Palin: Wrong For Alaska, Wrong For America 3

AGIA – Palin’s plan to progress construction of a natural gas pipeline
I’ll begin my analysis of AGIA (which stands for Alaska Gasline Inducement Act) with some general background information, which is helpful to evaluate Palin’s performance in progressing a natural gas pipeline for Alaska. AGIA, which provides $500 million in state money and an exclusive state license as incentives, is Palin’s gas pipeline plan. It is one of two major plans currently underway in the 30-year long saga to build a gas pipeline in Alaska. The other pipeline plan, which is proceeding with no state money, is named Denali and is a 50-50 joint venture between BP and ConocoPhillips.

The gas that would be transported in the pipeline is located in Alaska’s Prudhoe Bay oilfield and the Pt. Thompson gas field. Both field are critical to the project and are owned primarily by the major oil companies (ExxonMobil, BP and ConocoPhillips).

Before AGIA, Frank Murkowski, the previous governor of Alaska negotiated a contract with the major oil companies to build a gas pipeline. Murkowski’s contract was widely criticized due to a combination of factors, including real flaws in his plan. Two major problems were that, at the time it was presented for a vote, the contract was not fully negotiated and the oil companies had not signed it.

In addition, there were legitimate concerns that the contract was in conflict with the Alaska constitution (with respect to contracting away the taxing authority of future legislatures) and state regulations (e.g. in regard to the definition of “Stranded Gas”). Theoretically, the issues with respect to Alaska’s sovereign taxing authority and state regulations could have been solved politically with an amendment and proper legislation; but Murkowski’s extreme unpopularity made that impossible.

Although Murkowski’s pipeline plan would have been rejected in any case, the deep-seated mistrust Alaskans have of the major oil companies didn’t help.

Also complicating any plan for construction of a gas pipeline are: 1) the Alaska public’s view that the natural gas it would transport is “their gas,” and 2) the constitutional requirement that the state “maximize” the resource value for the people of Alaska. Many Alaskan’s fail to properly recognize that ownership of the gas resource is transferred to the producer (i.e. “Big Oil”) at the point of production. The price paid by the oil companies to buy the gas from the state is the royalty, usually 12.5%. Because many Alaskan’s believe the gas in the pipe would be “their gas” they don’t see state levies against that gas as taxes even after the transfer of its ownership to Big Oil. Instead, Alaskans view taxes as a return of “their fair share of the gas’s value.” Additionally, the objective to maximize the resource value tends to cause Alaskan’s to focus on the short term at the expense of longer-term goals.

Palin’s the two major objectives in enacting AGIA were to 1) provide incentives for construction of a pipeline and 2) provide incentives for committing gas to be transported in the pipeline.

In addition, it was generally believed that AGIA was intended to prevent the major oil companies that controlled the undeveloped gas from owning a major portion of the pipeline (something Palin’s administration clearly wants) while attracting bids from independent pipeline companies, specifically Mid-American Pipeline Company and Trans-Canada.

Interestingly, two companies that had been expected to submit proposals under AGIA wrote letters to Palin explaining why they would not, or could not, submit a proposal. Both letters indicated that Palin would need a different way forward than AGIA. BG’s (British Gas) letter seemed to imply they wanted to hold separate negotiations with the state with a goal to liquefy the gas. The more insightful letter was from Mid-American (controlled by Warren Buffet) which cited “deepening and ongoing investigations into political and corporate corruption in Alaska” as the primary reason that it could not submit a proposal. In addition, Mid-American stated that ongoing litigation regarding natural gas leases merited consideration of a new way forward for Palin’s administration. Mid-America’s letter can be viewed at http://gov.state.ak.us/agia/PublicApplications/Declined/midamerican_letter.pdf

Side note: I hold that Palin’s self-promoted image as a reformer would not hold up to close scrutiny, and Mid-American’s letter, which clearly implies that Alaska’s political process had not yet been reformed sufficiently to allow it to invest in a gas pipeline project, is just one piece of evidence that Palin is not, in fact, a reformer – at most she is a dissenter.

In the end AGIA attracted five bids – and only one from a company that could legitimately be considered as having any chance of eventually constructing a pipeline. It’s also worth noting that nothing under AGIA requires a company to actually construct a pipeline – it only requires that certain preliminary work be done that any company would have to do before beginning a construction phase.

The Federal Energy Regulatory Commission (FERC) is the agency that has authority to issue construction permits and set tariffs – not the state of Alaska. AGIA included terms that are contrary to FERC regulations, specifically the requirement for “rolled in tariffs.” The FERC policy prohibiting rolled in rates is intended to encourage owners of known gas resources to commit those resources to a pipeline project by protecting them from paying costs attributable to other parties at later dates.

To explain the concept of rolled in tariffs, I’ll use an analogy. But first, I need to explain that there are about 30 separate leaseholders at Pt. Thompson. The leaseholders include major oil companies as well as individual people. It also important to keep in mind that the leaseholders will pay all tariffs of the gas pipeline.

So, imagine that a group of 30 people decide to establish a community and want water service instead of individual wells. To do this they will need a to construct a pipeline to bring water from a reservoir about 5 miles away. The community studies their needs, makes projections of population growth and looks at several construction options. To be cost efficient and meet current and projected needs, the group decides to build a 10-inch diameter main pipeline to the town center and distribute water to individual houses from there. Each town member pays a tariff based on the initial construction costs and the ongoing operating costs. Based on all this, lets say that the water rate is set at $2.00 per 1000 cubic feet of water use.

Later, over time, another group builds a community 3 miles further away from the reservoir and they eventually want water service also. They study their needs and identify two options: 1) they can build a totally separate 8 mile long, 8-inch diameter pipeline from the reservoir to their community that will result in a tariff of $4.00 per 1000 cubic feet of water, or 2) they could connect onto the first community’s existing pipeline and have a lower tariff. Of course they would like to connect to the existing pipeline, but there are problems.

The first of many problems is that in order to transport water for both communities the original 10-inch diameter pipeline would have to be modified; more pumps and pressure control devices would have to be added. The rub – under Palin’s illegal AGIA scheme, the original community of 30 individuals would have to bear some of the cost to modify the original pipeline for the benefit of the second community.

This means the original community, the very individuals that took the risk of “going first,” would now have to pay more than $2.00 per thousand cubic feet – but they would get no additional benefits. In fact, if the total demand for water from both communities grows beyond the capacity of the modified pipeline, the original community would also be at risk of being prorated (forced to cut the amount of water they get) and/or face even higher tariffs to modify the pipe yet again – solely due to the decision of the second community to tap into the pipeline they initially developed.

It easy to understand why Alaska included this quasi-socialist arrangement in AGIA; it provides incentives for additional exploration after the original pipeline is in place. And, if more gas is found and produced, it would generate more tax revenue to Alaska, while shifting all the risk to the companies that built the pipeline initially. By doing so, AGIA is fundamentally flawed, which helps to explain why two major players in the pipeline industry took the unusual step of writing Palin to encourage her to seek another path forward. It also explains why other major companies did not submit a proposal under AGIA (and I’m referring to others besides ConocoPhillips and BP).

But, as stated above, rolled in tariffs violate FERC regulations for a good reason: the FERC, unlike Palin, realizes that requiring rolled in tariffs would create disincentives for companies to take the initial risk of building a pipeline.

One of the fundamental misunderstandings of Palin and her administration is that somehow they can “force” or provide state of Alaska incentives to get a pipeline built. The reality is that the pipeline will be built based on economics – an analysis of the likely future prices of natural gas, the cost of transportation and the expected volume and timing of gas to be produced. Each of these individual variables has risk, but their combined risk and the estimated $35 billion price tag makes this project a company potential company breaker. The fact that Alaska is offering $500 million in incentives has almost no effect on a company’s decision to construct a pipeline. It only provides an incentive for a company to do pre-construction studies.

Although Palin often implies that the pipeline is on a straight course toward construction, that is simply not the case. Neither Trans-Canada nor Denali have made commitments to construct a pipeline, they are only engaged in pre-construction studies – Trans-Canada using state money and Denali using its own $600 million. Further, the FERC has clearly stated that Alaska is interfering with progress and Palin’s attempts to involve more than one pipeline company would strain their resources and delay the issuance of any permits to go ahead with the project (only the FERC and NOT the state of Alaska can authorize construction of a pipeline). So, simply put, Palin’s AGIA has muddied up the waters.

Palin has advanced the argument that competition will result in construction of the pipeline sooner and with lower tariffs than negotiating with the resource owners. But this ignores the fact that the resource owners themselves have greatest incentive to build the pipeline quickly once the project becomes economic and build it at the lowest cost. Granted, each resource owner will evaluate whether the Alaska pipeline project is economic in light of all the other projects in their portfolio – and this could (and has) been in conflict with the state of Alaska’s position, but that is just the way free markets work. Tariffs are set based on costs of construction and operations and paid by the resource owners – so they have plenty of incentive to keep these costs low.

It is actually the pipeline companies that don’t have the incentive to keep tariffs low. Returns on pipelines are regulated by FERC (they generally range from 7% to 14%), which creates a situation in which if they lower the costs of the pipeline they receive a lower tariff, and vice versa (these costs are simply a pass through to the resource owners in the form of a tariff).

Ironically, ExxonMobil, a company reviled by Palin and most Alaskans, is playing a pivotal role in the effort to get a pipeline built and may turn out to be Palin’s most effective ally in this process. ExxonMobil is the largest owner of the Pt. Thompson natural gas, which is critical for any pipeline. The company has said it will be a major owner in any pipeline project. It has yet to commit to either the Denali plan or the Trans-Alaska plan – no surprise there because it is still too early. But, because it will eventually chose one of the two, ExxonMobil is the driving force behind the competition between the two. So, when ExxonMobil (not Palin) picks a winner based on its (and not the state’s) evaluation of timing for construction and cost structure, undoubtedly Palin will claim victory without acknowledging ExxonMobil (or anyone else) regardless of what company ExxonMobil picks.

So the question is: What are the chances that ExxonMobil will choose Trans-Canada? There is almost no chance ExxonMobil will pick Trans-Canada: the reason is that Trans-Canada has a $10 billion “hairball” that it hasn’t coughed up and likely won’t be able to. The “hairball” is a liability disclosed on Trans-Canada’s SEC filings and it relates to money owed to partners that withdrew from a prior attempt it took at building the pipe. During that attempt Trans-Canada formed a partnership and spent money on a pre-construction study, when they were unsuccessful, partners withdrew, leaving Trans-Canada with the data from the study and the potential right to build the pipeline at a later date. The partnership agreement called for Trans-Canada to buy out the withdrawing partners, but it did not do this. That partnership agreement is still in effect and, if Trans-Canada is chosen to build the pipeline, it will have to deal with this liability – this situation puts too much uncertainty into a Trans-Canada pick.

Outside of AGIA, Palin has introduced unnecessary risk into the quest to build a gas pipeline when her administration tried to take back the Pt. Thompson leases (mostly to punish ExxonMobil, but it would also take away the rights of all other owners – including the individuals). As noted, this gas is critical to the project and by putting a cloud over its title, Palin puts any (Denali or Trans-Canada) pipeline project at great risk. (I may write more on this in a latter analysis).

And finally, Palin has not yet reached agreement with the major oil companies with regard to “fiscal certainty” (the need to set tax rates in a fashion that provides a reasonable amount of certainty – regardless of how high or low the taxes are). She is aware that this is a critical step that must be addressed before any pipeline can be built, but she continues to ignore it. I suspect she is doing so because she sees any agreement with the major oil companies as a threat to her popularity.

There are those that say Palin may be a victim of bad advice with respect to AGIA; but, if this is true, she is surely guilty of making poor choices to fill important state posts. Palin claims to have taken on big oil, but in reality she hasn’t “beaten” them and by failing to adopt a win-win view, she has violated the spirit of the constitution by failing to use Alaska resources for the maximum benefit of its citizens.

At a fundamental level Palin’s logic for AGIA is flawed in the following ways:
A $35 billion pipeline is not something that $500 million can prime (it works based on economics)
Any pipeline plan must be supported by the resource owners
Without support of the resource owners it cannot be financed
Eventually fiscal certain must be provided
A $10 billion “hairball” makes Trans-Canada an unlikely “winner”


Summary: Palin’s has subjected Alaska’s and America’s energy future to unreasonable risk due to her undisguised desire to punish the oil companies. Rather than demonstrating vision in passing AGIA she, once again, put her finger to the wind and did what was popular at the time.