royalty and net profit share calculations, and then on page 6 is the tract allocation calculations. I just wish to point out that's how we get to a 89 percent average - 89.39 percent average net profit share. Incidentally, you'll see in here a row of pound signs. That's a fluke of printing out this model, just for your benefit. It's simply 100 percent is in one number. The number was too big to fit in the cell so that the Excel software reproduces a row of pound signs. On the right it's 16 3/4 percent which represents the effective state royalty on - out of all of the production on the Northstar unit, including the 27 percent, take that we get from the federal government. CHAIRMAN LEMAN: So that number is 16 3/4? MR. BANKS: 16.34. CHAIRMAN LEMAN: The top one? Then the other one, I assume, is 23.2? Is that correct? MR. BANKS: We're looking on page 6, Mr. Chairman? CHAIRMAN LEMAN: Yes. MR. BANKS: There's a row of pound signs on the - no, it's 100 percent, it's the sum of that entire column. And the 16.34, that's the percent of 130 million barrels that belongs to the state in royalties. Page 2 of the model includes ... SENATOR FRANK: Did you get down into this [indis.]? MR. BANKS: I could if you like, sir. SENATOR FRANK: I'm kind of on that same theme as before with the per barrel analysis and I guess - is that what you have here? You go down to 1998, when apparently production begins somewhere in there, you have five producing wells, you have a pump station number one net back oil price? MR. BANKS: Yes sir. SENATOR FRANK: How does that net back oil price differ from what we think of as West Coast market? MR. BANKS: Well, the calculation works this way, Mr. Chairman: $13.99 - I hope it is... SENATOR FRANK: The year 1999? MR. BANKS: I'm looking at 1999. The pump station one oil price, $13.99, is equivalent to the West Coast ANS price, and in fact appears on the following page, minus marine costs and the TAPS tariff. SENATOR FRANK: So, those others are just there for informational purposes? MR. BANKS: Here again, it's the way the ... SENATOR FRANK: You showed them there? MR. BANKS: That's right, and that's the way the model sort of backs into and backs out of a West Coast price, rather than list them independently. SENATOR FRANK: I thought that's what net back was but I wasn't sure. So then, from that net back of $13.99 you'd have to subtract your lifting costs and that was like $1.50? And then all of your taxes? MR. BANKS: That's correct sir. SENATOR FRANK: And it would be applicable? MR. BANKS: That's correct sir. SENATOR FRANK: And then you'd start with your severance? And that was like nine percent maybe? MR. BANKS: I believe it's something like that? SENATOR FRANK: And then 20 percent royalty? MR. BANKS: Yes sir. SENATOR FRANK: 20 percent of the $13.99? MR. BANKS: It would be of the $13.99. SENATOR FRANK: Okay, so they don't get to deduct their operating or their lifting costs first, before they do royalty? MR. BANKS: No, royalties are paid at the meter. The oil is ready for sale presumably. SENATOR FRANK: And it's the same with severance? MR. BANKS: That is correct, sir. There may be some deductions allowed, but I'm not a DOR economist. SENATOR FRANK: And then you have, let's see, severance, royalty, lifting, what else? MR. BANKS: There are other minor production taxes - spill and conservation taxes, and then we have to back into a per barrel estimate of their income tax and their property tax. SENATOR FRANK: Income tax - now are you talking state or federal? MR. BANKS: Both. SENATOR FRANK: Okay, state, fed, and property. MR. BANKS: Excuse me Mr. Chairman, I may have mis-spoke. We're trying to get after the development contribution here? SENATOR FRANK: I guess so. MR. BANKS: We can look at the state take, the fed take, out of that $13 or $14. If you're trying to get after what would be an allowable ... SENATOR FRANK: What's going into that capital account or what's coming out of it or what's reducing the capital account. MR. BANKS: Then the income tax would not be calculated in there. SENATOR FRANK: What about the processing costs, where they bring the oil up and they have to separate out the water and all that processing, or whatever they call that? MR. BANKS: We call them "field costs" but they do not apply to these leases. That was a characteristic of the newer leases post ... SENATOR FRANK: Because they didn't have those types of costs back then or you didn't think about it, or what? MR. BANKS: Well - I don't know. I'm sure the history of field costs is pretty long and serious. I know the leases that were in Prudhoe Bay - well there was a dispute between the industry and the state about allowable field cost charges. The leases here, I think, made it clear there would be no charge whatsoever against royalties. SENATOR FRANK: Or severance? MR. BANKS: I can't answer the question about severance - I just don't know. That is a regulatory issue, not a lease - a contract issue. We haven't calculated any field costs against severance tax for the purposes of modelling. If it reflects reality, perhaps the answer is: do you have any field costs [indisc.]. SENATOR FRANK: I guess I was trying to look at a - well, the way I would term it, kind of a contribution to profit and overhead and capital recovery, or something like that. MR. BANKS: On page 2, the three boxes on the top: box #1 is a set of assumptions about the Monte Carlo, and for the moment I'll leave that to say that you can see that we have an ML for "Most Likely" and a min/max number of 105 to 160 million barrels for most likely the reserves of 130, and capital expenditures, for drilling and facilities pipeline and lifting costs or operating costs per barrel, are also adjusted by a similar range of values. CHAIRMAN LEMAN: What's the fourth column? The Monte. MR. BANKS: That would be a predicted number and, in fact, when the model is running in Monte Carlo, these numbers, with each trial, change. Then finally, at the end, a distribution of numbers for each of these will be produced. We'll get into that a little bit more later. CHAIRMAN LEMAN: Okay, but then I see that those numbers are a little bit different from the most likely. MR. BANKS: It's the last trial that was done when the Monte Carlo was run here. It is just a ... CHAIRMAN LEMAN: Okay, that's just - the significance of this is the last trial that you ran, whatever it was. MR. BANKS: After 200 or 198 trials that was what where it ended up. CHAIRMAN LEMAN: What's the significance of this reference way over to the right - "Do not touch"? MR. BANKS: What we've done in calculating the supplemental royalty, two things had to be done: we needed to know what we were going to be paid, a supplemental royalty, on a monthly basis, so what we did was predict oil prices on a monthly basis, basically taking the predicted number from the Department of Revenue, assigning that as the average price, and then backing out, or interpolating the January through December prices that would lead you to that average. So that's what - as you can see here - ANS and West Coast oil price is a bunch of prices for each year, for each month. That little box in the right just keeps us from falling off the edge of the Earth in the end. The calculation without that number would give us a result in the last column that would be incorrect. It actually, as you can see in the last six months of 2025, the number is $42.67. That's the price of oil in the West Coast, assuming that the nominal growth of oil prices, according to - or extrapolating from the Department of Revenue - that's where we get. You'll notice the last six months of the year are also $42.67. If I had indicated maybe like $43 there you would see those last six months rising up to, and hitting, the $43. It's just the way the equations are worked out. It's interpolating for each month, assuming that the $42.67 is the price you have in June, the middle of the year. If you change it, we'll get a bunch of zeros at that end of the spread sheet and everything goes haywire. CHAIRMAN LEMAN: About how much more time do you think you'd want to spend on this? I'm not trying to rush you, I'm just trying to ... MR. BANKS: I hope to go as quickly as I can. I mean, I want to be responsive and be pretty - if I'm getting into too much detail, please ... CHAIRMAN LEMAN: No, and you're going into a lot of detail but I'm just trying to figure out how much more time you think we'd - we've got a babysitter challenge here and ... MR. BANKS: Let's try 15 minutes? CHAIRMAN LEMAN : Okay. That'll be fine. I'd like to wrap it up by 10:00. MR. BANKS: So would I! CHAIRMAN LEMAN: You didn't have to go through session on the floor. MR. BANKS: No, I got the easy job. The second set of prices here in the shaded area, these are all predicted prices. As we get into discussing Monte Carlo and what BP I think referred to as "price volatility" in some of their tables - that's what's going on here. We're presuming that the price, each month, varies around the average price indicated in the table above. In the shaded area, as the model runs these numbers, click and tick and change up and down, above or below what the average predicted value was in each of the months above. From that, an average annual supplemental royalty is calculated and that is in the last part of that table on this page. CHAIRMAN LEMAN: We're just asking for you to - just as you're moving on. In my letter to BP I asked the question about what the expected tariff would be. I said is this a common carrier pipeline. They said yes, it would be, I think they said 50 cents to $1.00 just estimated right now. It may have been a quarter to a dollar - whatever it was - per barrel. Did you account for that in this model - the tariff cost from Northstar to pump station one? MR. BANKS: What we did is we included the construction of the pipeline as part of the capital expense and so, in a sense, it's accounted for in the model insofar as BP's paying for that to get their oil to pump station one. It presumes that the tariff would be calculated in similar ways as the treatment of capital expenditures for the pipeline. SENATOR HALFORD: If the tariff base includes capitalizing all the costs of building it, is there a capital component in the tariff that comes out of the transport of the oil through it? MR. BANKS: Well my familiarity with the calculation of pipeline and common carrier tariffs is that there's some kind of gross up of the capital expenditures in certain allowable depreciations. SENATOR HALFORD: What the point is, is the direct offset from the state's share in the net profits equation for all the costs that are capitalized up front. If the pipeline, the gathering pipeline, is capitalized up front, it is already totally taken out of the picture in terms of a capital base for return of capital component of the tariff, I would hope. MR. BANKS: On the other hand, or in addition to that Mr. Chairman, Senator Halford, we might say you have this $28 million for the pipeline construction, and then this 8 1/4 prime rate that's accumulating that number, so it - I presume the APUC would calculate a tariff differently than this but I think we're accommodating that, at least in the calculation in the net profit share, and certainly in calculating the impact on BP's economics in the other cases that we ran. SENATOR HALFORD: I'm probably asking the wrong person, but the right person is probably back there who can answer it later, and that's, I'd like to have a list of all the things that have been, over time, excepted as components of the capital account for the net profit share and a list of all the things that have been denied as components of the net profit share - I mean of the capital account for calculation of the net profit share, because that's a significant question in terms of how the existing system goes forward that you're comparing it to. I assume Ken Boyd, or somebody - maybe it's the Department of Revenue that has to figure that out. CHAIRMAN LEMAN: I think we're on page 3 now, right? MR. BANKS: Yes, we'll turn to page 3. In this part of the model is the results, basically. I've shared with the committee printouts or tables that show what the real state royalty, supplemental royalty, the net profit share, the value of the income tax - all of these are calculated on this page, both in money of the day or nominal dollars, accounting for inflation, and then the larger box shows what happens when you keep numbers in 1996 dollars. There's a section in here where all of those values are discounted by that nominal ten percent discount rate. This is basically the results table from which those printouts, that I've shared with you already, have come from. Page 4 of the model - it kinds of gets back to my very most simple spreadsheet. This is where most of the calculations are being done. You're basically taking the gross oil, deducting royalties, calculating net barrels and then multiplying that by price to get the working interest revenues and the deductions for various state production taxes, capital expenditures, and operating expenditures. Of course there's gruesome details in each one of those categories. I might add that although there is production allowed for gas, gas was regarded as a fairly small factor in terms of what impact that has on revenues so it just simply was not included, it was not predicted. Page 5 is the calculation of net profit share and particularly the revenue and development accounts and this follows quite the same way as the description that Mr. Bill Van Dyke provided to you earlier. Abandonment costs, I may add, Mr. Chairman, are charged just as an operating cost would be against revenues and so, hence, deducted from the development account, by regulation. Then to page 6 - that's tract allocation. Page 7 is calculation of BP's economics, if you will. They're before tax and after tax cash flows plus a few rows for how they calculate abandonment rates and depletion rates, page 7. Some of these numbers come from the very back of the spreadsheet, are of more importance to BP in the assessment of the accounting impact of the development. My focus was pretty much on the economic benefits and costs of the project for each of the participants, the state, BP and the feds. SENATOR FRANK; What page is that? MR. BANKS: Page 7. SENATOR HALFORD: Okay, the percentage shares are in the income tax box - no - what's the total net share, state, federal, and company? Where do I find that in this page? MR. BANKS: I'm not exactly sure of your question of shares. SENATOR TAYLOR: [Indisc.] be the income tax? SENATOR HALFORD: Well, total return. SENATOR TAYLOR: That'd be part of it, I assume. SENATOR HALFORD: I see the income tax category. SENATOR TAYLOR: The state gets 26 cents, the feds get $4.43. MR. BANKS: Actually, to be precise, the feds are paying, in a sense $4.43, because that's a liability against taxes owed elsewhere and so it counts as a... SENATOR HALFORD; That's in '96 you mean? MR. BANKS: That's right. SENATOR HALFORD: But as soon as you come over to production... SENATOR TAYLOR: As soon as you get into '98 it goes up - actually '99. MR. BANKS: My point is that this page sort of illustrates the perspective that the operator has about this prospect. We've looked at several other - earlier on there was a display of revenues to each of the state, feds, and BP. A lot of those numbers originate from this page here for BP's income tax and funds flow. SENATOR TAYLOR: Is there a way to answer, off this page, Senator Halford's question? MR. BANKS: What share between each of the ... SENATOR HALFORD: One of the questions that used to be kind of a guideline in a lot of the development decisions that were made in these years in the combination of income taxes, severance taxes, royalties and so forth, was that the state share be approximately equal to the federal share and to the industry share. I guess we don't really have that in this calculation. MR. BANKS: I think you can look to page 3 again to see how that breaks down. In the top half of this page are inflated dollars, the total state take in this example is $555 million, way over there on the right. The feds get $328, and the funds flow number is the cash flow to BP - is $479 million, $480 million. SENATOR FRANK: What do you mean by "funds flow?" MR. BANKS: That's there expression for the positive cash flow. SENATOR HALFORD: Is there something of real dollars of that same equation. MR. BANKS: Yes, just down below, if we step down, the same break-out, except that I've inserted some rows here that get you net present value numbers. I'll just point out to the state, total real is $438, to the feds it's $260.9, and funds flow for BP $352. SENATOR FRANK: That means for - these are back in real dollars, okay. That's 1996 dollars? MR. BANKS: Yes sir. SENATOR FRANK: The BP number includes - that's after you capture your capital plus interest plus the discount rate, or how does that figure? MR. BANKS: The $352 is the revenues over expenses, costs, taxes, everything else. It's the money they get to keep. SENATOR HALFORD: How does that treat the development account that's existing now. MR. BANKS: The development account is assumed to evaporate. There is no calculation in the model that activates it. SENATOR FRANK: So that's over and above the ... SENATOR HALFORD: [Indisc.] doesn't account unless the net profit [indisc.]. MR. BANKS: In fact there's a switch in the model that says if net profit shares are on, then calculate net profit shares and so you can see there's a row for net profit shares. I hope it's zero. In this particular printout it's the supplemental royalty that's off. We're actually calculating net profit shares in this example rather than supplemental royalties so that if I were to switch it the other way around ... SENATOR FRANK: So then in this case, then, it does have the capital account. SENATOR HALFORD: So this is existing ... MR. BANKS: That would be the existing page ... SENATOR HALFORD: Page 3 of 10 is existing ... MR. BANKS: The whole model is existing. This particular spreadsheet illustrates ... SENATOR HALFORD: But what we need is the comparison of this to the proposal, but then if this is the model, then the - for example the industry's return includes the credit for the $260 plus million in the capital account. MR. BANKS: Yes sir, that's correct. SENATOR HALFORD: Any discount in the purchase price of that capital account would be a dollar for dollar increase in this bottom line number. MR. BANKS: I'm not sure, it could ... SENATOR HALFORD: Well if you had a capital account of $200 million and you bought it for $10, you'd gain $190 - would you not? And I realize this is not the proposal, this is the status quo. MR. BANKS: That's right. That is I think the way the model treats the development account although I believe in regulation, at least acquisitions, are probably not an allowable cost - an allowable charge to the development account. SENATOR HALFORD: Well but the development account - I mean the lease - all the expenses on the lease go with the lease: the development account goes with the lease. MR. BANKS: Yes sir, that is correct. SENATOR HALFORD: So all previous expenditures carry forward as basically a prepaid credit on net profit share. MR. BANKS: That is correct sir. CHAIRMAN LEMAN: Mr. Luttrell did you want to enlighten us? Could you come up here where we can pick you up on the microphone? MR. ERIC LUTTRELL, BP: [Indisc.] something about the development account because the development account is totally independent of the financials of BP. It is simply an account which exists over on the side over here which allows the state and BP to understand whether or not [indisc.] net profit share is in play or not in play but the $260 million that we acquired is simply to be on that piece of paper. It has no affect on our financials at all. The $325 million you see on that piece of paper doesn't pay any attention to that at all, it only depends on the money that BP has actually spent, so we get no credit in our financials, where on this spreadsheet for $260 million, whatsoever. SENATOR TAYLOR: That's why when you first answered you said it just disappeared. MR. LUTTRELL: That's not what he said... CHAIRMAN LEMAN: But the agreement has disappeared... SENATOR HALFORD: Because your proposal doesn't - I mean this is existing law which is totally changed under your proposal, right? MR. LUTTRELL: But the economics reported in the model reflect the existing law. SENATOR HALFORD: If existing law were to stay, you would get the credit for ... MR. LUTTRELL: We'd get it only on this development account balance and not on our financials. It has no affect on our financials whatsoever, it is simply another account system that sits out there for the sole purpose of calculating if we ever get to net profits in a {indisc.]. SENATOR HALFORD: For our calculation it is treated as a prepaid credit that we should deduct out before we evaluate the combined total of the one proposal versus the other because that would be a credit that you could take if you left the existing lease program in place, you have a prepaid credit, essentially, of $260 million, to which you would add all of your development costs, and that would all have to get paid back before there were a net profit share. MR. LUTTRELL: In the development account itself, yes. In the separate financial account [indisc.]. so the $325 you see on this page is our what we are [indisc.] ... SENATOR HALFORD: And you wouldn't get credit for it for federal income tax purposes, they'd give you whatever you paid and that's your cost basis but because of the way the net profit share carries with the lease, it would apply under the old net profits calculation. MR. LUTTRELL: In the development account itself, in no other calculation. SENATOR TAYLOR: But what you keep saying is this entire model is all based upon existing law. MR. BANKS: Forgive me, I think I would have rather brought in a model that would have showed what the supplemental royalty would pay but I forgot to turn the switch off at the outset before printing it out and so we're calculating the status quo in this particular printout. SENATOR TAYLOR: That's very helpful, I appreciate knowing that. We need the second printout now to lay along side of it so we can make a comparison. MR. BANKS: That will be fine. CHAIRMAN LEMAN: Just remember this is illustrative. SENATOR FRANK: But if it's the same figures it would give you a pretty good feel for... SENATOR HALFORD: But the comparison is - what is the important thing? MR. BANKS: I have no problem at all in doing that. CHAIRMAN LEMAN: Did you bring the model with you? Do you have it on disk? MR. BANKS: I haven't got it with me. SENATOR FRANK: On that net profits lease, in this scenario, then where do we see that being paid? MR. BANKS: On page 3, it's start paying, if you look, say for example, I'm down on the box where real numbers are. The row of net profit share - NPSL - you see the first year it starts to pay is in 2008. SENATOR FRANK: So that's the year in which all of the capital account has been brought down to zero. MR. BANKS: That is correct sir. SENATOR FRANK: And does that include - so that would mean that $260 million or $260 million with interest has been paid to zero plus the $350 million in development costs has been recovered? MR. BANKS: Yes sir. CHAIRMAN LEMAN: Taxes have been paid, and operating costs, and all of those things. SENATOR FRANK: This doesn't have the balance on it. MR. BANKS: I can point out the balance - the calculation of how the net profit share works appears on page 7 for the development account - excuse me page 5. And you can see that in the development account closing balance in 2008 is $2.3 million but the revenue account is $47 million. So it shows a $2.3 NPSL payment there, or $2.0. SENATOR HALFORD: This model doesn't show any expenditures from 2001 and 2007 under the capital expenditure column of the development account, right? MR. BANKS: That is correct sir. SENATOR HALFORD: Is that realistic? MR. BANKS: It assumes that there will be no tertiary recovery in the future and since this is a stand alone prospect with all of the facilities being put on the island, pretty much what you buy is what you're going to get and I think BP's probably better prepared to explain how the development decisions were made, but I think that the contemplation of further investment will come as an incremental decision later on and it would be difficult to be able to model that together with the initial ... SENATOR FRANK: Do those set numbers add up to $350? MR. BANKS: I don't know that sir. SENATOR HALFORD: No they don't. SENATOR TAYLOR: We've got 262 and 96. SENATOR FRANK: No, I'm talking about the additional capital investment that is going to be required to develop the field. I thought it was $350 but those don't appear to add up to $350. SENATOR HALFORD: I don't think they do - they add up to about $300. MR. BANKS: I can check the answer for that. SENATOR HALFORD: There may be some precapitalized operating costs in the, I don't know, some other way to calculate that adds the other $50 million. MR. BANKS: I don't think it's that complicated, but I'll get you an answer for that. CHAIRMAN LEMAN: Kevin, are you going to be able to be with us on Saturday? MR. BANKS: Yes sir. CHAIRMAN LEMAN: You were planning on it? MR. BANKS: Here? CHAIRMAN LEMAN: Well, were you planning to be in Anchorage? MR. BANKS: Well, yes, that was my personal plan. CHAIRMAN LEMAN: I was planning on it too. I guess we all suffer together. I was just wondering if you could have the other run for us on Saturday. MR. BANKS: I can have the other run for you tomorrow morning, Mr. Chairman. CHAIRMAN LEMAN: But with this being so small, if you faxed it we're going to lose a lot. MR. BANKS: I can do it here tomorrow morning and give it to you by noon. CHAIRMAN LEMAN: That will be fine. SENATOR FRANK: Have you calculated the rate of return on the - if you just take the year 1998 through 2008, from the time they begin production to - or I suppose you should really do it from the time they begin making expenditures calculated to the time that they empty out that capital account. My gut tells me it's a pretty good rate of return because they've started out with $262 million that, I don't know what they paid for it, but if you calculate that in, and they're able to pay all down, plus pay their capital - the $350 capital plus interest on that, and it's all down to zero by the year 2008, it seems like there'd be a pretty good rate of return. MR. BANKS: Mr. Chairman, I have a recollection of having done that at some point in the process, but I don't remember what the number is. CHAIRMAN LEMAN: Was that the 21 percent or is that a different ... MR. BANKS: No, I share Senator Frank's prognosis. I suspect it would be a pretty good number but that's another number I'll be happy to share with you. SENATOR FRANK: I know it's better than eight. SENATOR TAYLOR: I'm surprised in your modelling that you didn't calculate or contemplate something for technological advances or additional recoveries because models similar to this were presented to the legislature on the Prudhoe Bay field and had we relied upon those models we'd have been flat broke and out of oil sometime ago. SENATOR HALFORD: They told us we were going to get 35 percent recovery. SENATOR TAYLOR: Yes. I guess what I was getting at, it just seems to me after the years of experience and the exponential growth and breakthroughs and developments that occurred, there ought to be some fudge factor in here for what you may contemplate to be additional technological improvements yet to come in the future. Who can predict where we're at 12 years from now, but I can only imagine that they're going to be ever more efficient in the discovery and acquisition of oil 12 years from now as they are today. MR. BANKS: In a sense that has been done in some of the high side cases that BP has provided to you with the proposal in the 160 million barrel reserve estimate and mind you, that was at 70 percent recovery. This is at a 45 to 50 percent recovery that involves some initial secondary recovery invested in the field at the time you develop it and I think I'd defer to BP to respond to that. I believe that the recovery factors right now at Prudhoe Bay are not anywhere near 70 percent and are probably in the neighborhood of 50-55 percent, that the current reserve estimates are now, after considerable investment since the initial start up of the field. SENATOR HALFORD: That's a combination of two things: that's a combination of increases in the estimate of the oil in place; and increases in the rate of recovery, is it not? MR. BANKS: I am not real sure about that sir. CHAIRMAN LEMAN: Is there anything else you wanted to cover tonight? MR. BANKS: I think this would be an appropriate place to break. SENATOR TAYLOR: I just had one other question here. To what extent does kurtosis, in the back here, ... MR. BANKS: It's just a little bit skewed as a result of my kurtosis, Senator. SENATOR TAYLOR: I've never heard of kurtosis. I thought is was an affliction that bothered toenails but it shows up here on the back page that we have variance, we have skewness, we have kurtosis and I really wasn't sure what that was. MR. BANKS: It's one of the factors that tells you what kind of shape of a distribution you have, I believe. SENATOR TAYLOR: It's been a long time since Statistics 101. MR. BANKS: I'm afraid it's been too long for me as well, sir. CHAIRMAN LEMAN: Thanks a lot. Our next meeting on SB 318 will be on Saturday. The schedule is going to be, best as we know now, 2:00 to 5:00 on Saturday - that's a change from 11:00 to 2:00, not at our desire, but it's to accommodate the other constraints of the Senate and I'll just note that our regular meeting of the Senate Resources Committee will be tomorrow at 3:30. There being no further business to come before us, we're adjourned.