The Fourth in the Alaska Business Monthly Series: “Alaska Oil Policy| Achieving Alignment” (from the January 2013 Alaska Business Monthly)

As noted on these pages previously, I write a bi-monthly column on oil & gas issues for the Alaska Business Monthly.  This is the fourth column, originally published in the January 2013 print edition and available online here.

The last column in this series (“Out of Alignment,” Alaska Business Monthly, November 2012) focused on the reasons why Alaska oil policy is misaligned with the objective of maximizing the development of the state’s oil and gas resources.

The column discussed the state’s attempted use of two tools—tax credits and direct regulatory intervention—to steer investment to Alaska and why those tools have failed to produce significant results in terms of increased production. As I explained, the state’s use of the tools has been similar to backseat driving—and just about as successful.

The column also briefly mentioned a potential solution to the state’s alignment problem—developing a means for the state to co-invest alongside industry in the development of the state’s oil and gas resources. This month’s column further explains that concept.

What is co-investment?

Simply stated, co-investment is the direct investment by the state as a partner in the development of the state’s oil and gas resources. The state assumes an ownership share as a working interest owner, bears a proportionate share of the investment and operating cost required to develop the resource, and receives, as a partner, a proportionate share of the production.

The reason that the approach better aligns the interests of the state with the other owners and the development of the resource is because the state directly sees the economics of various projects and responds, as do the other owners, to those that produce the greatest economic returns. It also positions the state to help drive those projects from the inside, as an owner, by putting its own investment on the line.

Under Alaska’s current approach, the state does not see those economics and even if it did, frankly does not have the incentive to promote those that produce the best returns. Instead, as I explained in the previous column, Alaska’s efforts are heavily influenced by political considerations. As a result, the state and industry often work at cross purposes, with each somewhat stymied by the actions of the other.

Government co-investment in the development of Alaska’s oil and gas resources is not novel. In 1996, Anchorage’s Municipal Light & Power, a division of the municipality, purchased Shell Oil Co.’s  interest in the Beluga Gas Field, located in Cook Inlet. Since that time, ML&P has acted as an owner in the field, contributing its share of the required investment and operating costs, and receiving its proportionate share of production in return.

ML&P’s involvement in the Beluga field has been a success. Through its ownership share, ML&P has brought a focus to the continued development of the Beluga field that otherwise might not have occurred. While Cook Inlet gas supplies have reached dangerously low levels, that point might have been reached much sooner had ML&P not been positioned to encourage, identify and participate in continued investment in the development of one of Cook Inlet’s largest gas fields.

The co-investment model also has been successfully adopted in other countries where, as in Alaska, the state owns the resource. In the early years following the discovery of oil in Norway, for example, the country used a royalty model, similar to that used currently in Alaska, to derive the state’s take from production. As a member of the Ministry of Petroleum and Energy explained last year, however, after a few years the government realized that the approach misaligned the interests of government and industry and resulted in suboptimal investments.

While the royalty model resulted in the government receiving some cash with little risk, it also caused underdevelopment of the nation’s resources. The government decided that it achieved a better return from realigning its interests and becoming an investor in the development of its own resources, even though it meant bearing some of the risk. While there are additional factors that also contribute, today Norway maintains a much stronger production and investment profile than Alaska, despite also having one of the highest production tax rates in the world. The Norwegians, at least, attribute that significantly to their involvement as an owner.

Co-investment does not mean that the state becomes an operating oil company. ML&P certainly is not an operating oil company. ConocoPhillips operates the Beluga field. While in the early years of co-investment Norway did manage its co-investment share with an operating oil company, in 2001 the government reformed the approach significantly. Today, Norway’s co-investment share—called the State Direct Financial Interest—is managed by Petoro, a small investment company of 60 employees.

Co-investment also does not mean that the state assumes ownership of entire fields. ML&P owns only the one-third interest in the Beluga field that it acquired from Shell. On average, Petoro only owns approximately a 20 percent interest in each of Norway’s oil fields.

How could co-investment be implemented in Alaska?

There are several ways that co-investment could be implemented in Alaska. ML&P’s approach to becoming an owner in the Beluga field suggests one—the state could simply buy a share of the working interests in various fields.

Others have suggested that Alaska could gradually adopt the co-investment model by including the option in future leases.

Neither of these is likely to be successful, however. The cash levels required to purchase enough of an interest in enough fields to make a difference is prohibitive.

Limiting implementation to new leases also would not achieve the overriding objective of increasing production. As I explained in another of these columns (“Ships Passing in the Night,” Alaska Business Monthly, July 2012), a significant share of the known remaining oil and gas on the North Slope is located in existing fields, which are covered by existing leases. Limiting co-investment to new leases would miss the opportunity to reap the benefits of alignment in these fields. Moreover, it might do more harm than good, by causing the state to tilt its policies even more in favor of new leases over the old.

Finally, that approach would violate one of the basic precepts of investment. Co-investing only in new leases would concentrate the state’s investment—and risk—in the most speculative opportunities. To provide the greatest opportunity, and alignment, the state’s investment should be spread among all fields. In Norway, for example, Petoro holds an ownership interest in each field in the country.

The way to achieve this result is simple. Alaska already owns an interest—the royalty share—in each of the existing fields located on state lands. The easiest way to adopt co-investment is simply to provide for an opportunity to convert that royalty interest to a co-investment, or working interest.

Such a conversion cannot be achieved by government fiat. The terms governing the royalty share are established in contracts between the lease owners and the state. In Norway, however, the state was able to negotiate the conversion of its interests in its legacy fields from a royalty to a working interest once it decided that was a better policy course. Alaska can do the same.

There also is the question of where the responsibility for co-investment should be housed in state government. This is an important issue. Co-investment only works if the focus remains entirely on economics and achieving the best returns. Injecting political objectives into the process—such as setting as a criterion the number of jobs created by any given investment—will undermine the process and largely produce the same dissonant result as the current Alaska approach.

Because the focus should be on achieving the best economic return on investment, the Permanent Fund Corp. likely is the best home for the effort. That corporation already is skilled in co-investment. A portion of the Permanent Fund, for example, is co-invested in various real estate ventures throughout the country, with the corporation acting as a co-investor along with industry partners skilled in operating such ventures.

Creating an additional investment arm within the corporation, with a similar skill set focused on co-investing in oil, is doable and has strong precedent in Norway’s Petoro.

Isn’t it Socialist?

When I have discussed the potential for Alaska co-investment with others, their final question is usually, “Isn’t this approach socialist?” The answer is no.

This is not a situation where the state is displacing private industry. Last year, Department of Natural Resources Commissioner Dan Sullivan estimated that Alaska needs, “at a minimum,” $4 billion of investment per year if it is to arrest and stabilize the state’s production decline. Interpreted liberally, current industry investment levels are around $1.5 billion per year and there are few who believe those numbers are likely to increase to the levels mentioned by Sullivan even with oil tax reform.

Moreover, this is not a situation where the state is creating a role for itself in an industry where it otherwise is not involved. Alaska owns the oil and gas resources located on the state’s lands; it inevitably is integrally involved in their development. The question is: what management approach best develops the resource? Co-investment is a proven way to achieve that objective.

Bradford G. Keithley is a Partner and Co-Head of the Oil & Gas Practice at Perkins Coie, LLP. He maintains offices in both Anchorage and Washington, D.C., and is the publisher of the blog “Thoughts on Alaska Oil & Gas” (bgkeithley.com).