From the desk of: Richard A. Fineberg
P.O. Box 416 Ester, Alaska 99725
Phone / Fax (907) 479-7778 ° E-mail: firstname.lastname@example.org
Follow-Up To Our Visit (Arctic National Wildlife Refuge)
Dear Ms. Gramp:
My thanks to you and Mr. Cawley for taking the time to meet Thursday to discuss my report on revenue projections from oil and gas leasing on the Coastal Plain of the Arctic National Wildlife Refuge. This memorandum follows up on several points we touched on during our meeting.
Rates of Return
The U.S. Energy Information Administration (EIA) indicates a rate of return on investment for "makers" (discoverers) of oil or natural gas reserves of 12.71%, v. 10.25% for "buyers" (purchasers) of already discovered reserves).(1) The difference in rates of return reflects the higher price that purchasers of reserves are willing to pay to reduce exploration risk. These rates of return approximate the industry standard that economists such as Pedro van Meurs currently use in training courses (the 12% figure I mentioned) but may be significantly lower than the actual hurdle rates companies are using today. It should be noted that the hurdle rate, as its name implies, simply sets the bar for calculation of project net present value. And, as we discussed, the hurdle rate is something of a moving target, as each company sets its own and that rate will vary with opportunities and other changing conditions.
In considering the relative attractiveness of the Arctic Refuge Coastal Plain to potential investors, it should be noted that major transnational corporations may operate profitably with lower rates of return than smaller companies because the latter must repay their investors more rapidly.(2) It appears, then, that the Arctic Refuge - a high-cost environment requiring relatively large discoveries for success - should be more attractive to the companies who have demonstrated their preference for other regions of the globe (e.g., BP, ChevronTexaco and ConocoPhillips) than to smaller companies that may not be able to wait for long-term repayment of their investment.
EIA also notes a marked increase in finding costs in the U.S. in recent years, with the exception of a retrenchment after an extraordinary rise in offshore costs associated with the deepwater Gulf of Mexico). Specifically, the three-year weighted average for 2000-2002 was up nearly 20 percent compared to the 1999-2001 period.(3) Presumably, there will be an update to these data with the publication of Performance Profiles of Major energy Producers. (Originally scheduled for release in January 2005, I understand it is now due out later this month.)
The discussion of finding cost trends must also consider technological developments. In this regard, note that continued improvement in the prospects for development of the more than 20 billion barrels of heavy oil already discovered but as yet undeveloped in the immediate Prudhoe Bay vicinity has an advantage over oil that may (or may not) be discovered beneath the Arctic Refuge Coastal Plain of both finding costs and the transportation from the Coastal Plain to Pump Station #1 at Prudhoe Bay. As noted in my report, in August 2004 Alaska's two major developers announced plans to spend more than $500 million to increase heavy oil production from the Prudhoe Bay complex from 10,000 bpd to 45,000 bpd by 2007.(4) This expenditure will result in the production of something like five percent of the original heavy oil in place and already discovered within the already-developed Prudhoe Bay complex. In light of the heavy oil developments in the Orinoco Basin (Venezuela) and the Athabascan oil sands (Canada), it is reasonable to anticipate additional improvements in the costs of developing heavy oil deposits closer to Pump Station #1.
While EIA notes that finding costs can be expected to move in concert with oil prices,(5) the relevant price is the long-term price of oil. In this regard, it is relevant to note that EIA forecasts a significant decline in oil prices before a long-term trend of gradually rising prices begins.(6) As prices rise, the experience of the 1970s suggests that when prices escalate, the relative attractiveness of alternative sources of energy will increase, putting a limit on the extent to which higher oil prices will underwrite increased finding cost expenditures.(7)
In my estimation, all of these factors reduce the likelihood that bids for unexplored acreage on the Arctic Refuge Coastal Plain will replicate the high bids experienced on the North Slope in the years immediately after the extraordinary discovery at Prudhoe Bay.
Nominal v. Real Dollars
I want to return briefly to our discussion of my selection of nominal rather than real (inflation-adjusted) dollars for the charts I prepared to describe lease bonus revenue trends. As you correctly note, if expressed in real terms, historical bids would have appeared to be significantly higher. At the same time, the relative decline and the contrast between low bid offerings on the North Slope over the past 15 years would be exacerbated to precisely the extent that the value of historical lease bids, expressed in current dollars, would have been increased. Further, as we discussed, the conversion from nominal to real terms would have emphasized the downward trend in recent years but would have an insignificant effect on the disparity between the lease bonuses paid over in recent years and the amounts anticipated from Arctic Refuge leasing estimated in recent budget documents. Therefore, rather than force readers to go through this exercise, I opted for simplicity.
During our discussion, you expressed interest in learning more about the relationship between Alaska North Slope developments and the 64 lease sales on the North Slope since statehood. While I have not conducted a complete records search, preliminary review confirms the following historical information we discussed:
I believe the information in my report and this letter suggest that those who would forecast high bonus bids from the Arctic Refuge must address two fundamental questions:
Again, my thanks for your time and consideration. Please let me know if I can provide additional information.
Richard A. Fineberg
Cc: Rich Innes, Jim Waltman
Notes to Letter
4. See: ConocoPhillips, "ConocoPhillips, BP Announce West Sak Heavy Oil Expansion" (ConocoPhillips new release), Aug. 10, 2004
6. U.S. Energy Information Administration, Annual Energy Outlook 2005 (Early Release), Overview, December 2004.
7. In addition to existing petroleum alternatives discussed here, other energy sources become more attractive as oil prices rise. These include fossil fuels (e.g., nuclear, coal and natural gas), alternative technologies (including hydrogen, wind, solar and geothermal energy) and conservation.