Cook Inlet gas producers criticize royalty rates, others seek state funding

John Hendricks was stressed out Thursday. He temporarily shut down a well that produces 50 percent of his company's gas from Cook Inlet for state-mandated testing. The well was producing a lot of water, and Hendricks wasn't sure if gas would come back.

“We were nervous about it,” he said.

Brett Huber, chairman of the Alaska Oil and Gas Conservation Commission, said tests of the safety valve went off without a hitch. Pressure was restored to the well by Friday, allowing Hendrix to continue producing gas. Another safety test is scheduled for October, which could again expose the company to tensions.

The well test was the latest challenge facing Hendrix, owner and operator of HEX Cook Inlet LLC, a private, independent Alaskan company that leases the giant Kitchen Lite unit near Nikiski. In April, the unit produced just over 5 percent of the gas delivered from Cook Inlet for heating and power in the Railbelt.

Hendrix has been trying to drill new wells to double production at the facility, which has proven to have significant gas supplies in south-central Alaska, but he recently lost a long-running property tax dispute with the state and was dealt a blow by an Anchorage judge.

For decades, the state has valued its oil and gas assets at replacement value — what it would cost to rebuild all of its producing assets if they were suddenly lost. Hendilks wanted to change that to market value — what the assets could be sold for today.

The state valued Kitchen Lite Units at just over $81 million in 2021 and 2022. Hendrix argued the property's true value is $18 million after buying Fury Operating Co. out of bankruptcy in 2020 with the help of a state loan.

[This oil platform stopped pumping 30 years ago. Alaska still won’t make the owner tear it down.]

Hendricks had been seeking a significant reduction in his $1.6 million annual property tax payment. In a 51-page opinion May 17, Judge Herman Walker said Hendricks had failed to show why the state's assessment methodology was flawed.

“We will survive, but there will be less money going into the drilling rigs,” Hendrix said Wednesday, adding that he has not yet decided whether to appeal.

The challenges facing HEX go beyond one well or one property tax dispute. The company pays the standard state-mandated royalty rate of 12.5% ​​on its gas, plus an additional 12.5% ​​to the holders of priority royalty interests in the units. Additionally, HEX is responsible for the capital investment costs of its former owners, as required by the bankruptcy proceeding.

The company's chief commercial officer, Mark Slaughter, told lawmakers in February that the combination of these factors could effectively cost HEX a 35% profit on the gas it produces. He called these the “fundamental” problems the company faces in bankruptcy.

Hendrix said the company has applied to the state Department of Natural Resources for a reduction in its royalty payments but has not yet been successful. Approval hurdles are so high that the state has granted only three applications since 1995. The holders of priority royalty interests in the unit also have no interest in lowering their payment rates, Hendrix said.

The challenges facing independents come after Hilcorp, by far the largest producer of Cook Inlet gas, told Railbelt utilities in 2022 that the aging basin doesn't have enough natural gas reserves to offer new gas supply contracts after existing ones expire in the next few years.

Since then, power companies have suggested importing natural gas may be the best option, which could send electricity and heating bills soaring.

Enstar recently took a cautious but concrete step toward gas imports by filing an application with state regulators to expand its service area and build a pipeline to Port Mackenzie. The natural gas utility is in talks with Cook Inlet producers to secure new contracts but said it has had limited success.

[Warning of shortfall next year, Enstar takes step toward pipeline that could receive natural gas imports]

The state Legislature recently debated several measures to encourage new production. The House passed a bill that would have drastically cut royalties on oil and natural gas from the basin, but it died in the Senate. Key senators said there was insufficient evidence that giving up state revenues would significantly increase new natural gas production.

Hendrix said the plan was to invest $20 million to drill a new well this summer, but now that likely won't happen.

“If there is no royalty waiver, we will not drill,” he said Wednesday.

Hendrix has long fought to reduce state taxes, and last year the Senate abruptly repealed proposed changes to the state's oil and gas property tax assessment law that would have resulted in huge revenue losses for some localities after the political website Alaska Landmine revealed that Hendrix was behind the effort and would be its main beneficiary.

Reserve-Based Lending

Texas-based independent energy company BlueCrest Energy has 15 days, beginning June 1, to resolve issues with the state's investment bank over a $30 million loan issued in 2015.

The Alaska Industrial Development and Export Authority (AIDEA) loaned BlueCrest money to help fund the onshore drilling rig. BlueCrest still owes $13.1 million, plus interest, according to AIDEA. The loan has been restructured several times since 2015.

As of Friday, BlueCrest was in forbearance on its existing loan. The company has the option to either repay the roughly $1 million by June 16 or formally apply for a loan modification with the AIDEA board and project finance committee by then. Otherwise, BlueCrest will default on the loan.

BlueCrest President and CEO Benji Johnson said he was confident the repayment issues would be resolved.

“We have never defaulted on our debt before and we don't expect that to happen this time either,” he said on Friday.

Despite the challenges, Johnson hopes to secure more loans from the state.

BlueCrest is seeking to raise $400 million to produce gas from its giant Cosmopolitan unit, primarily to buy the platform, but also the permits it needs. The unit, located three miles offshore near Anchor Point, has proven reserves that could supply Southcentral's entire gas needs for years. But investors are having trouble finding them.

“We believe that every big bank, every big investment fund, every private fund has run out of money,” Johnson said.

Facing a $2.5 billion deficit, the Alaska Legislature ended a generous cash credit program for Cook Inlet oil and gas producers in 2017. Blue Crest relied on those credits for its business plan and hasn't drilled any new wells since 2018, Johnson said.

In lieu of royalty cuts, lawmakers approved a provision as part of House Bill 50 that explicitly authorizes AIDEA to issue state loans based on producers' gas reserves (known as reserves-based loans).

“The problem with Cook Inlet has always been capital. The natural gas is there, but we don't have the capital to develop it. And we think this proposal would break that,” Sen. Bill Wielehofsky, D-Anchorage, said in support of the proposal earlier this month.

Hendrix said Wednesday he's not interested in taking on a loan from the state because his project is “not profitable” at this time, but BlueCrest has expressed interest.

“We supported it and it's really good to see it,” Johnson said.

AIDEA officials said the investment bank currently has $180.6 million in uncommitted funds available for lending, but some of that money is being directed toward other energy projects.

AIDEA will conduct “thorough due diligence” before making any reserve-based loans, and state legislatures could allocate additional funds to help AIDEA cover loans to producers, the investment bank said.

But the idea has its detractors: the state would own the resource and lease units to operators to produce gas, essentially giving publicly funded loans to private companies, secured by its own resources.

This form of reserve-based lending is probably unique in the U.S., “so it's a very strange thing that we're doing,” said Brad Keathley, a longtime oil and gas consultant. He believes natural gas imports are inevitable, and said a 2023 Utilities Working Group report showed LNG imports could be cheaper than investing in new Cook Inlet production.

“Governments should let the market function and not try to replace it by stepping in and subsidizing outcomes,” he said.

That could lead to a worsening gas shortage in southcentral Alaska over the next few years. Analysts say policymakers have few good options to encourage local production. Willechowski said the state could demand the return of leases if operators don't produce gas. But that would likely lead to lengthy litigation, he said.

With more than 70 percent of Alaskans living in the rail belt, attention is focused on whether independent companies can rise to the challenges of filling a looming supply gap.

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