Arguments Falling on Deaf Ears

This evening I listened to the House Finance Committee debate amendments to SB21, the Oil and Gas Production Tax. I heard Joe Balash, Deputy Commissioner for the Department of Natural Resources state, ”We are taking less in order to get more.” This is a variation of the Reagan Tax cut philosophy. Reduce taxes and grow the economy. Since it worked for President Reagan, why wouldn’t it work for the State of Alaska. Cutting taxes to grow the economy works when you have a potentially expanding pie. The U.S. economy wasn’t a limited resource, and the U.S. economy grew and generated more wealth for individuals and businesses and additional revenue for the U.S. government.

Alaska oil production potential, on the other hand, is a limited resource. State lands on Alaska's North Slope between the Colville and Canning Rivers is a mature region as it relates to oil potential. There is only a minor potential to expand production. You might consider it a marginally expanding pie. The state can encourage new production, but it will only affect production on the margin. In other words, at best, the oil industry will only produce marginally more oil based on a change in the tax. If the Alaska legislature reduces the tax substantially, there is simply not enough oil on state lands to make up the difference. The numbers just don’t work.

I also heard that lower taxes will result in higher bids at lease sales on state lands. There is a failure of logic in this assumption as well. Lower bids at lease sales on state lands are not because of the tax structure, either high taxes or low taxes. Lower bids at state lease sales are because there are no longer any potentially large hydrocarbon structures that might hold significant new reserves on state lands. All the major oil structures on state lands on the Alaska North Slope have already been drilled and explored. The geologic potential on state lands is limited. Any geologist, whether from DNR or the industry, will tell you there are no more “elephants” on state lands on Alaska’s North Slope.

So how will this reality play out at the next lease sale? If the legislature passes a reduction in tax, the lease sale will occur and the bids per acre will continue to remain small, and the higher bids per acre that the administration suggested would occur if the tax is reduced, will not materialize.

Lease bids per acre will not increase substantially at the next lease sale or any sale thereafter if the legislature decreases the tax, but you will not find the administration acknowledging their error or apologizing for their mistake. In fact they will conveniently ignore that they suggested substantially more revenue at the new lease sales based on the reduction in tax. Their failure in logic is they don’t understand that lease sale bids are based on geology, not taxes. They don’t understand that you can’t make up for a substantial revenue shift from the state to the industry based on the potential of new production in an already mature region. They don't understand the financial implications of a significant revenue shift from the State of Alaska to the oil industry. They don't understand that there is not enough oil to make up for the revenue shift. They merely provide scenarios of the new production that is required to make their proposal work. I have already written about the standard upon which the proposal will be reviewed. I wish the numbers were there to make their proposal work, but the numbers simply don't pencil out.

 

It may be appropriate to modify the tax. It may be appropriate to create a better balance between the industry and the state so far as sharing revenue at low and high oil prices, but the argument that the state can transfer a significant amount of revenue from the state to the industry and make it up in revenue from increased production just simply doesn't pencil out.

As I listened to the discussion at the House Finance Committee, I wished the parties could put down their political affiliations. I wished for an engaged discussion of the finances of proposal. I wished for an evaluation of the likelihood of success of the proposal. I also wish that this article would stimulate additional discussion and evaluation of the proposal, but I am afraid my efforts at encouraging debate will fall on deaf ears.

Bummer for good decision-making. Bummer for the people of Alaska.

 

 

Hall of Fame or Hall of Shame

The Alaska legislature is considering a revision of the oil and gas tax structure in the State of Alaska. There are several estimates of the impact of the change, and not all agree; but it is clear that the proposed change will transfer billions of dollars from the State General Fund to the pockets of the oil and gas industry in the coming years.

How do the legislators know if they are making the right decision?

How will their decision be evaluated in the future?

When will the chickens come home to roost? (sooner than you think!)

Those legislators that vote for the change in oil and gas taxes will either be elevated to the Hall of Fame if they are correct or the Hall of Shame if they are wrong. What is clear is that their vote will certainly be remembered. The next question is how do we know if they should be elevated to the hall of fame or relegated to the hall of shame?

In the article that follows I propose a standard upon which they should be reviewed and I share my concerns with the process and the information that has formed the basis of their proposed legislative change.

The Standard of Review.

Each fall the Department of Revenue produces the Fall Revenue Sources Book for that year. The section of the Book that is the most important for purposes of our discussion is the production projection section. Read pp. 40-45 of the Fall 2012 Revenue Sources Book starting at 4. Crude Oil Production. I recommend legislators read this section because it will be the standard upon which they will be evaluated.

The Revenue Sources Book projects a High Case, a Low Case, and a Risk Adjusted Case. The Risk Adjusted Case is the Department of Revenue’s projection of production in the future based on the current tax structure. (See Figure 4-12, at p. 44).

If future production is equal to or less than the Risk Adjusted Case then the reduction in tax and the transfer of billions of dollars in revenue from the General Fund to the oil and gas industry will be a failure, and the governor and the legislators that voted for the tax should be held accountable.

If future production is greater than the high case projection, then the reduction in tax will be deemed a glowing success and the governor and the legislators who voted for the reduction in tax should be voted into the Hall of Fame because they have made a great decision on behalf of the State of Alaska.

If future production is greater that the Risk Adjusted Case and less than the High Case then the result is uncertain. It will depend on how close production is to the Risk Adjusted Case or the High Case. In this world those in favor of the tax and those against the tax will both have justification to argue for their positions.

Some have argued that all the industry has to do is make sure the decline curve is less than 6% in order to show success, but this is not the case. The Risk Adjusted Case in the near term is a much lower decline curve than that. The Risk Adjusted Case has an Alaska North Slope production decline as follows:

Year    Production      Prod Decline   Percent Decline

2013    552.8

2014    538.4               14.4                 2.6%

2015    518.6               19.8                 3.7%

2016    499.7               18.9                 3.6%

2017    476.1               23.6                 4.7%

2018    442.9               33.2                 7.0%
 

If the industry doesn’t beat the Risk Adjusted Case over the next few years, then the reduction in tax will have been an unfortunate decision.

For a more detailed analysis of the Department of Revenue Forecast see C-2b Crude Oil Production – Forecast at p. 105 of the Fall 2012 Revenue Sources Book.

For those of you that believe the decision cannot be reviewed in the short term because it takes 6-10 years for an exploration project to come on line, you have been misinformed. Production impact can be seen in a much shorter timeframe.

We are talking about increasing production between the Colville and the Canning Rivers, in essence in or near existing fields. Production in or near existing fields can be brought on-line in as few as 2 years. If you need authority for this position, you need only look at the development of Meltwater and Tarn. I was the permitting director on Tarn and I know how long it took. The impact on the Department of Revenue Forecast can be impacted as soon as the wells are on the books to drill, and certainly by the time they are completed. Clearly before the next election cycle there will be sufficient information to begin to see if the reduction in tax has been a success or failure.

Concerns with process and information

The governor has proposed that new additional production will more than exceed the revenue given up in the reduction in tax. But where will that production come from, and is there sufficient production (beyond what is already projected in the Risk Adjusted Case) to account for the increase.

Once again I refer you to the Fall 2012 Revenue Sources Book at page 45. The Department makes reference to the 2007 U.S. Department of Energy Report. The Report projects the Mean Technically Recoverable Oil for the Alaska North Slope State lands (Colville-Canning Area) to be  4.5 billion barrels of oil or only 11.7% of the Mean Technically Recoverable Oil on the North Slope. If you add NPRA to that number, you increase the percent to 14.1 percent. That means that over 85% of the Mean Technically Recoverable Oil on the North Slope is not affected by the change in tax because 85% of the Mean Technically Recoverable Oil is on federal lands and cannot be taxed by the State of Alaska. Some would point out that 27.2% of that oil is projected to be in ANWR. This is true, but that would mean that 58.6% of the oil would still come from the federal offshore that cannot be taxed by the State of Alaska, and no change in the tax will impact industry decision-making in those areas.

Another interesting fact, if you add up all the production the Department of Revenue projects to be produced between 2013 and 2022 you come up with 4.5 billion barrels. The Department of Revenue is projecting that industry will produce all of the Mean Technically Recoverable Oil based on the current tax regime. Clearly the legislature has a lot of questions to ask before it is ready to pass a change in the oil and gas tax.

Next, I am concerned that the governor is withholding information from the legislature and the Alaska public. If the governor has asked for and received reports from other consultants, whether favorable or unfavorable to his position, he is obligated to release them to the public. If the information is adverse to the governor’s position, the governor is subject to being accused of abusing his position and manipulating the data upon which the legislature is making its decision. First it is a breach of ethics and second it is probably illegal. The Alaska Public Records Act, by letter and intent, requires to governor to provide the reports timely, in this instance, before any vote on the subject of oil and gas taxes is made. The entire legislature should demand nothing less. This is not a political issue. It is the responsibility of the sovereign to make sure a thorough and complete review and analysis is done by the legislature prior to making decision of such magnitude. If the governor is withholding reports he has received, he is violating his responsibility to the people of the State of Alaska. If he does not have the integrity to uphold his responsibility to the people, the legislature should do so for him. The legislature should stall the vote until they have all the pertinent information upon which to base their decision. They should then review the reports proceed ahead with the legislation as they see fit.

 

In conclusion, I am surprised that the administration has not put forth more factual/statistical data to back up their proposal. The governor cannot merely make projections based on the numbers he hopes will occur. He must analyze the possibility that his projections might occur. I have reviewed his projections and I cannot back them up with data.

The legislature should not pass such a significant piece of legislation without understanding the reasonable possibility of its success. Merely "going with the party" because they are prodevelopment is not sufficient in this case. The result could cost the state billions of dollars and could cost the proponents their next election.

 

Technology or Tax, Week 7 in Review

In the governor’s Week 7 Oil Tax Message, the governor posts a chart of Oil Production Trends in four areas: Alberta, Texas, North Dakota, and Alaska. Alberta, Texas, and North Dakota show increases in production. Alaska shows a decline. The implication is clear. Alaska is not competitive because of its oil tax structure. This article will examine that premise.

Alberta

Alberta’s production chart shows progressively increasing production since 2001.  In order for the governor’s premise to hold true, Alberta’s tax structure should show consistency since 2001 and certainly should not show any substantial increases in tax during that time. The problem with the premise is that Alberta passed a New Royalty Framework in October 2007 that became effective January 1, 2009 during the time that Alberta saw a constant and substantial increase in production. Alberta’s government analysts projected that royalties would increase approximately $1.4 billion in 2010 based on the change. In essence the opposite conclusion from the governor’s premise could be suggested. But the real answer is not the increase or the decrease in taxes. It is in the Alberta Oil Sands and the technology to produce oil from the sands.

Texas

The chart representing Texas oil production shows substantial increases in production starting in 2010. For the governor’s premise to be validated, Texas would have had to change its tax structure prior to 2010 leading to the increases in production. Once again taxes had nothing to do with the increases in production. Dr. Mark J. Perry, professor of Economics at the University of Michigan explained it best when he stated, “The exponential increases in Texas crude oil over the last two years have been largely the result of the dramatic increases in oil being produced in the state’s 400-mile long Eagle Ford shale formation in south central Texas, which was only recently discovered in 2008. Eagle Ford crude production has more than doubled over the last year, from 120,532 barrels per day in July 2011 to more than 310,000 barrels per day in July of this year, according to a recent Reuters report, and now accounts for about 16% of the state’s monthly oil output. Advanced drilling technologies like hydraulic fracturing and horizontal drilling have also contributed to an almost doubling of the Lone Star State’s oil production over the last three years.”

Once again the change in oil production was a result of advanced drilling technologies, not taxes.

North Dakota

The North Dakota chart shows a substantial increase in production starting in 2006. The governor’s premise would suggest a possible change in oil taxes prior to 2006 created the North Dakota boom. But the tax structure did not change. The culprit was the Bakken Formation which now produces 91% of North Dakota’s oil production. Horizontal drilling and hydraulic fracturing is the reason for the change, not taxes.

Alaska

Much has been written about the decline in oil production in Alaska. But the bottom line is that we have changed the tax structure several times and regardless of the tax structure, the developed fields in Alaska have followed a standard decline curve as they should. The region of state lands between the Colville and the Canning Rivers is a mature region so far as oil is concerned. We can expect that the decline curve will not change substantially based on any tax change.

The bottom line is that most increases in production anywhere in the world is based on new reservoir discoveries or changes in technology. I could not find a single region where substantial increases production was the result of anything other than successful exploration of a new area or advances in technology.

The governor's premise that the tax structure is the reason for the increase in production in other regions and reason for the decline in production in Alaska is not substantiated by the facts.

 

KISS Principle

We have all heard the KISS principle (Keep It Simple Stupid). Normally it is better to not add complexity where complexity doesn’t add substantial benefit. It just provides more ways for something to break. The governor has embraced this “simple” strategy in laying out his four guiding principles. The governor's third principle is that oil taxes must be simple so that they restore balance to the system. The question that needs to be asked is how does simplicity affect the economics of oil and gas in Alaska.

First off, I’m not sure how simplicity equates to balancing the system. If the governor means that we should get rid of progressivity to obtain the balance he perceives as correct, that would make sense. But simplicity, in and of itself, doesn’t increase competitiveness or put oil in the pipe. I have never heard of an oil company, especially a major oil company, say “We are not going to invest in that country. Their tax system is just too complex.” Actually what happens is that the oil company sets their tax lawyers to work trying to understand how they can use the complexity of the tax to their advantage. You need only look to how the oil companies managed the ELF (economic limit factor) over the years to understand their ability to manage a tax. A simple tax will not increase exploration and development in Alaska because simplicity does not change economics or geology.  

Arguing that deleting progressivity from the tax will somehow make it simple is to not understand the tax. The progressivity formula is quite simple to implement. Some may not like the results, but the formula is simple. The real problem with the complexity of the tax comes in identifying capital and operating costs, and credits and deductions. This is where the complexity comes into play. This is why the department of revenue is so many years behind in auditing the oil companies. If the governor wanted to make the tax simple and reduce complexity, this is where he should have focused, and even that would not have added oil to the pipeline because it does not change economics or geology.

Stating that the tax should be simple may make for a good sound-byte, but it doesn’t impact the production of oil into the pipeline. Simplicity will not increase or decrease production. It’s just not material.

Next, what about economics and geology? Can we change the future by modifying the tax?