Arctic National Wildlife Refuge

Super Profits Keep Oil in the Pipeline

[Reprinted with permission from the Alaska Conservation Foundation, Winter, 1993]

With the mighty Prudhoe Bay oil field now in decline, how much longer is Alaska going to be pumping oil? Unless you become catatonic when you hear the word "oil" or you landed in Alaska yesterday from someplace other than Houston, you probably know that Prudhoe currently yields approximately 1.6 million barrels of crude oil each day. That's down from a high point in excess of 2.0 million in 1988. Atlantic Richfield (ARCO) recently announced it has halted efforts to produce its Kuvlum find in the Beaufort Sea at the edge of the Arctic National Wildlife Refuge, while Conoco just sold its Milne Point field to British Petroleum (BP), joining a host of other companies who have packed up and pulled out of Alaska. Clear signs the caboose on Alaska's gravy train is in sight, right?

Wrong! Despite what you've been led to believe, the end is nowhere near in sight. Almost from the moment in 1977 when the first drop of oil flowed through the trans-Alaska pipeline to the tanker terminal in Valdez, there have been dire warnings about pumping the "slope" dry. Some analysts believe a North Slope shutdown could occur between 2000 and 2010, whenever oil pipeline output falls below 600,000 barrels per day, which they treat as the threshold of profitability. This benchmark is based upon Alyeska Pipeline Service Company's assertion to Congress's General Accounting Office. But a 1991 report for the federal Department of Energy put the pipeline's lower limit as 300,000 barrels. The authors of that study also got their information from Alyeska! A clear reading of this factor alone could add to or cut the forecasted life of North Slope production by more than a decade. Pipeline output exemplifies the haziness concerning the economics that will determine the North Slope's future.

Back in 1977, when the nation's first arctic and only super-giant field began production, it was thought that Prudhoe would begin its decline in 1985. The decline didn't begin until late 1988. At the same time, total production forecasted for the life of the field increased from 9.6 to over 12 billion barrels. The principal reasons for these increases are the field's fecundity, knowledge gained from working the field, and technological developments in horizontal drilling and injection of water, gas, and other materials into the field enabling its producers to extract more oil than originally anticipated.

Why then do Alaska policy-makers and oil industry analysts constantly warn that the North Slope shutdown is just around the corner? One reason is that industry improved efficiency in production infrastructure and oil field management, resulting in significant declines in employment. ARCO, for example, boasted in its 1992 annual report that it had cut Prudhoe operating costs by 17 percent. It has been to industry's interest that the press has emphasized the human drama of lay-offs and cutbacks, interpreting this as evidence of a worrisome decline in oil, instead of evidence of increased operations efficiency and profitability. By and large, Alaska's reporters overlooked the fact -- reported in the same financial report -- that, during 1992, ARCO increased its after-tax earnings on Alaska production by nearly 10 percent, despite a reduction in gross production revenue. Playing on the fear of oil depletion, the industry argues that increasing costs will shorten the life of North Slope oil production, forcing the State of Alaska to look elsewhere for the $2 billion annual income it receives from North Slope taxes and royalties. In a January 6, 1992 speech to the Anchorage Chamber of Commerce, James Hermiller, then president of Alyeska Pipeline Service Company, the corporation created by the major North Slope producers to operate the 800-mile pipeline and the Valdez oil terminal, warned that North Slope production was declining, as he plugged for less environmental regulation. "If the state imposes excessive financial burdens on the owners of the production going through the line or on the pipeline system itself," Hermiller said, "the line will close sooner than later."

"We must live within our means," Hermiller said. "As throughput declines one third over the next six years and our costs are reduced by less than one third during the same period, our cost per barrel will increase. Accordingly, we must find ways to reduce costs to be able to keep the pipeline a viable economic enterprise for as long as possible in the coming years." As an example of a cost Alyeska should not be asked to bear until unacceptable harm to the environment or to public health is shown, Hermiller cited the proposal that Alyeska be required to install a vapor recovery system to prevent benzene from venting into the air near Valdez.

Benzene is a known carcinogen and the VaIdez terminal emits more benzene into the atmosphere than any other facility in the country.

Hermiller concluded his remarks with a call to action to the Anchorage chamber: "The coming decline ... can be temporary or final, depending upon what we as individuals do to promote development of other petroleum reserves throughout the Arctic ... Alaska's citizens really do affect their government's behavior with a phone call, a conversation, or a teleconference."

Here's what Alyeska's president did not say: Installation of the hard-piping system at the Valdez terminal would reduce after-tax per barrel profits by approximately one penny per barrel. This means, for example, that in the year 2000 estimated profits of $5.90 per barrel would drop to $5.89. At low and high-price scenarios, estimated industry profits would range from $4.94 per barrel to $6.39; the one cent per barrel reduction in profits for hard- piping in Valdez would remain constant. The environmental mitigation costs that the industry has spent so much effort resisting are virtually negligible when compared to total profits and the unavoidable uncertainty about the price of oil.

Hermiller is not the only Alyeska official who has warned that the costs of environmental protection measures at Port Valdez and on the oil pipeline must be weighed carefully or risk wringing the neck of Alaska's golden goose. Speaking at an international conference on energy issues in Anchorage in July 1992, Alyeska Vice President M.F.G. Williams pointed out that "there comes a time when all of those small costs [for environmental measures] become factors in future operating or investment decisions." Williams recalled his experience in coal mining to suggest that foreign coal producers seemed to undercut their U.S. competitors "by the amount we had to pay to the U.S. for mine reclamation."

There is a curious irony in the example Williams selected. The original pipeline construction permits require the pipeline owners to dismantle and remove the pipeline and its associated facilities, and to reclaim and restore the 800-mile pipeline corridor once the oil runs out. Although the exact specifications of pipeline dismantling, removal, and restoration are not stipulated, Alyeska Pipeline Service Co. has steadily collected funds through the pipeline per-barrel-of-oil tariff to pay for eventual dismantling, removal, and restoration (DR&R). The portion of the tariff for DR&R, in fact, constitutes a hidden or "off-book" cash cow for North Slope producers of uncelebrated but astonishing proportions.

Instead of requiring that funds collected against the vague legal obligation of DR&R be held in an identifiable reserve account or placed in escrow to their availability for future use, the 1985 oil pipeline tariff settlement allows the pipeline owners to co-mingle this money with internal accounts, re-invest it for profit, or distribute it to shareholders. According to the terms of the 1985 tarriff settlement, the money collected for DR&R was supposed to equal the amount required to restore the pipeline corridor to its previous condition. Due to changes in calculating factors such as inflation, tax rates, and estimated corporate earnings on internally-held funds over the 35-year estimated life of the pipeline, it has been estimated that if dismantling actually takes place in the second decade of the next century, DR&R collections and their earnings will exceed requirements by $11.7 to $22.1 billion in real (inflation-adjusted) dollars. This projected gain to the pipeline owners from DR&R profits is in excess of -- over and above -- the after-tax per barrel profits! Moreover, the desire to delay dismantling pay-outs may serve to further delay the day when it finally becomes too expensive to keep pumping oil through the pipeline.

The constant pessimism about the longevity of North Slope oil production has served the oil industry well. AII the doom has nearly eviscerated state government's capacity to ensure effective environmental regulation of oil production and transportation, and it enables the industry to galvanize public support whenever oil companies want to search for new oil deposits in pristine environments, such as the Arctic National Wildlife Refuge. Ironically, the industry has also realized that its fear mongering can be too convincing.

Shortly after British Petroleum lost its lobbying campaign in Congress to open up the Arctic Refuge, BP began a major television campaign in Alaska to reassure Alaskans that just because it had been threatening to pull out of Alaska if Congress didn't open the Refuge, BP didn't mean that it actually would! And the underlying reason BP won't pull out , the reason which the oil company would prefer to be a well-hidden secret, is the tremendous profitability of Alaska oil.

The press has done little to inform the public on the dimensions of North Slope profitability. In a lengthy front-page report in May 1993, the Anchorage Daily News explained ARCO's continued presence and prospects in Alaska this way:

ARCO is here, [CEO Lodwrickl Cook and analysts said, because it has to be: because it understands Alaska and Alaskans, because it owns so many oil leases in the state and because its enormously profitable refining and retailing system is geared for North Slope crude.

The 2'1/2 page article omitted all references to North Slope profits, which are roughly twice that of the company's "enormously profitable refining and retailing system."

One way to get a handle on Alaskan oil profits is to compare after-tax income from North Slope production and pipelining to the most profitable industrial corporations in the nation, as presented annually in Fortune magazine's "500" list of leading operations. Consider the following:

Over the last seven years, North Slope production and pipelining activities have earned after tax profits estimated at over $3 billion per year, or $6,000 per minute. These operations make so much money for their owners -- principally ARCO, BP, and Exxon, who control and jointly operate more than 90 percent of them -- that if these operations were controlled by one company, that firm would have ranked between second and fourth on the Fortune 500 list of the most profitable industrial corporations in the nation during the last three years.

Even at today's relatively low oil prices, North Slope production and pipelining income for 1993 will still exceed that of the company ranked fourth on the Fortune list in each of the last three years.

Profits in the year 2000 should exceed $2 billion in real (1993) dollars, based on the figures in the Alaska Department of Revenue's forecast scenario. These profits, although two- thirds of the current level, would still be strong enough to place North Slope operations between fourth and sixth on the Fortune list in each of the last three years.

How do we get these numbers? Let's take the 1993 estimate for example. We begin with an average price for North Slope crude oil, then subtract pipelining costs, tanker costs, state royalty, production and property taxes, and production costs. The remainder forms the basis for state and federal income tax. What's left is the industry after-tax production profit. But don't forget to add pipelining profits to that figure. Since the North Slope owners also own the pipeline, it is their stockholders who get the North Slope pipeline profits.

Estimated North Slope Production and Pipeline Profits, CY 1993
($ per barrel)

Estimated CY 1993 Average Price (thru Sept.) =$ 16.35

Pipeline, Feeder Line Tariffs - $3.00
Tanker Costs - $1.11
State Royalties, Production & Property Taxes - $3.35
Production Costs (lifting costs + capital costs) - $3.47
State, Federal Income Tax (production) - $1.96
Industry Production Profit - $3.46

Industry Pipeline, Feeder Line Profit - $1.08
Total Industry After-tax Profit = $ 4.54

Total Profit (CY 1993) = $4.54 x 589 million barrels = $2.674 billion

To look ahead to the year 2000, profits can be estimated from forecasts from the Alaska Department of Revenue. The Department of Revenue puts out three forecast scenarios to represent the range of probable economic conditions that may affect oil production and prices. Below is the profit estimate based on the Alaska Department of Revenue's spring 1993 mid-case forecast scenario. Since the Department of Revenue forecast is known in the trade as a fairly conservative one, the production and price assumptions result in a fairly conservative estimate.
Estimated North Slope Production and Pipeline Profits, FY 2000 (in 1993 $ per barrel)
[Estimated from Alaska Department of Revenue Spring 1993 MidXase Scenario]

Forecast FY 2000 Average-Price =$ 20.20

Forecast Pipeline, Feeder Line Tariffs - $2.52
Forecast Tanker Costs - 1.22
State Royalties, Production and Property Taxes - $4.10
Production Costs (lifting plus capital costs)- $4.45
State, Federal Income Tax (Production) - $2.76

Industry Production Profit $ 5.15

Industry Pipeline, Feeder Line Profit = $0.75
Total Industry After-tax Profit = $5.90

Total Profit (FY 2000) = $5.90 x 410 million barrels = $2.419 billion (1993 $)

The figures above do not include the profits North Slope owners also derive from marine transportation to the Lower 48, refining and marketing profits, or the intangible value of a stable crude oil supply for its refineries. Nor do these figures include hidden or offbook profits from Alaska operations, such as the DR&R funds discussed above.

The figures that delineate the remarkable profitability of North Slope oil production aren't published by the industry, and they're not published by the state. They should be, for they have enormous public policy implications.

It is important to note, moreover, that the state's forecast from which the FY 2000 profit is estimated assumes that production will be 410 million barrels or about 1.1 million barrels per day. Interestingly, ARCO and BP have both advised investors that they anticipate that the Kuparuk field will probably hold near current levels of 300,000 barrels per day through the year 2000.

And ARCO officials have stated that West Sak production will be used to fill gaps in Kuparuk's production. On this basis, 300,000 barrels per day in the year 2000 is virtually guaranteed from Kuparuk and West Sak. But the state's mid-case forecast for fiscal year 2000 shows combined Kuparuk-West Sak production at approximately two-thirds of that figure. The profit estimate for the low-case scenario would be about $2 billion, and from the high-case scenario about $3.1 billion.

Under these scenarios, estimated profits for state fiscal year 2000 would range between $2.0 and $3.1 billion. While we have no way of knowing what the Fortune 500 will look like in the year 2000, we can say this: For 1990 through 1992, profits of $2.0 billion would have been good enough to rank the North Slope fourth in 1991 and 1992 and seventh in 1990.

With a firm grasp on the unique profitability of Alaska's North Slope production and pipelining operations, it is difficult to take seriously the claims of those who assert that the end of North Slope production is anywhere near in sight. If North Slope profits rival those of the handful of most profitable companies in the nation, and continue to do so into the next century, what could cause the golden goose to cackle its last? The answer is: barring an unforeseen and irreversible complete collapse of world oil prices, practically nothing will cause a shutdown of the North Slope early in the next decade. And although nobody would claim a crystal ball that provides a clear picture of the more distant future, it is not at all unlikely that relatively large-scale North Slope production will continue well into the next century. The oil is there and the money is there. It's that simple.

Alaska's future is tied to oil. For this reason, it is important to correctly identify and quantify the key economic parameters within which the major North Slope producers and Alyeska formulate and eventually execute decisions regarding environmental protection measures.

While it is important to recognize that oil production will last well into the next century, rather than drying up in this century as the industry would have us believe, it is still imperative that Alaska begin planning sooner rather than later for a transition to a sustainable economy once the oil finally does run out.