[A COMPARITIVE ANALYSIS OF TWO NATURAL GAS PROJECTS]

Transcription

1 2012 University of Alaska Fairbanks Ed King [A COMPARITIVE ANALYSIS OF TWO NATURAL GAS PROJECTS] The Fairbanks community is deeply dependent on oil as a source of heat and electrical generation. As the price of crude oil continues its ascent that began in 2005, the community members of the Fairbanks North Star Borough seek out ways to decouple their cost of energy from the price of crude. The most obvious and sought after solution is the delivery of natural gas to the Fairbanks area. Although this idea has been debated for over 40 years, market forces have not yet prevailed in making it happen. One reason that no solution has come to fruition is the threat of more than one major project attempting to supply the market creating an investment risk for anyone with capital willing to participate. To date, this has resulted in inaction although profits are available. This paper compares two of the competing projects in the context of whether the threat of supply competition should prevent action.

2 Executive Summary: Many project proposals have been made that could bring natural gas to the Fairbanks markets. Most of these proposals are intended to monetize the natural gas resources that are currently stranded on the North Slope. Each of these proposals carries a source of natural gas close enough to the Fairbanks market to meet local demand. Additional projects have been proposed with local demand as the target market. Two of the projects that could bring a natural gas supply to the Fairbanks North Star Borough are a trucking LNG option and a 24 diameter pipeline bringing natural gas from the North Slope to the Anchorage market. This report evaluates the potential benefit from each project in terms of reduction from the current and projected price of energy. The potential savings from each system are measured to determine if both economic incentives and household savings are possible. It then compares those factors over time to determine a net present value of each project in terms of household savings. Projections are made utilizing the Department of Labor population projection and Department of Energy oil price projection each of which end in For this reason, this report also projects forward until One of the decision points on whether or not to pursue investing in each project is the likelihood that the other moves forward. A financial risk exists if both projects progress simultaneously. This report finds that those fears are well founded. If a trucking project begins delivery to the market under a regulated utility framework, additional savings do not exist to justify the additional capital for a straddle plant and spur line from the proposed pipeline to the Fairbanks area. Likewise, a trucking project is not economic if the project does not have at least 6 years of non-competition to recover the capital investment required. Either project is economically viable on its own. However, the best response to either party moving forward is for the other to withdraw. Savings Comparison $4, $3, $3, $2, $2, $1, $1, $ $ Savings Combined Savings with Pipeline Savings with Trucking Figure 1: Annual household savings achieved versus no project being completed

3 Although the pipeline does deliver lower cost fuel, the trucking project is superior to the pipeline for all discount rates over the 20 year range, primarily due to the lag in delivery between the projects. This provides the trucking option the ability to reduce electrical generation costs across the borough with a 5 year lead time as well as the ability to make natural gas available for tier 1 households prior to first gas from a pipeline. NPV Pipeline NPV Trucking NPV Combo 0% $43, $46, $46, % $26, $29, $29, % $19, $22, $22, % $14, $17, $17, Table 1: net present value of projects to the residential customer It was determined that the most probable and advantageous project is the trucking project, especially if there is sufficient cause to doubt the timely completion of a larger scale project. Therefore, the decision of whether or not to support or invest in a trucking project is not contingent upon the actions of a pipeline proposal. In should be supported without respect to that decision, so long as there is at least a 5 year gap in first gas. It was also determined that if both projects were conducted by a single entity able to shift some of the trucking project capital costs into the future following a pipeline construction, further advantages could fall upon the consumer base. Such a situation allows flexible supply delivery to increase with delivery system build-out, which improves the economics of a pipeline by completing conversion prior to pipeline gas delivery. Such a system shifts future savings into the present and creates a greater benefit to residents than either project on its own.

4 Introduction: A dependence on diesel fuel developed in Fairbanks as the extraction and delivery of oil grew in the 1970 s with the construction of the Trans-Alaska Pipeline System (TAPS). After TAPS was put into place in 1977, access to energy for the military vehicles and aircraft, commercial airlines, and residential heating needs became greatly increased. As this pipeline brought oil through Fairbanks on the way to the ocean port at Valdez, the transportation cost to bring that oil to Fairbanks was subsidized. Being accessible and affordable, it made economic sense to develop infrastructure utilizing that oil to meet energy needs as it passed by. Since 2005, the price of crude oil has grown at an alarming rate. The dependence on oil products for heat and electrical generation created hardship for residents. With a short-run demand near perfectly inelastic, the cost of energy put tremendous pressure on the households while simultaneously providing surpluses in the state budget. Residents began putting pressure on elected officials to find a solution. With the goal to reduce the total energy cost to a household, local and State governments have already implemented programs to promote increased efficiency and reduced heat loss through change out and winterization programs. Currently, debates revolve around what level of involvement the governmental bodies should play in reducing the cost of the fuel source. Many projects have been proposed to find an alternative to the use of oil. Most of them focus on introducing a greater supply of natural gas. However, the population is small in comparison to urban centers around the country. With such a small population to serve, large volumes of demand do not exist to make huge capital investments profitable. Unfortunately, most major project proposals require huge investments in capital as well as tedious bureaucratic processes in which the competing interests of those involved tend to muddy the picture of what should be pursued. To add complexity to the situation, all of these projects have a variety of benefits to offer and often address more than one problem concurrently. The inability to separate the value of each proposal creates an environment in which progress is impeded. This report seeks to compare two of the proposals and their merits in a way that can provide clarity to the situation at hand. Current Energy Demand: The energy demands of Fairbanks are met by an electric cooperative, three refineries, and a fragile shipping route. A large portion of this energy is derived from the oil that is produced 500 miles to the north and sent through a 48 inch pipe to an export terminal. An off-take provides up to 220,000 barrels per day to Flint Hills Refinery and 22,000 barrels per day to Petro Star Refinery in North Pole. These refineries now produce at a level well below that capacity as production has declined on the North Slope. These two local refineries now process between 35,000 and 70,000 barrels per day of that oil into home heating fuel, jet fuel, vehicle grade gasoline, and middle distillates which the power company uses to produce electricity (FHR ; PetroStar). Additional unmet demand for liquid fuels is supplied by the refinery operated by Tesoro located in Kenai, Alaska (Tesoro). In rare cases fuel is imported from either Canada by truck or by ocean barge, typically from Seattle.

5 Electrical Demand: The company that powers the Interior, known as Golden Valley Electric Association (GVEA), has ownership interests in six production facilities around the State as well as the ability to purchase power off of the intertie which connects the Fairbanks and Anchorage markets. 29% of the energy sold to Fairbanks area residents is purchased from the intertie. That power is generated from natural gas available in the Cook Inlet area. Another 14% is generated from a GVEA coal plant near Healy that utilizes the large quantity of coal available from the Usibelli Coal Mine. This coal provides a much lower price per kilowatt hour produced than any other source and acts as a production baseline, operating at capacity most of the time. Figure 2: Relative fuel costs over time Source: PetroStrategies, Inc. For this same reason, the University of Alaska Fairbanks and the military installations also generate their own power from coal. The use of crude oil distillates, hydro and wind projects, are used to fill any void beyond that baseline. In 2010, 38% of the Fairbanks area power needs were met by burning naphtha produced at the Flint Hills refinery in North Pole (GVEA 2011).

6 Fairbanks Electricity Fuel Source Natural Gas 29% Coal 28% Diesel 38% Hydro 5% Figure 3: sources of electrical generation for the Fairbanks market Source: GVEA 2011 Annual Report (GVEA 2011) The ability to supply electricity to the Fairbanks market carries a much higher cost than most communities face. The average Fairbanks resident uses around 700 kilowatt hour (kwh) per month and pays around $0.24 per kwh. That rate is subject to the volatility of the price of oil as a result of increase feedstock costs. Heating Demand: For the purpose of this analysis, we utilize the findings from the Cold Climate Housing Research Center that an average home in Fairbanks has 1,886 square feet of interior space and requires approximately 160 Million British Thermal Units (MMBTU) to overcome the nearly 14,000 degree days within a given year (Insights 2009). For the purpose of this report, the estimated heating needs of an average house can be met one of the following quantities which translate to the associated total cost at current market prices. Natural Gas 160 MCF $3, Heating Oil 1,183 gallons $4, Wood 13 cords $3, Electricity 38,280 kwh $9, Propane 1,652 gallons $4, Coal 19 Tons $2, Table 2: Required amount of fuel and cost required to meet average home heating needs Natural gas has become increasingly attractive across the country as the supply glut of new production in the continental states has decoupled natural gas prices from oil and has driven prices to very low levels. While the majority of US residents now enjoy access to cheap natural gas for home heating,

7 cooling, and electrical generation, Fairbanks does not. About 86% of the home heating needs in Fairbanks are still met with home heating fuel, compared to only 6% of the rest of the county. As the price of heating oil is tied directly to the price of crude oil, natural gas is now much more attractive. Figure 4: Heating oil and crude oil price correlation (cents per gallon) While some natural gas has found its way to the Fairbanks market, only 1.3% of residential heating needs are currently being met with it. One challenge comes from the fact that these products are in a gaseous state at surface temperatures and one atmospheric pressure. Therefore, additional effort must be applied to transport the gas under compression and at lower temperatures. This additional effort implies additional costs including heavier tanks that must be transported at an additional cost. To overcome these costs, the spread between the pre-transportation costs must be very favorable to result in net savings. As the price of oil has increased rapidly since 2005, it has widened that gap in relative price, making it much more attractive. In fact, because heating oil is the closest substitute, profit potential exists if it can be delivered at a price below the burner tip price of oil. And, because the market share captured is small, the profit incentive for oil producers to reduce prices to recapture that share is not positive. As a result, Fairbanks natural gas users realize a savings of about 10-15% over oil. An additional result of the high cost of fuel oil is a reversion back to burning wood or coal. While about 10% of heating demands are met from burning wood or coal, most of these are secondary heating sources supplementing an oil fired boiler. The potential savings from wood or coal can be large as a cord of wood costing about $250 can offset up to 100 gallons of fuel oil. Additional out of pocket

8 expenses could be further reduced by cutting, splitting and collecting wood directly. Despite these possible savings, the share of wood in the energy mix is relatively low. This indicates that a premium exists for heating oil over the same energy content of wood. This may include the internal value of additional labor, the ease of use of liquid fuels, and the social stigma of higher polluting fuel. Transportation: Gasoline is a major component of the household energy budget. Fairbanks residents consume about 35 million gallons of gasoline per year to operate 67,004 registered passenger vehicles according to the Department of Transportation (DOT 2011). At a current retail price for gasoline of $4.25 per gallon, transportation costs add $4,300 to the residential annual energy budget. That gasoline is sold to retailers from three in-state refineries. Sourdough Fuels refines their own product at the Petro Star refinery in North Pole. Holiday gas stations purchase their signature brand known as Blue Planet from the Flint Hills refinery in North Pole. Tesoro is supplied by their own refinery in Nikiski. The remaining retailers purchase their products wholesale from one of these three refiners, the majority of which comes from the Tesoro refinery (AAG 2008). Bringing supplies of natural gas to Fairbanks is not expected to reduce the cost of transportation fuels. This is mainly due to market structure. Any cost savings that are found by converting refining processes to natural gas are likely to stay with the refiner as there is not an incentive to reduce prices in order to increase volume. For this reason, transportation costs are held constant across projects and will not appear in the rest of this report. Projections: The Fairbanks population has grown considerably since the 1920 s. Due to the increased absolute number of people now burning wood, oil, or coal for heat, along with the increased population density, the exhaust output is concentrated. Compounding this fact is a unique situation found in the valley area of Fairbanks in which a temperature inversion traps those pollutants from dispersing. This results in particulate matter greater than 2.5 micrometers in diameter (PM2.5) being suspended in the air which residents breathe. Health studies have shown strong correlation between exposure to air high in particulate matter and serious respiratory and circulatory dieses (Ayres 2009). In response, the EPA has issued a designation of non-attainment over the Fairbanks and North Pole areas. Due to the higher levels of chemical composition which generate particulate matter in wood and coal, as well as the higher levels of these compounds that find their way into the air through exhaust from these systems, it is expected that higher oil prices would translate to higher PM2.5 levels by way of increased wood and coal burning, especially if that burning is not conducted responsibly. In order to mitigate that, regulatory action is expected to prevent a large conversion to wood or coal and will limit economic growth in the form of denying permits for new commercial or industrial activity that would add to the environmental burden. The combined economic and environmental hardship puts pressure on the population. Fairbanks has gone through a series of population growth and decay cycles in its history. The main drivers of population change have stemmed from military spending and resource development. While birth rates

9 have exceeded death rates throughout the recent history, net migration levels have not always been positive. In fact, net migration has been negative since 2000, but by less than the natural growth rate. The result is a population growth projection of 0.5% per year going forward (DOL 2009). However, this projection is highly uncertain. Decreases in military spending, increased economic activity in the rest of the country, and rising cost of living in Fairbanks all point toward higher levels of out-migration and lower levels of in-migration. This uncertainty is especially high due to the current young population which is much more likely to migrate. For this reason, the business as usual scenario could easily result in reduced opportunity, lower populations, and even higher costs in the future. The future price of oil is also highly uncertain. Since 2005, the price of a barrel of crude oil has increased well beyond the expectations of any forecasts. This is attributed to a combination of events that occurred including disruptions to supply channels and growing demand. The future technological advances that will drive the demand for oil versus other fuels, as well as the future costs of production, are far from known. This is evidenced by the extremely wide prediction range by the Energy Information Agency as well as the volatility of the futures market. This report will utilize the midpoint projection from the EIA of 2.6% real price increase in the cost of crude oil as a neutral value. Figure 5: Oil price projection Source: Annual Energy Outlook 2010 (EIA 2010)

10 Methods: This report begins by establish the demand for natural gas in the Fairbanks market utilizing published work and collected data. A baseline projection of future energy burden will be established utilizing a model built based on the information collected and the assumptions outlined above. Each project is then compared to the baseline in terms of normalized assumptions of financing costs, wellhead price, capital life and demand. The cost of money is assumed to be 12% regardless of how that money is procured. This represents either a return on investment or an opportunity cost and is defined as the allowable profit margin by the RCA. While oil and gas prices have decoupled in the lower 48, it is not the case for the rest of world, including Alaska. Wellhead price is assumed to be available under contract that is tied to the price of oil. That price per MCF is assumed to be 4.5% the price of a barrel of oil based on ISER reports derived from DNR royalty data (DNR 2010; Schworer 2010). All production and pipeline capital is assumed to have a life of 30 years and is depreciated over that time. After the cost of each project is established, the competitiveness of each project is tested against the other. Demand: Residential Space Heating: The 2010 US Census estimates the FNSB population at 97,581 individuals occupying 34,596 households (Census 2010). Based on the estimated average household fuel requirements, the entire Fairbanks area requires about 15,530 million British thermal units (MMBTU) per day to produce habitable living conditions. If all of these heating needs were meet by natural gas, and assuming that a heating system on either fuel is equally efficient, it would require approximately 5.7 billion cubic feet (BCF) of natural gas per year to meet the needs of the community. However, the reality of converting all of these residential units to natural gas is an unreasonable assumption. In order to distribute the gas to the end user, a fair amount of population density is required to make a distribution system economic. Table 3 is a population break-down by census designated place (CDP) of the North Star Borough. The census includes Fort Wainwright in the population count for the city of Fairbanks and was separated out manually.

11 Population by CDP 2010 Pop Estimated Housing Units Tier Fairbanks (city) 24,161 8,566 1 Badger 19,482 6,907 2 College 12,964 4,596 2 Fort Wainwright 7,374 2,614 3 Steele Creek 6,662 2,362 3 Chena Ridge 5,791 2,053 3 Farmers Loop 4,853 1,721 2 Goldstream 3,557 1,261 3 Eileson Air Force Base 2, Ester 2, North Pole (city) 2, Salcha 1, Undesignated Places Moose Creek Pleasant Valley Two Rivers South Van Horn Fox Harding Lake Total: 97,581 34,596 Table 3: Population by CDP in the FNSB Source: 2010 US Census (Census 2010) Northern Economics is currently is the process of compiling a natural gas distribution study for the Fairbank North Star Borough (Burden 2012). That study suggests that the most economical and efficient distribution system will consist of a trunk line running from the supply point, through the city limits of Fairbanks, and along the Richardson Highway to North Pole in order to serve large industrial users. This system will tie into the existing distribution system that currently services 463 residential and 656 commercial users including the University of Alaska Fairbanks and the Fairbanks Memorial Hospital. The areas that are most likely to benefit from a gas distribution system the soonest are labeled as tier 1. These are areas either already connected or that are likely to provide the most economic benefit for a LDC in the short run due to the density of the potential users or the proximity to the established trunk line. Once that distribution system is in place, the areas in which the marginal benefit of organic expansion is positive are labeled as tier 2. This includes running transmission lines down Geist road to Chena Pump Road and lower Chena Ridge neighborhoods, around Farmers Loop, and around Badger Road. The remaining areas which are limited due to low population density or distance are not likely to provide positive net benefits from expansion. Therefore, these areas are labeled tier 3 and are not

12 expected to convert. This includes the military installations that are not likely to convert from the existing district heating systems generated from coal due to economic considerations. Figure 6: Population density map of the Fairbanks North Star Borough available at The high density areas around the city boundaries of Fairbanks and North Pole account for 26,278 (27%) of the borough residents. Another 37,857 residents live in the medium density areas consisting of more than 100 and less than 500 people per square mile surrounding the city centers. Together, this accounts for two thirds of the total population. The remaining structures are not within the realistic range of supplying natural gas via a distribution system. The number of residents willing to convert from the current system to a new fuel source is a function of potential savings. As a general rule, a customer will switch if the cost of conversion is recovered within three years (Dismukes 2002). The cost of converting a fuel oil burner to a natural gas burner is

13 estimated at $3,000. For an average sized home using 160 MCF per year, the required savings would be approximately $6.25 per MCF. To establish an upper bound, the demand numbers for 100% market penetration over 5 years are established. The penetration rate of natural gas is assumed to occur at equal intervals to reach full conversion within 5 years of gas being made available to them, provided that a three year payback rate is achieved and savings are expected to continue. The following chart is a projection of demand based on this assumption. Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Tier ,234 4,004 5,775 7,546 9,317 9,317 9,317 Tier ,684 5,369 8,053 10,737 13,422 Demand (BCF/year) Table 4: Estimated households on natural gas assuming 100% penetration in 5 years These amounts are based on a static population converting to natural gas from heating oil. By utilizing the assumed population growth of 0.5% per year, the demand number is slightly higher. Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Tier ,280 4,098 5,916 7,734 9,552 9,600 9,648 Tier ,779 5,626 8,474 11,321 14,170 Demand (BCF/year) Table 5: Estimated households on natural gas assuming 100% penetration and.5% population growth Commercial and Industrial Space Heating: The need to heat commercial and industrial space is also a significant need. As they are typically larger spaces with higher ceilings and more heat loss, their significant volumes and access to capital encourage these units to take advantage of costs savings. For this reason, these users will switch fuels at a smaller relative price, allowing the LDC to charge a price closer to its substitute. This explains why only 8% of FNG sales are to residential units and only 5% of the accessible residential units have natural gas. On the other hand, 42% of commercial and industrial structures (654 of 1,549) use natural gas. FNG customers MCF / year sold percent of sales Number of customers Residential 63,515 8% 463 Small Commercial 431,998 53% 622 Large Commercial 192,171 24% 32 Hospital 107,892 13% 1 UAF 13,410 2% 1 Total: 808,986 Table 6: 2009 sales data for FNG

14 Although it is likely that the companies that have converted are the largest, and therefore the remaining customers will use less, an extrapolation can create an upper bound. If the rest of the structures were to convert and use a similar average amount, it would imply an available market for an additional 1.2 BCF/year for a total non-residential heating demand of 2 BCF/year. The estimate is consistent with the estimate put forth for the Department of Natural Resources in their in-state demand study which projects 1,291 customers using 2.1 BCF per year for commercial and industrial heating (Dismukes 2002). Newer studies from Northern Economics estimate the potential heating demand from these sectors as high as 7.5 BCF/year for 1,549 users (Burden 2012). Industrial Usage: Industrial usage for refining and electrical generation is the largest potential use for natural gas. Many studies on the demand for natural gas in the interior have pointed to conversion of the refining operations and the generation of electricity. There are three high potential industrial users in the North Star Borough. The first is the Flint Hills refinery in North Pole which produces light end hydrocarbon products such as gasoline, heating oil and jet fuel. This refinery currently uses its own products as an energy source for the refining process of its products and could utilize 3.5 BCF/year of natural gas as a substitute at current production levels. In addition, Flint Hills produces naphtha for the GVEA power generation plant in North Pole. GVEA is looking to convert the expensive naphtha burning turbine in the near future. Instead, the 60 MW GT3 combined cycle unit would utilize natural gas for electrical generation. The current unit is estimated to burn approximately 22.6 million gallons per year of naphtha (Burden 2012), which is roughly equivalent in energy content as 2.8 BCF/year of natural gas. Converting this turbine from naphtha to natural gas is expected to save several million dollars to GVEA, which will translate to savings to the rate payers. The third potential large user is the other refinery in North Pole own and operated by the Arctic Slope Regional Corporation (ASRC) under the name Petro Star. If the Petro Star refinery were to switch to natural gas for their distillation towers, an additional demand of up to 1.3 BCF/year could be generated. By converting these three industrial users, up to an additional 7.6 BCF/year could be required. Several other industrial users could potentially be added, however they are less likely to convert. The two military installations, the University of Alaska Fairbanks, and Aurora Energy all currently use coal to generate electricity and operate district heating systems. The cost of operating these systems on coal in Fairbanks is far cheaper than natural gas can provide. Therefore, economic incentives do not exist for such a switch to occur. Other potential users could include a petrochemical facility or the addition of mining operations in the future. However, for establishing a baseline projection for likely usage, these options are not included.

15 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Tier Tier Commercial and Industrial Heat Refining and Electrical Generation Total Demand Table 7: Total demand by sector in BCF/year with 100% penetration and.5% growth Many studies have been conducted on the expected demand of the Fairbanks area, each of which has made different assumptions and have generated a wide variety of projections. The figures above represent the total demand in the market given current conditions and assumptions. Commercial and industrial space heating conversions are expected to occur at a faster rate than residential units due to scale and capital access. Full market penetration is expected to occur within 3 years at even intervals. Refining and Electrical generation are held constant due to uncertainty in further conditions including declining access to crude oil as North Slope production declines. The final table in this section is a future fuel oil price projection over the relevant term and the required relative price of natural gas required to induce conversion. The fuel price projections are based on EIA forecasts of 2.6% real price increases throughout the relevant range. Fuel cost (gallon) Fuel cost (MMBTU) Max Natural Gas Price Willing to Pay (MCF) 2012 $3.86 $27.87 $ $3.96 $28.59 $ $4.06 $29.34 $ $4.17 $30.10 $ $4.28 $30.88 $ $4.39 $31.69 $ $4.50 $32.51 $ $4.62 $33.35 $ $4.74 $34.22 $27.97 Table 8: Price projections and maximum price of delivered natural gas to entice conversion

16 Proposed Projects: Because the price of oil has accelerated much faster than the price of natural gas, the spread in relative price makes way for potential profits by increasing the amount of natural gas available in Fairbanks. Since 1998, a local distribution center (LDC) called Fairbanks Natural Gas (FNG) has delivered natural gas to Fairbanks via tanker trucks from the Anchorage market. FNG owns a liquefaction facility near Wasilla with a processing capacity of about one billion cubic feet (BCF) per year. After purchasing raw gas from Cook Inlet producers and shipping the natural gas through the Anchorage area LDC transmission system, FNG processes and trucks the liquefied natural gas (LNG) to Fairbanks. The most recent available data shows that FNG sold about 0.8 BCF in 2009 (Burden 2012). FNG s pricing of the LNG they sell appears to be highly correlated with the price of heating oil. Although FNG is not rate regulated by the regulatory commission of Alaska (RCA), they do price their product such that savings exist over heating fuel, typically around 85-90% of the price. FNG is not taking on additional customers at this time as they are supply constrained. Therefore, organic build-out of the distribution system is stalled until additional supply is available. Many ideas for increasing supply have been proposed. For the purpose of this report, two of them will be evaluated. The first is an increase in trucking natural gas via a new production facility drawing gas off of the North Slope basin. The second is a spur line to connect Fairbanks to a proposed 24 inch diameter gas line connecting the North Slope basin to the Anchorage market, bringing the natural gas within 60 miles of Fairbanks as it passes. The next section will develop the market conditions for a business model in either of these cases. Then, each project will be developed based on construction costs and timelines to evaluate the ability to deliver the product at the required price. Trucking plan: In early 2008, FNG contracted with Exxon for a gas purchase on the North Slope. This was in response to dwindling supply in Cook Inlet causing prices to rise and putting the security of future supply at risk. FNG proposed to build a LNG processing facility on the North Slope and truck the product 500 miles down the Dalton Highway. Concerns were raised by state legislators about the implications of this action on the consumers that had already committed the capital to convert of natural gas in the Fairbanks area. The RCA was asked to investigate the impact of these actions on the consumers, the risk associated and the proposal, and the concern that if this more capital intensive process was profitable, then the current system was likely generating excessive profits. The RCA conducted an investigation and found that economic regulation was not in order. A large component of that decision came from the fact that FNG was charging a price below the nearest substitute, heating oil. Due to the high degree of capital required relative to the asset base of FNG, public support was sought to reduce the financial burden of the project. Public officials already interested in diversifying the energy base for residents became interested. In the late 1990s, three Alaskan boroughs formed an

17 entity known as the Alaska Gasline Port Authority (AGPA) under Alaska Code in order to encourage the desire for Alaskan resources to be developed in a way that benefited Alaskans. In 2010, seeing this trucking option as the only short-term solution to the challenge of bringing natural gas to Fairbanks, AGPA put together a plan to purchase FNG, complete the trucking plan, and operate the business as a non-profit, quasi-government entity. For a recoverable investment of $250 million, an additional 7 BCF per year could be delivered to Fairbanks within 2 years. Many objections began to surface, including concerns about the valuation of FNG, the legal authority of APGA in this role, and the ideological concern over the fact that the government was attempting to do something that private enterprise already expressed interest in doing. These concerns were enough to halt the project temporarily while the FNSB assembly decided on the issue. Instead, they opted not to take action on their own, but rather put it to a vote of the people on the October 2011 municipal ballot. Confident that the project would move forward and funding would be available, FNG began investing money in the early construction phase on the North Slope so that further delays could be prevented (Britton 2011). However, the project was conditioned on the expectation that GVEA would purchase about 3 BCF for electrical generation and Flint Hills would purchase up to 3.5 BCF for refining processes. These anchor clients would provide enough economies of scale to make the project viable, but would purchase the fuel with mark-up. With the possibility of the public not supporting the idea, these anchor clients began working the numbers themselves. By September 2011, Flint Hills and GVEA had announced that they were moving forward with the project on their own. Without the anchor clients, AGPA lost faith that the value existed for their purchase proposal and withdrew consideration. FNG has since put in an environmental impact survey on a small pipeline to deliver gas from a production well to their proposed processing plant. While Flint Hills and GVEA are in the process of their own pre-construction engineering, it appears that FNG has decided not to give up on the idea. On March 9 th, 2012, the RCA issued a certificate that allowed FNG to complete the 3.8 mile pipeline to the proposed processing facility (Lidji 2012). The trucking plan entails a contract with a producer, a delivery method for unprocessed gas to a processing plant, the construction, operation and maintenance of a processing plant, separation facility and liquefaction plant, storage and transfer area to tankers, the purchase of tankers and trucks, and labor, insurance, maintenance, and fuel for the trucks. The infrastructure at the receiving end includes increased storage, a re-gasification system and a distribution system build-out. Many of these costs have been estimated and made public during the AGPA effort to garner support. A typical tanker can carry between 8,500 and 10,000 gallons of liquid fuel, depending on the amount of space required to allow for expansion for safety reasons. This corresponds to approximately 700 MCF of LNG per truck. Because the tanker always delivers the same amount of LNG per trip, the price per MCF is static for any available level of delivery. The cost associated with each truck is a capital cost of $500,000 plus an estimated $180,000 in annual expenses including maintenance, insurance and labor,

18 and an additional round-trip fuel cost of about $700 ($3.50 per gallon, 1000 miles, 5 miles per gallon). Assuming that the truck travels in one direction each day, each truck delivers a maximum of 127,400 MCF per year. Capital Cost $ 500, Cost of Money 12% Life of Capital 5 Years Annual Payment on Capital $ 138, Annual Costs O&M $ 180, Fuel Cost per Trip $ Number of Trips 182 Annual cost of Fuel $ 127, Total Annual Costs $ 446, Volume of Product (MCF/YR) 127,400 Cost per MCF $ 3.49 Table 9: Added cost associated with transportation via truck The processing plant that is under consideration is a module type configuration that is transportable and expandable (Britton 2011). The 7 BCF/year target can be achieved with two module trains, at an installed cost of $125-$185 million. Using the upper limit, a 12% cost of money and a 30 year amortization schedule, the annual cost of capital is $22,966, Operating and maintenance costs are less well defined. Estimates for O&M include labor costs, heating, electrical, insurance, and routine repair. Standard estimates for utilities are around 2-3% of the capital cost, although costs can be significantly higher. Plant Annual Capital Payment $22,966, Plant O&M $5,550, Total Annual Cost $28,516, Volume (MCF/YR) 7,000,000 Cost per MCF $4.07 Table 10: Added cost to pay for processing plant The combined costs of a processing plant and roadway delivery system add at least $7.56 per MCF to the wellhead cost of natural gas. This price is significantly higher when efficiency loss is accounted for due to unstable demand over the course of a year. For example, at least twice as many trucks are needed in the winter time than in the summer. This drives up the cost of capital, although the marginal costs of fuel and maintenance are not incurred. A reduction to 50% efficiency in truck capacity results in an additional $2.56 per MCF. Similarly, the plant will not produce at capacity during the off-peak seasons and higher average costs can be expected. The 7 BCF volume anticipated suggests that industrial uses by GVEA and Flint Hills may be met, but very small amounts of additional supply would be available for residential use. Because of the module type configuration of the processing plant rather than a larger individual structure, it is assumed that additional modules can be added at constant returns to scale, if also producing at capacity. By adding

19 two more modules the cost and volume are both doubled to meet the total demand and average cost does not change. Although the additional capital cost does complicate financial structure, it is not assumed to impact average unit cost in this analysis. In-State Pipeline: The greater Anchorage area, including the Mat-Su valley, has benefited from their proximity to the Cook Inlet Basin since 1961 when the first gas production well went into operation. The added fortune of that resource already being commercial quality resulted in an incredibly low cost of energy. The combination of government subsidies to encourage exploration, tax credits to maintain production, little to no transportation or processing costs, and access to an ocean port, made life in Anchorage sheltered from the difficulties that the rest of the state faced. In 2010, the state legislative body realized that situation was approaching its inevitable end. The attractiveness of the lower energy costs attracted businesses as well as people. Economic and population growth greatly increased the demand for the resource and it was beginning to run out. Projections showed that there could be a shortage in the system, significant enough to be unable to meet the needs of the population, as early as In response, the state elected officials took two major actions. First, they instituted additional economic incentives for exploration companies to look for more gas in the Cook Inlet (AP 2011). This included a $25 million reward to the first jack-up rig to drill an exploratory well. The geology of the basin had been studied by the USGS and estimates of up to 19 TCF of remaining natural gas were published (USGS 2011). In November 2011, an exploration company announced that it had made a significant discovery of up to 3.5 TCF of natural gas. Concurrently, in the 2010 legislative session, the House also passed a bill that was intended to expedite the process of moving natural gas from the North Slope to offset the diminishing Cook Inlet supply. House Bill 369 created the Alaska Gasline Development Corporation (AGDC) as a State agency to move this project forward. An enormous amount of effort has been put into identifying the best way to produce the resources for the maximum benefit of the citizens of Alaska. The pipeline project proposed in response to HB369 is one that had been considered for many years. With the declining production of the mature oil fields on the North Slope along with the gas fields in Cook Inlet, the circumstances for developing such a project began to appear profitable. Enstar began studying the potential and their project is now being used as the foundation for the AGDC proposal known as the Alaska Stand Alone Pipeline (ASAP). The advantage of this project for Interior Alaska, specifically Fairbanks, is that the project moves a supply source closer to the community. This allows much more room for future expansion if new demand is generated in the future. Also, the increased volume that flows past the FNSB should create economies of scale and the buyers at the other end effectively help subsidize the transportation cost. This allows a small diameter pipe that can meet the needs of Fairbanks to be built only miles, rather than 500 miles. This should provide savings to the users in the area relative to the entire length of the pipe to the North Slope. However, these savings are contingent on the price of natural gas at the

20 straddle plant. If significant costs of the large pipe are passed on to the Fairbanks residents, savings are much smaller. Therefore, either the Fairbanks area is considered part of the entire project and shares the costs and benefits along with the rest of the market, or it is independent of the project and is simply a consumer. Processing Plant and Facilities on North Slope $ 2,790,000, Pipeline to Dunbar $ 3,410,000, Fairbanks Straddle Plant $ 210,000, Fairbanks Spur line (12", 60 miles) $ 60,000, Pipeline from Dunbar to Big Lake $ 1,430,000, Extraction facility and additional costs at terminus $ 570,000, Cost of Money 12% Life of Capital 30 Years Annual Payment on Capital $ 1,051,496, Annual O&M costs $ 254,100, Total Annual Costs $ 1,305,596, Volume of Product (MCF/yr) 182,500,000 Cost per MCF $ 7.15 Table 11: Estimated added cost from 24 pipeline at full capacity of 500,000 MCF/day, all costs shared (ASAP 2011) Alternatively, if the pipeline is built with the Anchorage market as its target and the capital to bring the gas to Fairbanks is bore by the Fairbanks customers, the price at Fairbanks is increased. Processing Plant and Facilities on North Slope $ 2,790,000, Pipeline to Dunbar $ 3,410,000, Cost of Money 12% Life of Capital 30 Years Annual Payment on Capital $769,690, Annual O&M $ 186,000, Total Annual Costs $ 955,690, Volume of Product (MCF/yr) 182,500,000 Tariff on gas at Dunbar $ 5.24 Fairbanks Straddle Plant $ 210,000, Fairbanks Spur line (12", 60 miles) $ 60,000, Annual Payment on Capital $33,518, Annual O&M costs $ 8,100, Total Annual Costs $ 41,618, Volume of Product (MCF/yr) 12,470,000 Cost per MCF $ 3.34 Total added cost (per MCF) $ 8.57 Table 12: Estimated added cost per MCF if Fairbanks is separate

21 Costs of Production and Delivery Tansporting to Fairbanks Extracting at Dunbar Processing costs Tranporting to Dunbar Figure 7: Cost breakdown of separated pipeline delivery system to Fairbanks When costs are shared among all Alaskans, the Fairbanks area receives a savings of about $1.42 per MCF over when they are treated as a consumer. The additional volume delivered to the Fairbanks area reduces the average cost of North Slope processing and the transmission across half the state. Without including the additional cost of delivering to Fairbanks on to the total project, and removing the Fairbanks demand from the system, the estimated tariff in Anchorage would be approximately $7.43. By adding the volume of demand for the Interior, all parties benefit from economies of scale, reducing the statewide tariff to only $7.15. When all volume is accounted for and priced separately, the Anchorage market benefits greatly with a reduction in price to only $6.93 while Fairbanks pays $8.57 despite being geographically closer to the supply source. Scenario 1: Utilizing the assumptions made thus far projections of energy costs to an average Fairbanks home can be determined. The following is a projection of population, electrical demand, and heating costs for the next 23 years. Population projections are based on the Department of Labor statistics which estimate a further growth of.5% per year. Fuel price projections are based on EIA data and a future price projection of 2.6% per year in real terms. An electrical generation price model was created based on publically available data and increases in demand from population growth are assumed to be met with diesel fuel power generation for the relevant range. This scenario estimates the average household energy burden assuming that no new projects or alternative energy sources are brought on line. This estimate also holds fuel consumption behavior constant under the assumption that social and political pressure will prevent major switching into solid fuels. Some wood and coal usage is allowed to occur in the same proportions as currently observed as

22 population increases. This scenario also assumes that in light of new Cook Inlet discovery, the existing LNG delivery system will remain intact, but no new supply is allowed. Population Average Home Heating Avg Electric bill Total Energy cost Percent of Income on Energy ,581 $4, $1, $6, % ,069 $4, $1, $6, % ,559 $4, $1, $6, % ,052 $4, $1, $6, % ,547 $4, $1, $6, % ,045 $4, $1, $6, % ,545 $4, $2, $6, % ,048 $4, $2, $6, % ,553 $4, $2, $6, % ,061 $4, $2, $6, % ,571 $4, $2, $7, % ,084 $5, $2, $7, % ,600 $5, $2, $7, % ,118 $5, $2, $7, % ,638 $5, $2, $7, % ,161 $5, $2, $7, % ,687 $5, $2, $7, % ,216 $5, $2, $7, % ,747 $5, $2, $7, % ,280 $5, $2, $7, % ,817 $5, $2, $8, % ,356 $5, $2, $8, % ,898 $6, $2, $8, % ,442 $6, $2, $8, % ,989 $6, $2, $8, % ,539 $6, $2, $8, % Table 13: Estimated average annual energy costs per household in Fairbanks (2010 $) This table shows that the residents of Fairbanks already bear an energy cost burden nearly twice the rest of the country. As population growth increases demand and prices continue to rise, that burden continues to grow. This rising cost of energy also creates economic incentives to change from the status quo.

23 Scenario 2: Unregulated, Non-Competitive Natural Gas Conversion (FNG): As the cost of heating oil rises, the economic viability of a natural gas project rises with it. While large scale mega-projects such as a 48 inch pipeline to the lower 48 states or tidewater continue to be risky (Buxton 2012), a small scale project that can meet local demand does not carry nearly the risk. Profit potential can lead to a small project to become a reality without the red tape of bureaucracy or the need for public funds. The implication of the demand side willingness to pay of $20-27 per MCF and the supply side cost of service of $7.56 per MCF is that profit potential exists. A surplus of $12-19 per MCF could be split between a producer to purchase the gas, the processing plant operator, the transportation company, the distributor, and the resident. Even with the assumed wellhead price of $4-5 per MCF, FNG could yield a profit of $7-14 per MCF. Given the projections and profit potential that appears to exist, one could expect this project to move forward with haste. The assumption is that a retail distributor can achieve 100% market penetration if the consumer can recover the cost of capital within 3 years. A non-competitive, unregulated market results in the retailer and producer extracting all welfare beyond the minimum savings required to entice the consumer to convert. Demand is assumed to be perfectly inelastic for base heating needs and the delivered quantity of natural gas is assumed to follow the demand schedule established. This will result in a marginal savings of $1,000 per year for each converted unit, and real savings of $1,000 per year after the three year payback period, assuming that price is not raised once conversion commitments are made. In such a scenario, supply price is moot so long as a contract with a producer can be achieved such that economic profits for the distributor are sufficient. Tier 1 Tier 2 Tier 3 Borough Average 2012 $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $3, $4, $4, $4, $3, $4, $4, $4, $3, $4, $4, $4, $4, $4, $4, $4, $4, $4, $5, $4, $4, $4, $5, $4, Table 14: Average home heating costs in non-competitive, unregulated market