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Trans-Alaska Pipeline System: Economics

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Richard A. Fineberg

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(Archived Sep 5, 2006)

Lessons from Business Week (Commentary)

Tale of 2 Barrels: Stable Region Big Fields
"Enormously Profitable" for Oil Companies

June 6, 2006

Two depictions of an oil barrel tell the story: In April, BP presented legislators with a brightly colored picture of a barrel purportedly showing that BP loses money on the North Slope at oil prices below $22.50 per barrel. The April 30 article published at this site refuted this misleading notion. The cover of Business Week May 15 also features a barrel of oil. Inside, the magazine reports that BP and its partners are "milking" Alaska's North Slope "for all that it's worth." (Continued below image.).

BP's so-called "Breakeven Barrel" which masquerades  more than $5.00 per barrel in profits.

Big Oil Companies Face Barrels of Global Problems Despite Record Profits

Approaching overhaul of the state's petroleum revenue fiscal regime from the narrow confines of the misguided proposals of Governor Frank Murkowski, The Alaska State Legislature continues to argue over relatively small changes to the panoply of proposed concessions to the major North Slope producers in pursuit of an ephemeral natural gas line. By taking this approach, the Legislature continues on a course that may be setting the stage for industry plunder of Alaska's oil wealth.

The paradox of this situation is revealed in the reality that underlies the two barrels -- one drawn by BP, the other on the cover of Business Week. Both refer to a per-barrel value of approximately $22.00, but there is a big difference. As discussed April 30, BP's misleading barrel is drawn to claim BP makes nothing at oil prices below $22.50 per barrel due to high production costs. In its article, Business Week also refers to a barrel of North slope crude that BP sells for $22.00. But that barrel is still in the ground (discovered but not produced). It therefore has no production costs, only finding costs

The May 15 Business Week article, which describes an industry beleaguered around the globe as governments insist on a bigger cut of the net revenue from high oil prices, is not unsympathetic to the industry.

"Yes, we know it sounds ridiculous," writes Business Week. "Exxon Mobil Corp. has been reporting the lushest earnings in the history of the business . . . . Combining the forecasted 2006 earnings of BP, Royal Dutch Shell, Chevron, Toital, ConocoPhillips, and Exxon Mobil, and you get roughly $135 billion, a sum greater than the gross domestic prroduct of the Czech Republic or Israel. These companies, moreover, enjoy huge political clout in their home countries, have spotty environmental records, and staunchly defend outrageous prices at the gasoline pump." (Business Week [BW], May 15, 2006, p. 66 [1].)

But, the article continues, "you don't have to love the big oil companies to worry about their ability to provide us with the energy we need. That job is getting difficult, thanks to technical challenges, competition from national oil companies, and demanding, even hostile foreign governments." Host countries are renegotiating existing contracts to achieve better terms than the industry offered as recently as a decade ago, when oil prices were low; some are nationalizing assets. New contract terms are tougher, too. For example, "[r]ecent auctions of exploration blocks in Algeria, Libya and Egypt have yielded terms that many executives believe won't generate returns to compensate for ever-higher risks." (BW, pp. 67-69.)

At this point Alaska enters the story: "Given these ever-tighter restrictions," Business Week reports, "the oil majors are milking the acreage they hold in polticially stable zones for all that it's worth. They include the North Sea, the Gulf of Mexico, and the North Slope of Alaska. Discovered in the 1960s and '70s, they are being depleted. As these fields dwindle, their scarcity value as safe zones is shooting up: BP recently sold fields in the Gulf of Mexico to Apache Corp. for $22 a barrel. Two years ago, the price might have been around $7 per barrel." (BW, p. 70.)

This description of the industry's global problems and the unusual position of the North Slope as a politically safe cash cow for its owners underscores the importance of determining whether the concessions the Murkowski administration proposes to offer to the industry are reallly necessary. The administration proposes to switch from a price-based production tax to a profits-based tax. Former state officials familiar with Alaska's revenue collection battles (this writer included) believe the switch would enable the industry to reduce taxes by claiming excessive cost deductions. At the same time, the Murkowski administration proposes to give up court and regulatory avenues of redress that have enabled the state to secure a significant portion of past revenue underpayments. Together, these concessions may outweigh the uncertain effects of the relatively small, incremental changes to the production tax rate, which are offset -- to a significant but unknown degree -- by tax credits and deductions in a complex arrangement aimed at overall revenue neutrality.

Five days before the Business Week article was published, Governor Murkowski finally released the first 352 pages of the draft Alaska Stranded Gas Fiscal Contract his administration had negotiated with BP, ConocoPhillips and ExxonMobil, along with an assortment of other documents, including the Commissioner of Revenue's 306-page Preliminary Fiscal Interest Finding (FIF). (2) The latter document reveals that the gas line project is so big and so complicated that it must be regaded as an extremely high-risk venture. To counter these risks, the governor wants the state to assist in the financing and grant concessions on critical fiscal terms. He hopes that the state can induce the industry to go forward with the project if it sweetens the pot sufficiently.

One example of the serious risks revealed is the lack of sufficient gas to assure comnmercial success. The FIF discloses:

The project requires producing approximately 53 tcf [trillion cubic feet] of natural gas to operate at capacity over the anticipated 35-year operating life of the gas pipeline. This means producers and other explorers must find and develop an additional 18 tcf of natural gas resources. The potential that sufficient and cost-effective sources of natural gas beyond the known ANS resources may not be found increases the risk of the project. This resource risk makes it important that fiscal certainty be available for a long period of time in order to provide incentives for natural gas exploration and development. (FIF, p. ES-3.)

The governor's consultant, Dr. Pedro Van Meurs, confirms that this problem is apt to spook prospective financiers; hence the need for so many sweeteners.

But even if the state grants all the concessions the governor has proposed and the missing gas is discovered in a timely manner, it is by no means certain that the gas line will become a reality. The FIF warns that "unforseen events could delay or even, at the extreme, prevent the project." (FIF, p. ES-11.) Among other problems, the project runs through Canada, where a host of regulatory and socio-political issues - entirely out of Alaska's control - have yet to be resolved. These include "outstanding issues of regulatory certainty, First Nations settlement agreements and land claims, and other issues that are yet to be resolved." (FIF, p. 197.)

Assuming the gas line project makes it through all of these hurdles, then the real fun begins. The possibility of cost overruns is a major risk that makes financing difficult to arrange and threatens to eat profits. In this regard, it is noteworthy that Business Week carried a companion article on Shell Oil's troubled Sakhalin-II project. According to that article, "Shell has hurt its reputation with investors and with its Russian hosts by letting the costs of the venture soar. In 2005, Shell announced that the price tag for the main phase of Sakhalin II would double, to $20 billion." (3)

After project completion, there are transportation risks. According to the Murkowski administration's preliminary FIF, "[t]he complexity of the capacity management provisions in the contract creates a risk in the application of the provisions, particularly to unforseen or marginal circumstances." (FIF, p. 194.) And there is always the risk that market prices could drop. According to Business Week, "pros like BP's [Chairman Lord John] Browne believe that prices could still 'turn on a dime'." (BW, p. 68.)

No wonder the draft fiscal contract does not set deadlines; in light of these uncertainties, that simply wouldn't be practical. But identification of the risks associated with the proposed gas line project raise other important policy questions.

One of the most fundamental of the questions given short shrift in discussions to date involves the trade-off between oil revenue and gas revenue. The policy question is this: Is it appropriate (or wise) to trade off more certain revenue from oil development in hopes that this sacrifice might induce gas line development, or should the state's more certain oil revenue be protected from the risks associated with the inherently more problematical natural gas project?

It is generally understood that public revenues are to be managed conservatively to minimize risk. The decision to sacrifice potential oil revenue - through such giveaways as the lenient terms of the proposed production profits tax and the freezing of those terms for an extended period - runs directly counter to this fundamental principle. In light of the uncertainties revealed by the preliminary FIF released May 10, oil revenue may be regarded as real money, while natural gas revenue is more akin to "Monopoly" (play) money. But the significance of the governor's approach to this fundamental question was masked by the withholding of vital information from public debate for more than three months.

Despite nearly 100 days of thoughtful deliberation, by the end of the 121-day regular session, legislators were left with little more than convenient generalities: all numbers will be wrong in the end because nobody has a crystal ball; don't underestimate the necessity for fiscal certainty; don't nitpick the details -- this agreement must be understood as a package.

Much the same language used by the Sheffield Administration in 1985 to secure the Legislature's blessing for the complicated and dimly understood TAPS tariff agreement. Like the implications of the trade-off between oil and gas revenue, the implications of TAPS tariff issues have been largely overlooked in Juneau discussions to date. These include atrophied North Slope development and reduced state revenues.

The four-week emersion in details of the draft Stranded Gas Fiscal Contract revealed an ancillary TAPS issue with broader implications: contract treatment of TAPS property taxes. The state and the municipalities through which the pipeline passes wish to maximize assessed value of the portion of a pipeline that passes through its borders in order to increase property tax revenue. The industry is on the opposite end of this perpetual argument. Because the pipeline property tax is a transportation cost, there is a chronic tension and a delicate balance between municipality desires and the broader state interests in minimizing those costs.

For the last decade, the Fairbanks, Valdez and North Slope municipalities have fought to keep the property tax rate base on the aging pipeline from a rapid descent as the assessed value of the aging pipeline continues to shrink, much like a balloon losing air. One argument in favor of the municipalities is that TAPS throughput and longevity have exceeded original expectations, so the assessments during the first decades of operation were too low.

The draft contract stumbled right into this complicated and thorny thicket. In keeping with that desire for fiscal certainty, the draft contract appears - almost as an afterthought -- to freeze the TAPS valuation at the 2005 level. Superficially, that may sound like an intelligent solution to a long-standing problem. But again, the devil is in the details. In May, the municipalities finally gained traction with an approach to TAPS valuation that led the State Assessment Review Board to significantly increase the valuation of TAPS by approximately 20 percent over the 2005 level. But the stranded gas contract appears to be frozen at the lower level. Thus, under the contract terms, the municipalities would be denied the benefit of this changing circumstance. (4)

There are two lessons to be learned from the TAPS property tax issue:

  • Before the ink is dry on the draft contract, here is an example demonstrating how granting the industry's demand for across-the-board fiscal certainty on public revenue issues -- however understandable that desire may be - can turn out to be a bad deal for the state and its citizens.
  • At the same time, the unfolding of this issue demonstrates the reason that the Legislature must go beyond the generalities to understand the implications of the details of the proposals they are being asked to ratify - and lock into place for decades to come -- on inappropriately short notice.

Whether TAPS tariff issues are understood as the Achilles Heel of the governor's package, as an example of the kind of details that can undermine legislative intent or as a warning flag that the governor's package is on the wrong course, this much is clear: Twenty-one years after the TAPS settlement, the state is still paying for the Legislature's failure to demand better information from an administration whose negotiators fell in love with the complicated, flawed agreement they negotiated. And four weeks into the special session on the draft natural gas pipeline contract and petroleum fiscal regime overhaul, it appears that the state has not learned from its painful experience with TAPS fiscal issues. (5)



1. Stanley Reed, "Why YOU Should Worry About Big Oil: Beyond the fat profits, the giants are surprisingly vulnerable worldwide. That's bad news for business - and consumers," Business Week, May 15, 2006, pp. 66-70.

2. Office of the Governor, Alaska Stranded Gas Fiscal Contract between the State of Alaska and BP Exploration (Alaska) Inc., ConocoPhillips Alaska, Inc., and ExxonMobil Alaska Production Inc. (Draft), May 24, 2006, 457 pages [originally released with 352 pages, May 10, 2006]; and Alaska Department of Revenue, Preliminary Findings and Determination, as required by the Stranded Gas Development Act for a Contract between the State of Alaska and BP Alaska (Exploration), Inc. [sic.], ConocoPhillips Alaska, Inc., and ExxonMobil Alaska Production, Inc. - Contract Version dated ______, 2006, May 10, 2006 (FIF).

3. Stanley Reed, "Sakhalin Island - Journey to Extreme Oil: Big Oil's future lies in such forbidding places as Russia's Far East," Business Week, May 15, 2006, pp. 74-76. (Sakhalin was discussed at this web site in a February 2005 article.)

4 This analysis is based on discussions at the Municipal Advisory Group meeting in Fairbanks May 24, 2006; the revised draft Alaska Stranded Gas Fiscal Contract of that datereferences to TAPS valuation at 2005 levels in at pp. 37 and p. 336; for the increase in TAPS valuatioin, see: Associated Press, "Review board boosts assessed value of trans-Alaska pipeline," Anchorage Daily News, May 25, 2006 (on-line).

5. For discussion of the role of delayed and inadequate information on the Legislature's 1985 TAPS settlement review, see: The 1985 TAPS Tariff Settlement: A Case Study in the Effects of Confidentiality on Information Available to Decision Makers (supplemental report to Oil and Gas Revenue Disputes, prepared by this writer under contract for Alaska State Legislature [1990]; for discussion of the effects, see the April 30 article posted here and the May 7-10 updates. For subsequent discussion and commentary, see Updates from Juneau, posted June 4, 2006.)

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