Gas line deal with China signals diminished expectations

On one day, Nov. 9, $250 billion in nonbinding deals between the U.S. and China appeared during the president's trade mission. This included the agreement for China to "work together" with the Alaska Gasline Development Corp. on North Slope natural gas, as well as arrangements for shale gas in West Virginia and two other LNG projects in the Gulf of Mexico.

China has many other similar deals with other jurisdictions. Some may be built. Many will not.

Notwithstanding that the intrinsic economic fundamentals (the cost, the competition, the market) for the Alaska project are challenging, should it happen, under the proposed structure the state will likely not make much money from it.

[Alaska gas line agency reaches deal with Chinese oil company, financial institutions]

With the state running a large deficit, and dependent on Permanent Fund earnings for state services and dividends, it will have no money to invest in the project. Thus it is doubtful it can earn any return on equity.

And there is no money to be made by borrowing money to put into the project. That is debt, and the return on debt is simply recovery of interest payments to creditors. (It is also unclear if the state has the assets to even engage in such a loan.)

It is unlikely there will be much upside price potential for the project. The state will be bankrolled by the customer, who will want the lowest possible price, and the Asian market is oversupplied. There will not be money to be made by buying gas low and selling it high.

That leaves production taxes and royalties as the primary sources of revenue. The lease terms give the producers the right to produce the gas and commercialize it under reasonable terms, for which they pay taxes and royalties. These will be based on the wellhead value.

Some third party will enter into a long-term buying commitment with the producers, who will presumably sell gas to them at the North Slope wellhead. Since the producers are passing on the cost and market risks downstream, they may accept a lower purchase price. This will suppress taxes and royalties.

[Here are 5 big questions about Alaska's gas line deal with China?]

What might be a commercially reasonable price? The economics are so thin on the project that AGDC needs a low purchase price to make it work. They have offered $1 per thousand cubic feet.

The irony here, to say the least, is interesting. A state agency has a vested interest in lowballing the value of the state's resources. And the producers may be vilified for wanting a high value. The misalignment of interests is palpable.

Suppose it is $1 per thousand cubic feet. At 3 billion cubic feet per year, that would be about $1 billion per year in value at the wellhead.

The current combined tax/royalty rate is 25 percent. That will result in a lackluster $250 million in annual state revenues. That would close about one-tenth of the current budget deficit. The promotional material for the project does not even mention revenues anymore. Obviously, the jobs and possibility of lower-priced gas would be good, but the big prize in resource development comes from the resource value.

It is unlikely the producers would sell gas to someone and then risk having a large chunk of value taxed away should the state increase production taxes. Thus it will also be commercially reasonable for them to pass on the taxes to the buyers in the purchase contract. This is exactly what Cook Inlet gas producers have always done.

These taxes would be part of the purchase price from the producers, and will need to be recovered from the ultimate consumers. Thus the higher the tax the less competitive the selling price.

This may be the best deal the state can do now. Maybe it's the best the state can ever do, in which case AGDC should be lauded. But it is not clear it's in the state's long-run best interests.

The Asian LNG market is now a buyer's market, and prices are low. Marketing to other places in Asia besides China will be no different.

Long-term prices are, of course, unknowable. Locking in under the current environment will guarantee a generation of low value for the resource.

However, if the Asian or North American markets recover, the state might regret hitching up to the first suitor to come along.

Over the past 15 years, between the Alaska Natural Gas Development Authority, the Stranded Gas Development Act, the Alaska Gasline Inducement Act, the Alaska Stand-Alone Project, the partnership with the producers, and AGDC, the state has spent $1 billion, with not too much to show for it. Given the economic fundamentals, all of these endeavors were low probability going in. But all were gambles that a gas line would eventually provide rich returns for the state.

AGDC's additional gamble now is that the best-case scenario is a rationed future of limited returns.

Roger Marks is a petroleum economist in private practice in Anchorage, specializing in petroleum economics and taxation. He is a former senior petroleum economist with the Tax Division of the Alaska Department of Revenue.