Berkowitz Revenue Proposal Analysis

The 100% Royalty Solution


Ethan Berkowitz has proposed a new approach for the State of Alaska to use for collecting oil revenue through its two main sources: royalty and taxes. What follows is a quote from his web page.

“The debate about Alaska’s oil and gas revenues has been too much about short-term gain and not enough about long-term interests. The result is a system that fails to optimize outcomes for either the state or industry. Alaska can do better – we can have a system that reduces development risk, increases production and jobs, gives Alaska a fair share of the revenues, enforces budget discipline in Juneau, strengthens the Permanent Fund, and takes the politics out of the state's relationship with the oil industry. Doing better, however, requires a new approach.” – Ethan Berkowitz



I like the goals he has set for the new system, but how does his proposal stack up against reality?

Ethan Berkowitz states that a 100% royalty solution provides fiscal certainty for the oil and gas industry. The industry has been looking for a way to lock in the state’s share of production. This would lock in the state’s share for the term of the contract, as long as 40 to 50 years. This would seem to provide the oil and gas industry with what it is looking for.

But the first problem with a 40 to 50 year lock on the state’s share is that the state has not been able to predict a reasonable tax structure for more than about 15 years. After about 15 years, unforeseen problems with the tax structure begin to show up. The economic limit factor worked for about 15 years before the problems with disproportionate revenue sharing created a need to change the tax laws. ACES has only lasted a couple of years before signs of problems have begun to show up. Heavy oil development and exploration on state and federal lands where the state has the power to tax are both showing signs of being impacted by the tax. If the state agrees to a fixed royalty system for the life of the leases, which could be 40 to 50 years, the system is sure to fail. Oil and gas prices are too volitile. A fixed 100% royalty solution will only work for a narrow range of oil and gas prices. When oil prices are low, the industry will be paying too much revenue to the state and when oil prices are high, Alaskans will believe they are not getting their fair share. That is why progressivity was added to the tax so that the revenue paid to the state by the producers could more closely match the revenue stream: lower taxes during times of lower prices and higher taxes during times of higher prices.

There can be debates about the rate of progressivity, but the intent of progressivity was to more closely match a fair split of the revenue stream between the producers and the state at low and high oil and gas prices.

In addition the only way a 100% royalty solution would work is for the state to pass an amendment to the constitution prohibiting oil and gas production from being taxed. Otherwise there would be no certainty for the oil and gas industry. If a constitutional amendment was not passed, the royalty would be fixed as it is in the current leases and the state could still impose a tax on the revenue if the state determined some day in the future it was not getting its fair share. Thus the industry’s fiscal certainty that it got through signing the 100% royalty leases would be lost anytime the next legislature wanted to pass a tax.

Passing a constitutional amendment prohibiting the state from taxing the oil and gas revenue would create its own problems. The state gets royalty and tax revenue from state lands but it only gets tax revenue from NPRA; so a 100% royalty solution would mean that the state would give up any revenue it might receive from production in the NPRA. I don’t think this was Ethan Berkowitz’s intention. I think he probably didn’t understand that the state doesn’t have the right to negotiate a royalty share from NPRA. And the state has neither the power to receive royalty or to tax the federal OCS.

As far as I can determine from the proposal, the state would negotiate royalty leases on existing production, presumably giving up something to get the industry to agree to the new contracts. The producers will not negotiate fixed long-term contracts to put them in a worse position than they already are. These 100% royalty only leases would then give the industry the fiscal certainty to explore new oil and gas prospects. Once again this sounds good until the proposal is applied to the facts.

According to the NETL Report, existing units on state lands have approximately 6 billion barrels of reserves left to produce. So the state would give up a certain amount of revenue on the 6 billion barrels left to produce to incentivize the oil and gas industry to explore for the additional 3 billion barrels of oil yet to be found on state lands. Existing units on state lands have approximately 34 trillion cubic feet of natural gas to produce. The state will also fix the royalty on the 34 trillion cubic feet of natural gas for the life of the leases as an incentive for the oil and gas industry to explore for and additional 30+ trillion cubic feet of natural gas on state lands. If the additional gas is discovered, those leases will also have fixed royalty rates for the life of the leases and pay no tax. The deal sounds more like giving up two in the hand for one in the bush than getting Alaska its fair share of the revenues.

In addition, in the NPRA the state does not have the right to collect royalty from the leases and only has the power to tax. So the state would be giving up the ability to tax all future oil and gas revenue from NPRA. According to the NETL Report, that would be an additional 6.5 billion barrels of oil and an additional 31 tcf of gas that the state would give up the right to tax.

Ethan Berkowitz could argue that the State of Alaska would only give up the right to tax oil and gas revenue on state lands and continue to tax the revenue on federal lands. This may sound like a good idea but it wouldn’t stand up to a challenge in the courts. The law would not allow the state to discriminate against owners of lease rights on federal lands by taxing them and not the owners of lease rights on state lands.

Ethan Berkowitz has recognized the need for changing circumstances in his proposal. He has proposed that all contracts should have reopener clauses. This would reduce the effect a fixed royalty would have on a fluctuating oil or gas price. When prices were low the unit owners would request a contract reopener and ask for a lower royalty. If the state determined that the royalty should be reduced, a contract amendment could be negotiated reducing the royalty rate. When prices were high the state could ask for a reopener…… but the industry wouldn’t agree. There is no incentive for a Unit owner to agree to pay a higher royalty unless it is getting something additional in return. The only way for the state to get a rate increase under that circumstance would be the take the Unit owners to court and argue that the new price of oil or gas was not contemplated when the original 100% royalty lease was negotiated. The industry would argue that of course the higher price was within the contemplation of the parties since the historical price of oil has been well over $100.

Ultimately reopeners will not work for oil and gas leases in the United States because the State does not have the right to nationalize the oil if they cannot come to an agreement with the Unit owners. Reopeners require both parties to have something to gain and something to lose for a reopener to be successful.

Alternatives that make sense

There does seem to be a problem with the current ACES tax system. The bellweathers for problems with the tax system are heavy oil production and exploration. Heavy oil production should see declines in production before all other production because it is the most expensive to produce. And exploration will see impacts because higher taxes changes project economics and requires larger potential field sizes to be worth spending the money to explore. Both heavy oil and exploration have shown signs of declining investment.

Based on this, it is probably time to reexamine the ACES tax system. Are tax credits sufficient incentive to change industry economics? Does the progressivity factor need to be reexamined? What about the base tax? Does it need to be adjusted downward? Wholesale change is probably not necessary, but a methodical approach to the problem is essential. New ideas and innovation are good but they need to be tested before they are proposed as a final solution to our problems.