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Recently Governor Parnell addressed the Alaska Legislature in his State of the State address. In that address he mentioned his proposal to lower taxes on oil but did not go into any great detail regarding the proposal. For perspective I have included herein the entire paragraph from the governor’s speech regarding the need to lower oil taxes:
“So the question tonight is, how do we continue growing an even more vigorous and diverse economy? And how do we create that gravitational pull for private-sector investment and job growth? It takes four things: keep taxes low, gain access to our resources, invest in Alaska energy, and strategically expand undeveloped resources. That's why this year I'm asking that we work together to lower taxes on oil, and create more jobs in Alaska. Let's build off the success of last year's tourism head tax reduction that pulled more investment to Alaska. Let's pass legislation to make our oil tax regime more globally competitive. Lower taxes lead to more resource development, and that leads to more jobs for Alaskans.” – Governor Parnell
House Bill 110 was submitted to the legislature at the request of the governor to address his recommended changes to the oil tax. According to the Department of Revenue fiscal note, the tax change could cost the people of Alaska approximately $5 billion over the next five years. But the tax is not just a five year tax. It affects all existing and future producing properties in the State of Alaska for the life of the leases. So why has the impact been projected to cost $5 billion? A quick look at the nature of fiscal notes gives us the answer. The impact of the tax change was projected to be $5 billion merely because of the relatively arbitrary reason that fiscal notes are only required to identify impacts for five years. The real question someone should ask is, “What happens in year six and every year thereafter?” The answer they will find is that this is not a $5 billion tax. It is a tax change that will cost the people of Alaska in excess of $10 billion over the life of the leases.
So what does the governor propose the people of Alaska get for their $10 billion? The answer is more jobs and hopefully more oil and gas exploration and development. But how do we know if this is a good deal?
Alaska jobs makes a good emotional appeal but certainly cannot justify the price tag of $10 billion. The only way to justify a tax change of this magnitude is through exploration and new production. The following examines the value of the proposed tax change to bring about new exploration and production.
Impact of the tax change on exploration and production
To determine the impact of the proposed oil tax change on production and on production from successful exploration it is important to first determine the projected production based on the current tax system. The best source for that information is the recent Department of Revenue, Oil and Gas Production Tax Status Report to the Legislature dated January 18, 2011. On page 10 of that report the department displays a chart showing production from all existing and discovered fields that the department expects will be produced between now and 2030. This is the Department of Revenue’s projection of present and future production based on the current oil tax without the proposed changes.
Impact of the tax change on production
Changes to the tax should see significant increases in production in addition to what has been identified in the chart. The problem is that state land, from the Colville to the Canning Rivers, is a mature province for oil production. We should not expect to see nor project discoveries in this area of anything greater than what we have seen over the last ten years, basically incremental satellite production which will, at best, reduce the production decline curve but should not be expected to increase production substantially over the next 20 years. The state will not capture a lot of incremental value here.
In terms of the legislation, the section that amends Alaska Statutes 43.55.011(e)(1) and (g)(1) reduces the oil tax by over $10 billion over the term of the life of the leases on the currently producing units with the hope that this change will increase exploration and development to sufficiently offset the tax change. The likelihood of this occurring on state lands is almost nonexistent. The only hope of significant additional production on state lands comes from increased production of viscous and heavy oil which will be addressed later in this article.
Changing the tax structure on existing production will only incentivize the producers to increase production in the existing fields which, as I have said above, will not occur to any major extent because of the maturity of the existing fields. In addition a tax change of this magnitude will have a significant impact on the future revenue of the state.
The Department of Revenue on January 25, 2011, made a presentation to the Senate Finance Committee regarding the Fall 2010 Revenue Forecast and a 10 year Revenue/Spending projection. On slide 9 of that presentation the department showed their projection of the potential revenue surplus over the next 10 years based on estimated revenue and spending projections. The tax change as proposed in HB 110 would all but wipe out this projected surplus and by the year 2021 would probably result in a deficit. The legislature should assure itself of the value it expects to receive in exchange for such an extreme change in the future revenue picture of the state.
Impact of the tax change on exploration
Changes to the tax structure on existing production will not incentivize exploration. Only changes to taxes on production discovered through exploration will incentivize exploration and the only place where significant oil exploration can still occur is in NPRA. The OCS still has significant potential for oil exploration, but the state has no power to tax the OCS oil; so I have not included it in this discussion.
The changes to the tax structure to incentivize exploration is a good idea because the geology of the NPRA is not all that impressive. Analysis by the Department of Energy, National Energy Technology Laboratory suggests that we can expect to find a few fields similar in size to Alpine and a number of smaller fields but nothing the size of Prudhoe Bay. And the most prospective area around Teshekpuk Lake near the Barrow Arch is currently off limits because of cultural and environmental concerns. The proposed changes to the tax structure for exploration do not cost the state any revenue from current production. It only provides that if oil companies will explore for oil in Alaska, they will pay less tax on that oil. The tax incentive may not be enough, but it is a step in the right direction.
You cannot incentivize an oil company to explore for oil where they believe none exists, but you can incentivize an oil company to explore for oil where they believe oil might exist, even if their belief is that the chance of finding that oil is low.
If changes are made to the oil tax and additional exploration tax credits are added this year, the state may see renewed interest in exploration for oil in NPRA. In a few years, if there still seems to be a lack of interest in exploring for oil in NPRA, the legislature may need to revisit this area to see if additional incentives are appropriate.
Impact of the tax change on heavy and viscous oil
Production of heavy and viscous oil is technically challenging and costly to produce. The tax change reducing the oil tax on existing producing fields will certainly help, but it may not be enough. Plus the tax is overbroad in its application. The producers do not need a tax reduction to produce most of the current oil that remains in the existing fields, but they may need a tax reduction to produce the viscous and heavy oil. A tax reduction that is targeted to oil that is technically challenging and costly to produce makes a lot more sense than a tax change that provides reductions where none are necessary, especially to the tune of $10 billion. Plus a tax reduction that is targeted to areas where the need has been identified can be much greater than was proposed for the existing fields and the negative impact will be much less. If a change in the tax can incentivize the oil companies to produce the heavy and viscous oil, the potential revenue from this production could be substantial since there are billions of barrels of viscous and heavy oil waiting to be produced.
Summary
Tax changes should be targeted to where there is an identified need to encourage action from the producers. Tax reductions and credits that encourage production of technically challenging and costly oil make sense. Tax reductions that encourage exploration of NPRA make sense. Any other tax reductions that are directed at addressing a specific identified need make sense. Tax reductions where a need cannot be identified is a gift to those who receive the reduction.
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As with any investment decision, the legislature should consider whether this tax change will provide positive net present value (NPV). Is the present value of the future benefits from (expected) incremental investment in exploration, and (expected) incremental oil production from that exploration, greater than the lost revenue from the lower tax rate on existing production?
ReplyDeleteWe have the estimated loss in tax revenue from existing production from the Department of Revenue - $5 billion over 5 years, maybe $10 billion for the life of the leases. The effects of the tax change on exploration activity, however, are uncertain, as are the results of that exploration for incremental production. So take this as your unknown and work backwards.
Pick a reasonable discount rate and ask the question: what incremental production would be needed as a direct result of this tax change to make it a positive NPV action? The result of this analysis of first-order effects is stark: the incremental production volumes needed are too large to be reasonably expected. In other words, this proposal is most likely not a positive NPV action for state revenue from taxation of oil and gas production.
But, as a matter of public policy, we must consider the second-order effects of general economic development. In other words, we must consider the incremental jobs from additional exploration and development activity in the state, and the associated multiplier as money cycles in the Alaskan economy. Unfortunately, even with a generous multiplier, the net social benefit of the Governor's proposal looks dubious.
Furthermore, the state will eventually grapple with budget deficits as oil revenue declines, likely necessitating a combination of reduced spending and increased non-petroleum revenue, perhaps through a broad-based tax like a state income tax. In this case, we will have traded fewer jobs with no income tax (since revenue from existing oil production is higher under the current tax system) for more jobs with an income tax under the Governor's proposal.
In the end, I am left thinking this is an example of politics rather than sound management: faced with declining oil production, it is easier politically for a Governor to take action to boost production rather than argue that robust taxation of a declining industry is the better course of action for the people of Alaska, even if the latter is true.
The best option for keeping TAPS operating is to secure development of resources in the Beaufort and Chukchi outer continental shelf (OCS). The additional flow will enhance existing onshore production in both value and volume. Value is enhanced since the transportation cost per barrel is less when TAPS is full, thereby increasing the wellhead value of oil, which is the basis for taxation. Volume is enhanced since expanded pipeline infrastructure will make development of some satellite fields economic. So, OCS development maximizes the value of Alaskans' finite oil resource in its conversion to monetary wealth.
ReplyDeleteBut since most of the OCS tax revenue goes to the federal government rather than state government (unless we secure revenue sharing similar to what exists in the Gulf of Mexico), the best way to manage Alaska's resource for the benefit of Alaskans is to maintain the existing robust tax structure in place for production from state lands.
Our Congressional delegation should be fighting to secure permission for OCS exploration to proceed - since the hangup for Shell is with federal permitting agencies - and should be working steadily for a revenue sharing arrangement with the federal government. (I say steadily because we have a decade before first oil from the OCS in which to get this done). Our state legislature and administration should recognize that their role is limited, that NO action on state tax policy is the best course of action, and should work tirelessly to support our Congressional delegation in their two critical tasks.
That's what sound management, based on rational analysis, would be. But I can't write this publicly; perhaps you can.