FAIRBANKS -- One of the difficult decisions the Legislature faces in evaluating the governor's proposed gas pipeline deal is whether the state would collect in cash or cubic feet.
The Parnell administration and the oil companies signed a non-binding deal last week saying they want royalties and taxes paid in cubic feet of natural gas instead of in cash. The oil companies see this as a way to increase their internal rate of return, which would make it more likely to get a pipeline built.
"The producers have made it very clear that this would be attractive to them," Deepa Poduval, a representative of the international consulting firm Black & Veatch, told a legislative hearing in December.
"It reduces valuation disputes, and it takes away the responsibility of treating, transporting, liquefying and marketing the state's share of royalty gas from the producers," Poduval said.
The state agreement would give the companies a "one time, irrevocable election, with no sunset requirement" -- the option of paying taxes with a fixed percentage of gas. The companies and the administration say it could be in the range of 7 percent to 13 percent of the total. That portion of the gas, added to the state's royalty share of about 12 percent, would mean that the state would be responsible for 20 to 25 percent of the energy in the project.
The consultant's report estimated total construction costs between $37 billion and $54 billion for a trans-Alaska gas pipeline and associated treatment plants. The oil companies say the upper end could be $65 billion or more, up from a $28 billion estimate in 2008.
The cash or cubic feet choice is founded on the notion that if the state collects cash, it will not be "aligned" with the oil companies, while it will have similar interests and goals if it owns part of the project and signs long-term contracts offering tax stability. The question of whether the state has the constitutional authority to make that call will be part of the debate.
If royalties and taxes are set by a fixed quantity of natural gas, there will be no need to argue about deductions and the taxable value of natural gas in the decades to come. Royalty and tax calculations will be simple math.
For the state, the advantage of taking possession of billions of cubic feet of natural gas is that it would gain better insight into the internal dynamics of the LNG market, Poduval said. On the other hand, the state has no experience in marketing natural gas and it would have to take on that risk. The cost of marketing is estimated to be up to $15 million a year.
When it seeks to sell its gas, the state can expect "discounted prices due to market inexperience and lack of diversity of supply," the Black & Veatch report said.
Where would North Slope gas be sold?
Among the many variables is the level of financial risk to the state, which would change depending upon whether the gas is sold on the North Slope, in Southcentral or in Japan
In addition, the Parnell agreement says the state could negotiate separate deals with oil companies for the "purchase or other disposition" of the state's gas. That way, gas that the state takes possession of would be bought by the oil companies or marketed to third parties by the oil companies. The cost of those transactions are unknown, though this would be one option given the state's lack of expertise in dealing with the world LNG market.
Including that provision in the agreement signed by the Parnell administration raises the question of why the state wants to take possession of the gas, if it intends to sell it to the oil companies or have them sell it for the state. Is it simply to create a contractual means of setting tax rates for decades?
If the state markets its gas, the lowest risk and lowest reward would take place if energy is sold on the North Slope. The greatest risk and reward would be if the sale takes place on a foreign shore. Additional risks include the need to balance and schedule gas treatment, equipment problems that would prevent deliveries, construction cost hikes and other unknowns.
"The other side of the coin is that there are rewards that come with taking the risks," said Poduval.
"The highest market price that the state can achieve for its gas will be at the very end of that supply chain," she said.
The governor intends to introduce legislation allowing his administration to enter confidential negotiations with the companies, with the goal of bringing back proposed contracts in 2015, balancing risk and reward.
The agreement signed by the Parnell administration with the oil companies says the state would be responsible for marketing its royalty gas, the portion that the state owns because the resource was found on state land, as well as the portion it would collect instead of tax dollars. Unlike the oil companies, the state does not have supplies of LNG around the world that provide a level of flexibility to deal with changing conditions.
Taking possession of the gas "could result in a substantial increase in the state's risk exposure and potential loss of royalty value," the consultant's report found. It would mean the state would have to enter a "large number of complex commercial agreements" with the oil companies.
"The state would be disadvantaged in the creation of such agreements by its statutory and regulatory structure (e.g., the need for legislative modifications), its inexperience in LNG negotiation, its status as a new market entrant and the lack of an LNG supply portfolio to optimize."
This creates the potential for lower revenue to the state. On the other hand, if the state elects to take dollars instead of cubic feet of gas, there will be "potential for dispute on valuation and deductions and misalignment of interests with the producers."
"The state has the ability to lessen project risk, but it will need to weigh those opportunities circumspectly -- risk mitigation and commercial agreements need to be addressed carefully to define the state's rights and obligations, manage risk exposure and to achieve objectives of transparency and open access for third parties," the consultants said.