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State's consultant says nation is primed for using Alaska gas

Doug Reynolds' career choice of 20 years ago has finally gotten red hot.

Reynolds is one of a small handful of energy economists working in Alaska. And increasingly he's being asked to share his insights and research on the biggest development issue before the state: the proposed $20 billion project to move the North Slope's natural gas bounty to Lower 48 consumers.

Last Monday, he started consulting on a state contract to explore how the Alaska job market would change during and after gas pipeline construction.

In 2002, he led a team helping the Legislature understand gas markets and pipeline-construction issues, and how state taxes could aid or harm the project. The next year he published a book summarizing his findings.

The book -- "Alaska and North Slope Natural Gas: Development Issues and U.S. and Canadian Implications" -- so impressed U.S. Sen. Ted Stevens, R-Alaska, that he has distributed copies widely in Washington and Juneau, said Courtney Boone, the senator's spokeswoman.

"The senator believes Dr. Reynolds really has a handle on the economics and what needs to be done for the pipeline and for ANWR exploration," Boone said.

Reynolds, 46, is associate professor of oil and energy economics at the University of Alaska Fairbanks.

He came of age amid the early 1970s energy crisis and thought technology and engineering would solve the world's energy problems. He earned a bachelor's in mechanical engineering, studying solar energy, nuclear energy and hydro power along the way. But oil prices crashed soon after he graduated and the industry slashed payrolls and spending.

"I was disillusioned when I saw that there were actually very few jobs in energy. It was much easier to get into defense work, so I did. I worked for a defense contractor," he said.

Within a few years, the Cold War was over and defense spending shriveled. Reynolds went back to college.

"I went into economics, which is the real heart and soul of energy solutions," he said about earning his Ph.D. in economics 11 years ago.

"Now I see a lot better how much we are dependent on energy, and how few solutions we have. After all, if there were so many solutions available, then why wouldn't firms hire tons of engineers in energy and make billions off of their inventions?"

The Daily News interviewed Reynolds in early December about Alaska natural gas issues. The North Slope's estimated 37 trillion cubic feet of gas is the nation's single biggest supply of undeveloped gas. Although natural gas prices are soaring, a project to tap the Slope's gas has yet to be approved or funded.

Two pipeline routes are under discussion: one down the Alaska Highway to the Midwest and the other to Valdez, where the gas would be superchilled into a liquid then exported on tankers to the West Coast.

The biggest North Slope oil and gas producers prefer the highway route and are negotiating state tax, pipeline ownership and other issues should they decide to pursue the project.

In his interview, Reynolds spoke on which route makes more sense, the slow negotiations with the oil producers and the billions of dollars in state revenue at stake. Excerpts are below.

Q. In your book you predicted the Lower 48 will undergo a severe natural gas supply shortage as rising consumption will outstrip supplies from U.S. and Canadian gas fields. Do you think that this shortage is under way now?

A. I recently submitted an academic article on that with a graduate student in Chicago. We see about 2007 as the peak date for North American natural gas production.

One of the interesting things with natural gas, though, is that the technology is so good that reserves are being depleted much faster. This means the peak may hold out a little longer, maybe even until 2008, then it will be followed by an even sharper fall.

The bottom line is the U.S. is in big trouble. The only really easy substitute for natural gas is oil. Coal and nuclear power will take time. But oil is tight, too.

Q. With rising natural gas prices, more Lower 48 drilling is going on, liquefied natural gas, or LNG, imports are being discussed, a proposed pipeline from Canada's Mackenzie River delta gas fields is being pushed. Will there be room for a big slug of gas from Alaska?

A. Yes.

Many of my colleagues still think that it was some sort of technological revolution that caused the oil prices to decline after the 1970s. But really, we just substituted natural gas, coal and nuclear power for oil.

This time around both oil and gas will have problems.

Even though technically there are a lot of natural gas reserves around the world, unfortunately, they are government-owned reserves.

You can see what that means if you look at what happened with government-owned oil production in the 1970s: it didn't increase all that much, and that was when OPEC had no production quotas.

So all these sources of LNG are government-owned, and they will not be increasing as fast as North American natural gas supplies decline.

Domestic unconventional natural gas, such as coal-bed methane, will not be enough to fill the gap.

Q. Lower 48 natural gas prices have been above historical averages for four or five years now, which has relit the interest in an Alaska pipeline. How lasting do you think these higher prices are?

A. These prices will last and probably go up and stay high.

Oil and gas markets are both tight, and with most oil and gas reserves around the world under government control, there is not much incentive to expand outputs. Look what Chavez did with oil in Venezuela. He retroactively changed all agreements in the country. That can happen in Russia, or in any of the producer countries. Then the incentives for quick expansion just aren't there. The countries will receive high rents, but production will lag.

The thing I am surprised about is how relaxed most energy economists are about how desperate the situation is for the United States. The U.S. really needs Alaskan natural gas, and if anything it will be the U.S. Senate that will be grilling the producers on why they haven't struck a deal with Alaska so that America can get our gas.

Q. Does it matter that negotiating state terms for the Alaska gas project is taking so long?

A. I think Alaska will be impatient with the amount of time it's taking, and we might go to court over it. We can delay too and get what we want. In the end look how the Deh Cho tribe in Northwest Canada is getting what it wants (on a proposed Mackenzie River gas pipeline) by delaying.

The producers will be able to out wait us, though, and get a slightly better deal.

The problem with Alaska is there are different ideas on what we want.

But what we should do is maximize revenue to the state. What we may end up getting is an extra equity share in the pipeline, but that doesn't give nearly as much value to the state as getting more gas.

Whatever agreement we get, it will probably be about as good an agreement as we can get.

Q. What is the minimum long-term natural gas price that will provide enough profit to the North Slope producers that they will back the project?

A. Probably $5, although we saw $3.50 as feasible when we did our models for the Legislature. They disagreed with that. With steel prices higher and labor shortages in Canada, costs could be higher, requiring a higher price.

Q. If your price forecast is right, how much money annually are we talking about for the state treasury?

A. That depends on the deal we strike. If we get a fairly good progressive tax, then we can easily see $5 and $10 billion every year as oil and gas prices go above the $100 per barrel of oil mark and beyond.

My best guess is that we will be averaging $5 billion a year in today's dollars for years to come.

But $10 billion or more would not surprise me.

Q. Why do you think the Alaska Highway route for a pipeline is more likely than one from Prudhoe Bay to Valdez?

A. From an economic/engineering point of view the Alaska Highway route is the best way to go.

It goes to a very tight Atlantic Ocean market where the United States is competing with Europe for natural gas supplies. Therefore you get a higher price for your natural gas.

The Alaska Highway route has a lower cost per cubic foot of gas, so Alaska gains more of the revenue.

And the project can be completed quicker in terms of construction.

Everything else is political or legal. If another route is chosen, it is important that all the benefits of the route can be compared. For example, does Alaska want a project that offers maybe a few more Alaskan jobs, or a project that offers each Alaskan a higher Permanent Fund dividend? Probably given the choice, people would choose higher dividends.

Q. What are the main advantages and disadvantages of the state being part owner of the pipeline?

A. The question is, where will Alaska receive most of the revenue from this project? From a $2.50 tariff (pipeline-use fee per thousand cubic feet shipped) to get the gas to market as part owner of a pipeline? Or from the $7.50 per thousand cubic feet or higher wellhead (the value of the gas as it comes out of the ground)? It will come from the wellhead, and we already control that, or at least are negotiating that.

Will having ownership help Alaska extract more value somehow in terms of jobs or expanding the gas line? That is a legal or a political question.

Q. The Murkowski administration wants to take its royalty share of production and its severance tax collection from North Slope producers in the form of gas itself, called an "in-kind" payment, rather than cash. Some say taking the gas in-kind exposes the state to the risk it won't be able to find buyers for the gas at the best price. Others say selling the gas should be no problem. What do you think?

A. You can always find buyers in the U.S. now. It is just the price you receive that changes, and there are spot markets for that.

We would have a pipeline to Chicago that we would be obligated to use. Once in Chicago, the natural gas market is almost as ubiquitous as the oil market. There will be plenty of buyers and pipelines to different markets.

Q. In your book you advocate a progressive state tax structure on gas production that will bring relatively more wealth to the state treasury when gas prices are high and relatively less when prices are low. Why would this be a good idea?

A. It will maximize average revenue to the state. With a straight tax/royalty we might get say 10 percent of the final price, which is roughly $1 billion a year at a Chicago price of $5 per thousand cubic feet. Then at $10 in Chicago we would get 10 percent and get $1.7 billion.

But if the state's take were say 20 percent at $10, then we would get about $3.5 billion.

At $20 per thousand cubic feet, which is not unthinkable seeing as prices recently climbed to $15, with a straight tax and probably higher costs we would get $3 billion. But if the tax/royalty rate went to 30 percent, we could get roughly $6 billion, again due to higher costs.

Q. That could lead to wildly fluctuating state revenue. How best should that be handled?

A. This is an excellent question. Revenue will be wild, even with a straight royalty/tax. You have to put every last dime into a fund, and live off the earnings of the fund. As the fund increases, the revenue increases, and this system can cushion the budget if a slide in gas prices causes lower revenue.

Norway has a petroleum fund that is five times bigger than Alaska's Permanent Fund even though they produce only three times as much oil as we do, although they do already sell natural gas.

We need to increase our fund, and live off of the fund.

Q. What are the main factors that could derail the Alaska project to keep it from being built?

A. That is another legal or political question. The economics are there even with the risk. After all, every business endeavor no matter how good it looks is risky.

Ask yourself this, if you were a retiree and you had to invest your last thousand dollars in something for a little extra money later, would you invest in a natural gas pipeline to America? Or Cold Fusion?

And by that I mean, what technology over the last 100 years has more consistently given higher returns than oil and gas? Not computers, not telecommunications and not retailing. Even GM is close to bankruptcy. All the energy alternatives over the years have ended up going nowhere.

Natural gas is the future, and we have it. Sooner or later, we will sell it.

Business editor Bill White can be reached at bwhite@adn.com or 257-4311.

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