More Alaska Production Act – Success or Failure

Senate Bill 21, commonly known as the More Alaska Production Act, was passed by the Alaska Legislature on April 14, 2013 and signed into law by the governor on May 21, 2013. The stated goal of the Act was to create a more business friendly tax structure that would result in more production. But is more production in a “tax friendly” environment the right answer, and how do you measure success?

State’s responsibility to the people of Alaska

The State of Alaska has a limited amount of non-renewable resources, and it is the State’s responsibility to manage those resources wisely. The revenue from those resources must be used to meet the needs of the current generation while saving a part of that revenue for future generations when the non-renewable energy resources will be gone. The state does this by receiving a royalty share from the sale of the oil. In addition the state has the power to tax the developers of that resource to obtain a fair value for the right to exploit that resource. The issue the State continues to grapple with is what is fair value for the State and what is fair value for the developer.

Corporation’s responsibility to its shareholders

The corporations who have contracted for the right to develop the resource have no obligation to either the present of future generations of Alaskans. They are not beholden to the State for what the State may have done for them last legislative session or even last week or yesterday  They have no loyalty to Alaska, and once the resources are depleted, they will leave the State. They have a responsibility to maximize the value to their shareholders. A part of that responsibility is the pay as low a tax as possible. Because of the risks the industry is willing to take to develop Alaska’s resources they should get a fair value for their efforts and the risks they have taken to develop those resources.

Alaska’s Clear and Equitable Share (ACES)

SB 2001, commonly referred to as Alaska’s Clear and Equitable Share (ACES), was passed by a special session of the Alaska legislature in November 2007. It is important to review the circumstances surrounding the passage of the bill to determine if anything changed that merited passage of SB21 and how the passage remedied the problem.

During the special session the contractors and analysts modeled a substantial number of scenarios to determine the range of progressivity that would encourage development of the existing fields while maximizing revenue to the state.

They took each variable in the model and ran it through a broad range of inputs. When they had completed dozens of modeling scenarios an economic picture began to arise. There was actually an economic “sweet spot” where it looked like the state could receive the optimum revenue from the production of oil, the industry would get a fair return on their investment, and the vast majority of the reserves in Kuparuk and Prudhoe Bay would be produced. The sweet spot was the progressivity factor of 0.4%. The models did not accommodate the economics of heavy oil; so it was possible that in the future some incentive might be necessary to encourage their development.

This modeling was completed prior to the Senate Judiciary Committee receiving the bill but after Senate Resources had completed their review. The 0.4% progressivity was presented to the Senate Judiciary Committee. The Committee amended the legislation to include the progressivity factor, and it was eventually passed by the entire legislature. On December 19, 2007 Governor Palin signed the bill into law.

SB21 - More Alaska Production Act

With the continued decline in production on the North Slope, the governor and the majority in the legislature believed that a reduction in tax to a more business friendly tax structure would result in more production. The result of the new law seems to be more activity on the North Slope, more jobs, and more production than would have occurred had the original tax remained in place. It looks like SB 21 accomplished its goal, but the question remains, was it the wrong goal, and are present and future generations of Alaskans harmed by the outcome.

Additional Production v. Added Reserves

The goal of any change to the tax structure should have been to increase reserves and thus extend the life of the pipeline while adding revenue to the state over the long run. But there has been no mention of the need to add reserves to the books in the SB21 discussion. If the industry merely produces existing reserves faster at a lesser tax, they meet the intent of the tax while the state loses value in the long run. The state will receive less tax for their resources and the life of the pipeline will be shortened. For example, assume there are a billion barrels of known reserves remaining in Kuparuk and Prudhoe Bay and assume the industry under the old law would have produced those reserves at 50 thousand barrels per year for twenty years. Assume the industry steps up production and produces 100 thousand barrels per year for ten years. The same amount of oil gets produced, but the result is a shortening of the life of the pipeline by depleting the reservoirs faster, and the industry pays less tax per barrel for their effort. The State loses twice.

But the Department of Revenue projects that reserves will increase due to current and projected drilling programs within the Kuparuk and Prudhoe Bay fields.  Certainly, additional drilling has and will result in incremental reserves additions, but as stated above these incremental additions were expected to be produced under ACES. And even if they weren’t, the incremental additions to the reserves base and the increased production doesn’t come near to covering the loss in revenue that the change in tax created.

More Alaska production, without the accompanying increase in reserves, merely depletes the State’s resources and allows the industry a reduction in taxes for doing so.

Low risk v. High Risk Investment

On June 24, 2014, Ryan Lance, ConocoPhillips chairman and CEO, spoke to the Resource Development Council (RDC)  regarding “The U.S Oil & Gas Renaissance – Alaska’s Role.” In his presentation he made an important point. He stated that the best opportunities to find additional oil are in legacy fields. Drilling in legacy fields like Prudhoe Bay and Kuparuk are low cost, low risk, high chance factor wells as compared to true exploration. This type of drilling will slow the decline of production of existing fields and will add to the overall reserves base of the Units. But they will not substantially change the reserves picture in the State. This type of additions to production are exactly the types of wells ACES was projected to produce. They may not have been produced this year, but as oil prices increase and production decreases, these reserves were expected to be produced.

Regardless of the price of oil, by only drilling wells within the Unit boundaries the major producers are not spending capital on exploration and not increasing the reserves necessary to make up for the benefit they are receiving in the changed tax. Basically they are in a harvest mode in the State of Alaska. 

What the State of Alaska really needs is for the industry to invest in true exploration, exploration several miles outside the unit boundaries. This is where incremental value can really be added in Alaska. Sadly, the major producers on the North Slope have limited capital budgets committed to exploration. Their announcements primarily deal with increased activity inside the Unit boundaries. They are committed to the production of the low cost, low-risk resources. SB21 doesn’t seem to have changed this policy. It appears that SB21 has incentivized the industry to produce known and potential reserves inside the Units faster and as an added benefit they pay less tax.

The Price Factor

After the vote defeating Referendum #1, the proposed repeal of the More Alaska Production Act, one of the leading proponents of the More Alaska Production Act was quoted as saying “The vote in August sent a clear message to the producers that Alaskans expected more production investment. And even with the collapse in oil price that nobody saw coming, the producers are keeping their promises and we should stay the course.” What the individual didn’t take into account is that when prices fall, industry becomes capital constrained and projects are delayed or they begin to fall off the books because industry doesn’t have sufficient funds to move their projects forward.

The ConocoPhillips announcement on January 29, 2015 to slow the pace of investment on Greater Mooses Tooth Project is one of the casualties of the drop in oil price. There will be other announcements forthcoming from the industry of additional investments delayed or taken off the books. I assume that one of them will be the new drilling rig, the Doyon 142, scheduled to begin drilling in Kuparuk in February 2016. I assume that ConocoPhillips will take delivery of the rig, if at all, at a substantially later date than the February 2016 projected date.

These decisions by the industry to reduce capital outlay in a low price environment should not be perceived as the industry going back on its word. The industry is merely doing what it must to survive in a capital constrained environment. What is also clear from these decisions is that oil price has a substantially greater impact on investment decisions than any tax, whether it is ACES or the More Alaska Production Act. In a low oil price environment the industry will cut back on capital spending, and in a high price environment industry will increase spending regardless of the tax.

The impact of price on the revenue stream coming from the More Alaska Production Act is significant. In a low price environment the State of Alaska saves a couple hundred million dollars per year under the Act as opposed to ACES. In a high oil price environment the State of Alaska loses a couple billion dollars per year under the Act as opposed to ACES. The cross-over point seems to be about $80/bbl. Below that oil price the More Alaska Production Act brings in incrementally more revenue. Above that amount, ACES brings in substantially more revenue. According to the Revenue Sources Book Fall 2014, the Department of Revenue projects the price of oil will exceed $80/bbl in 2017 and exceed $100/bbl by 2018 and beyond. This means that the legislature has a couple of years to fix the tax until it begins to lose billions of dollars in tax revenue to the industry.

A Fair Tax

Again I would like to cite the Ryan Lance’s presentation to the RDC on June 24, 2014. In that presentation he noted that the “ELF” Tax Period Encouraged Significant New Production. I assume that he believed that the ELF tax was a reasonable tax. It is important to note that the tax was changed from the ELF tax specifically because it was not a fair tax to the State of Alaska. Each year under ELF Kuparuk was paying less and less tax. The projections were that Kuparuk might get to the point where it paid no tax even when the oil price exceeded $100/bbl. This is the tax that Ryan Lance refers to as a reasonable tax for the oil and gas industry. The point here is not that Ryan Lance believes the State of Alaska should go back to the ELF tax; the point is that the industry believes that any reduction in tax is a good tax, even to the point of not paying any tax at all. This means that the State of Alaska must not depend on what the industry says to make decisions about taxes, but it should evaluate what a fair tax would be independent of any oil industry input.

Conclusion

Governor Parnell in a Compass Article dated May 22, 2013 stated, “Our new tax system centers on the idea that not only our generation, but future generations of Alaskans ought to benefit from Alaska's massive resource basin on the North Slope.” The problem is that the governor actually sacrificed long term revenue for short term jobs and increased production without the accompanying requirement to increase our reserves base.

What the legislature should have done was fix ACES in a low oil price environment and possibly modify the credits and deductions, if appropriate, and keep the progressivity of ACES. If all of the reserves aren’t getting produced, a change in the tax may be appropriate, but that time is several years in the future. If the legislature decides to add progressivity back into the tax, the State of Alaska will have protected both present and future generations of Alaskans.