The Alaskan Pipeline to Nowhere

Image source: BP.

No one disputes that Alaska has massive natural gas reserves. Commercializing and bringing that gas to market, though, poses a unique set of challenges. Primarily, how do you get the gas from Alaska's North Slope to the Kenai Peninsula, where it can be prepared for export? The current solution is to build an 800-mile-long natural gas pipeline and liquefaction facility, via a partnership comprised of the state of Alaska, BP (BP 0.98%), ConocoPhillips (COP 0.39%), and ExxonMobil (XOM 0.39%).

Alaska Governor Bill Walker, citing waning support from the project's three oil-producing partners, recently proposed that the state, with possible backing from international or institutional investors, should take sole ownership of the pipeline project. If you are an investor in any of those three companies, you should be alarmed by that news. Here's why.

The proposed pipeline

The project is a monumental undertaking: Current projections put the price tag at an estimated $45 billion to $65 billion. The whole project will include the 800-mile-long, 42-inch-diameter pipeline; the liquefaction facility on the Kenai Peninsula; eight compression stations; five takeoff points for in-state delivery; a North Slope gas treatment plant; and transmission lines linking the Prudhoe Bay and Point Thomson fields to the gas treatment plant.

BP, ConocoPhillips, and ExxonMobil agreed to the project because they hold the largest natural gas assets in the North Slope and would like to get the gas to market. Alaska, reeling from the downturn in oil prices, sees the project as a major cash infusion into its economy.

In December of last year, the partnership agreed to provide the requisite $230 million to fund planned development and permitting in 2016. While that's some serious cash, it pales in comparison to the nearly $2 billion that will be required for planned 2017 activities. This is where the three oil companies are beginning to bristle, and where Alaska is preparing to step in.

The need for the pipeline

Again, no one is challenging the production potential of natural gas in Alaska. Estimates put the Point Thomson and Prudhoe Bay natural gas reserves around 34 trillion cubic feet. Most gas currently being extracted is actually being reinserted into the ground to stabilize pressure for oil production. Oil and gas producers would prefer to bring the gas to market, rather than reinject it into the ground.

In May, ExxonMobil began to tap into this potential by beginning production on what it hopes will become 10,000 barrels of natural gas condensates per day. After spending $4 billion to develop the field, though, the company hopes to significantly expand into natural gas production, which will depend on the price of natural gas and on the ability to transport it to a terminal for export.

And that's key for all three companies. For the pipeline project to move forward into the costlier 2017 phase, the three oil-producing partners indicated that oil and natural gas prices need to climb higher. The specific number is unclear, but a lack of volatility at persistently high prices is almost certainly required for these companies to feel comfortable investing tens of billions through 2025, when the pipeline would theoretically begin transporting natural gas.

Cause for concern

Unfortunately, there are a number of potential issues with Alaska's proposed plan to become the sole owner of the pipeline. The Walker administration believes it might be able to rely on third-party partners for the required investment, but this is far from a certainty. By relying on large oil companies, Alaska found partners with vested interests in developing infrastructure to transport gas at the lowest possible cost. International or private investors -- Walker mentions Asian utilities or pension funds -- need a financial incentive to invest, via either guaranteed natural gas deliveries to their respective countries or profits from transporting the natural gas, which would further cut into future profits for oil and gas companies..

Without digging too much deeper into why or whether a country should invest in the pipeline, this all leads back to the economics of producing the natural gas in the first place. It's not too far of a reach to say that oil companies would have begun producing from the North Slope natural gas fields if it was good business. By acknowledging the volatility of natural gas prices in their decision to pursue the pipelines, companies are tacitly acknowledging that it might not make sense to pursue these opportunities.

To be sure, there is a flip side to the coin.  The oil companies have actually suggested that Alaska should take a larger role in the project, which would enable them to avoid paying billions for a pipeline while giving them an outlet for future natural gas production.  Oil and gas companies utilize independent pipelines all across the country, which is a proven business model.  The difference here is size -- the potential third-party investment could reach higher than $50 billion -- and if a state government instead of oil and gas companies can successfully complete the pipeline.

As investors, what we really need to consider is the breakeven point.  Does Alaska ownership lower the breakeven point for BP, ExxonMobil, and ConocoPhillips, thereby making natural gas production more viable?  Or will the need for investors to recoup the massive investment, presumably with interest, raise prices above and beyond the fixed-fee rates of other independent pipelines, thereby making natural gas production in Alaska less viable?  The number of unknown factors -- potential investors, price of natural gas, agreed upon price for gas transport -- make that a truly difficult question to answer.

Foolish bottom line

BP, ExxonMobil, and ConocoPhillips remain partners in the project today and continue to weigh their options. There's no doubt that they all want to tap into the potential of bringing Alaskan natural gas to the open market. A lot of obstacles stand in the way, though, and Alaska's proposal to take ownership of the pipeline project just adds another. Alaska and its potential third-party investors could cut into profits, thereby making natural gas production even less economical, and that's assuming the state can find investors to begin with. This makes for a strong possibility that the Alaskan LNG pipeline will go unfinished or will be severely underutilized -- which, by any definition of the phrase, would make it a pipeline to nowhere.