Alaska’s future: It’s the oil

Let’s start with a basic fact. For various purposes, government agencies, securities analysts and oil and gas producers often measure oil and natural production and reserves on a common basis — barrels of oil equivalent (BOE). Based on energy content, 5.8 Mcf’s (thousand cubic feet) of gas equals one barrel of oil. As it turns out, that is a critical statistic to understanding Alaska’s future.

First, that statistic helps to provide some sense of the relationship between volumes of oil and gas. Currently, Alaska is producing roughly an average of 600,000 barrels/day of North Slope oil subject to state production tax. On a BOE basis, 3.5 Bcf (billion cubic feet)/day of gas equates to about the same amount of oil. Coincidentally, that is roughly the same amount of gas which some suggest would be moved to the Lower 48 through an Alaska pipeline. Thus, if focused only on volume, an observer could argue that Alaska will not be harmed if gas supplanted oil as the primary source of revenue for Alaska.

A second, and more important, application of the statistic proves that conclusion false, however.

The statistic also may be used to compare the value of oil to gas. As reported on the Department of Revenue (DOR) website, the current market value of Alaska North Slope crude oil is $75/bbl. For a variety of reasons, gas trades at a discount to oil. The Henry Hub price for gas (also reported on the DOR website) recently has hovered around $5.00/MMbtu. Multiplying that price by 5.8 to compare it to an equivalent quantity of oil results in a value for natural gas of roughly $30/BOE.

Consequently, while the effect of substituting gas for oil might seem roughly equivalent from a volume perspective, the value outcomes are significantly different.

At current prices, 600,000 barrels of oil equates to $45 million in gross market value (600,000 x $75/barrel). An equivalent quantity of gas only produces $17.5 million in gross market value (3.5 Bcf x $5.00/MMBtu). Even at a higher volume of 4.0 Bcf/day, which some project a pipeline could handle but is not sustainable, the gross value of gas is only $20 million, still less than half the value of oil. At 2.5 Bcf/day, the level projected by some for the Valdez LNG project, the gross value is only $12.5 million, less than 30 percent of the value of current oil production. The fact that North Slope gas also contains liquids such as propane and ethane helps offset that differential some, but not much.

Moreover, even these numbers don’t tell the full story. Gas costs significantly more to transport than oil, leading to a lower realized net for gas than oil. For example, according to the Spring 2010 DOR Forecast, ANS oil costs $6 per barrel to transport to market. Using the nominal estimate made by TransCanada for transporting North Slope gas, however, transportation costs for gas are $3.50/MMbtu or a near staggering $20-plus/BOE (again, compared with a current market value for gas of only $30/BOE).

Moreover, those transportation costs only move the gas from the North Slope to Canada. Gas available in Canada historically has traded at a significant discount to the Henry Hub price. Factoring in the long-term historic differential between the two locations reduces the value of Alaska gas by another 15 percent.

As a consequence, the net advantage of oil over gas is even greater than the $75 v. $30/BOE difference suggested by current market prices. Using these nominal transport costs and historic location differentials, the net value of current oil production is in the range of $41.5 million per day, compared with a net value for an equivalent volume of gas of $4.4 million. Even at a production rate of 4 Bcf/day, the net value of gas is less than 15 percent of the value of oil.

Why are these statistics important?

Simple. Some have suggested that a gas pipeline, or an LNG project, is sufficient to sustain the Alaska economy going forward, and essentially ignore the State’s long term oil policy. Bill Walker, for example, suggests that the state is “running out of oil,” but that will be offset by the Valdez LNG project.

These statistics prove that false. Unless gas rises significantly in value compared with oil (a development no one contemplates), Alaska state government revenues — and the Alaska economy — will suffer deeply if Alaska ignores the ongoing significance of oil, and blindly relies on gas to replace oil.

This does not have to be the result. According to testimony before the Legislature in 2006, the decline rate in TAPS could be slowed from 6 percent to 3 percent, the end of life for TAPS lengthened from 2025 to 2050 and ultimate oil recovered increased by nearly an additional 4 billion barrels (or $300 billion in today’s market value), if investment in North Slope oil development increased from the then-current $1-1.5 billion per year to $2-3 billion per year (in 2006 dollars). If additional investment reached $100 billion over that same time period, ultimate recovery could be as much as an additional 14 billion barrels of oil (a little over $1 trillion in current market value) and stretch well beyond 2050.

What is standing in the way of that future? Investment. Alaska is not “running out of oil,” it is running out of the investment required to develop its oil.

And why is it running out of investment? One word: ACES (the acronym for “Alaska’s Clear and Equitable Share”), the Palin-Parnell-French tax increase which was signed into law in 2007.

By raising the level of government take to 70 to 80 percent at current price levels — and leaving producers with only the remaining 20 to 30 percent from which to pay development, production, transportation and marketing costs and receive a return on their investment — ACES has priced Alaska out of the market for new oil investment. At that level of government take, producers are able to achieve much better returns on their investments elsewhere in the world, and consequently, have chosen to invest their available capital in those locations, rather than Alaska.

The evidence of the effect of ACES on investment in Alaska is clear. Since the passage of ACES, investment in oil and gas development (adjusted for amounts spent maintaining infrastructure) on lands subject to ACES has declined, to the point, for example, that ConocoPhillips is not drilling a new onshore exploration well this year for the first time in the past 40. Oil production is starting to decline at rates higher than 6 percent per year; the decline curve certainly is not decreasing toward 3 percent.

Some have suggested that Alaska does not need the majors and can be as well served by smaller independents. A report last year on Arctic drilling by the Energy Information Administration dismisses that view, concluding “The high cost of doing business in the Arctic suggests that only the world’s largest oil companies, most likely as partners in joint venture projects, have the financial, technical, and managerial strength to accomplish the costly, long-lead-time projects dictated by Arctic conditions.”

If Alaska does not reform its oil policy and reopen Alaska for oil investment by its largest investors, the Alaska economy will become a shadow of its former self, even if the best of the current gas projects becomes successful. The question won’t be whether to fund one program or another. The question will be how many teachers and other state employees to lay off and how many state programs to totally eliminate. Alaska’s private economy — which also is driven significantly by oil — will be in similar shape. The consequences will be severe.

During the 1992 Presidential Campaign, James Carville repeatedly reminded those in Clinton’s Little Rock “War Room” that “it’s the economy, stupid.” In Alaska, we need to realize that “it’s the oil” that drives our state government and economy. Debating the future of Alaska gas is important, but never should overshadow developing a policy which maintains continued oil investment.

Reprinted in Alaska Dispatch, Commentary (July 10, 2010) (