The Specious Argument

I recently finished watching the March 10, 2011 Governor’s Press Availability on Gavel to Gavel where the governor discussed his tax change legislation. He discussed the three areas of focus for the bill, 1) new units (tax reductions for areas not in production now), 2) infield drilling tax credits, and 3) progressivity changes. And he explained that his administration is “focused on creating more production here, more investment here, more jobs here.”

This is all well and good and I commend him for his energy and effort, but I question his response to those who have expressed concerns that his legislation could cost the state billions of dollars. In response to those stated concerns about the cost of the legislation he stated “Let’s talk about that specious argument before we go any further.” His comment was out of character for the governor and without a rational basis for the position taken. In the past the governor has not used such a pejorative comment in referring to those who oppose him. Normally he would merely have responded with his position, supported by facts and analysis without putting the opposition down. So why did he use such a strategy this time?

There are several possible reasons why he attacked the opposition with name calling instead of analysis.

Perhaps because he didn’t remember that it was his own staff who wrote the fiscal note that stated the financial impact of the change to the tax would be in the billions. Perhaps he was not around to listen to his Department of Revenue Commissioner and revenue staff explain that the impact would be in the billions. Perhaps he did not read his consultant’s report and did not listen to his consultant testify that the long term cost of the change could be approximately $20 billion.

Or perhaps he is just uncertain about the position he has taken and doesn’t know how to logically defend it; so he reverted to name calling and putting down the opposition.

Or perhaps he doesn’t understand cost/benefit analysis. In its most basic form cost/benefit analysis is first understanding the short and long term cost of the change as well as you can. Once you fully understand the costs of the change, you must determine what the proposed benefits will be and the chance of those benefits occurring. Then you calculate the difference. The result may be that there will be more jobs for Alaskans or the life of the pipeline will be extended, or the possibility that the state may never recoup the difference in tax it gave up in the legislation. Even with the potential negative impact of not recouping the cost of the change in tax, the state may determine the change is still a reasonable course of action. The state may determine it wants short and long-term jobs and an extended life of the pipeline more than it wants to fill its savings account. This would be an acceptable analysis.

But what is not acceptable is not counting the costs and arguing that those costs are not real, that they are “fantasy,” that concerns regarding the costs are “specious.” The costs are real. They can be determined within in a reasonable range, and they range in the billions of dollars. What is not real, what cannot be determined, and what can only be hoped for are the benefits from such a tax change. Those benefits may occur, but they cannot be calculated because a third party must make an independent decision sometime in the future based on present actions by the legislature. Maybe it will be worth it, but the state should count the cost and understand the risk before making such an important decision.

What the governor should have done is provide the analysis necessary to support his position, provide the analysis necessary for the Alaska public to support his legislation, provide the analysis necessary for the legislature to pass his proposed legislation.

What the governor should have done is provide the legislature with an analysis of possible decline curves.

The governor’s consultant used a 6% decline curve to define what might happen if the legislation was not passed; yet the governor’s Revenue Commissioner presented an estimation of future revenue based on a 3.2% decline curve under the current tax. What does the governor believe to be true? What are the ranges of possible decline and what are the bases for those assumptions?

What the governor should have done is explain to the legislature where the governor believes the new reserves are to be found.

A thorough understanding of reserves potential is essential for the legislature to understand so they can determine if there are sufficient potential reserves to compensate the state for the lost revenue from the change in the tax.

What follows are projections from the United States Geological Survey and the State of Alaska, Department of Natural Resources, Division of Oil and Gas of resource potential of exploration areas of the north slope.

NPRA: consists generally of lands west of the Colville River and north of the Brooks Range.

The National Petrolem Reserve-Alaska is not a good source for future oil revenue. The USGS has recently substantially reduced the reserves of technically recoverable conventional accumulations of oil it believes are located in NPRA to less than a billion barrels of oil, about 10 percent of what it previously projected to be in NPRA (See 2010 Updated Assessment of Undiscovered Oil and Gas Resources of the National Petroleum Reserve Alaska (NPRA) ).

Beaufort Sea: consists of all offshore state lands between Pt. Barrow and the U.S-Canadian border.

The Department of Natural Resources, Division of Oil and Gas has projected: “The petroleum potential in the area is considered moderate to high.” (See the January 2011 Five-year Program of Proposed Oil and Gas Leasing Program Report at page 22).

But concerns about oil spills in the offshore environment, concerns about the oil industry’s ability to clean up oil in broken ice, concerns about bowhead whales, polar bear habitat and two species of endangered seals may make it difficult to explore for or produce oil from offshore in the near-term.

North Slope Areawide Oil and Gas Lease Sale: the area consists of all state-owned lands between the National Petroleum Reserve-Alaska (NPRA) and the Arctic National Wildlife Refuge (ANWR), and from the Beaufort Sea to the north and the Umiat Meridian Baseline to the south (an east/west line drawn just north of Umiat, Alaska).

The Department of Natural Resources, Division of Oil and Gas has projected: “Petroleum Potential in this area is considered low to moderate with the potential generally increasing from south to north.” (See the January 2011 Five-year Program of Proposed Oil and Gas Leasing Program Report at page 27).

North Slope Foothills: the area consists of all state-owned lands between the National Petroleum Reserve-Alaska (NPRA) and the Arctic National Wildlife Refuge (ANWR) south of the Umiat Meridian Baseline and north of the Gates of the Arctic National Park and Preserve.

The North Slope foothills are not a good source future oil potential. The Department of Natural Resourses, Division of Oil and Gas has stated “Petroleum potential in the area is considered relatively high for gas, and relatively low for oil." (See the January 2011 Five-year Program of Proposed Oil and Gas Leasing Program Report at page 30).”

Even though the governor believes that these areas “have not been touched for thousands of years,” they have actually been evaluated and tested geologically. That is why the Division of Oil and Gas can project the potential for oil in this area as relatively low. The legislature should request a map of the north slope depicting all the wells that have been drilled. Then the legislature should ask one of the geologists at the Division of Oil and Gas to explain why they believe the oil potential in this area is low.

Federal OCS: the offshore area in the Chukchi and Beaufort Seas seaward of the state offshore.

Even though the governor referred to Shell’s exploration activities in the Chukchi Sea during his press availability, the governor’s tax legislation does not affect Shell’s offshore projects from an economic standpoint because the tax credits do not apply to the federal offshore and the state has no power to tax the federal offshore.

What the governor should have done is explain to the legislature when the new reserves are projected to be produced.

The state land with the greatest oil potential (high potential) is the state offshore, the most difficult area to permit and develop a field. Bringing production on from the state offshore will take at least 10 years and probably closer to 15 years if it can be done. In fact even permitting and developing a new onshore field (low to moderate potential) will take at least 10 years. Therefore we should not expect or depend on any revenue from new exploration in the short-term and little in the long-term.

What the governor should have done is explain the projected revenue and the timing of that revenue from the reserves he proposes will be found.

Even though we don’t expect much from new exploration, the credits have not cost the state much. But maybe someday, many years from now, any new production to be found will be a net positive from a revenue standpoint (after deducting the cost of the credits). In addition, what can be determined with reasonable certainty is that revenue from new exploration will not begin to balance the cost from the tax change for at least 10 years.

What the governor should have done is explain to the legislature the criteria the governor is using to determine if or when the tax change has failed.

In his Press Availability the governor suggested that the legislature would not sit idly by if the proposed tax change was not having the desired effect. What the governor needs to share with the legislature are his expectations for a successful outcome. What would he consider a success? What would the governor consider a failure? How long is the governor willing to wait to see positive impacts from the tax change?

Finally the governor in a final posture challenged the press to ask the “nay sayers” that say the governor’s proposal is going to cost so much what their plan would be. Well I’m not necessarily a nay sayer, and I am certainly not a legislator,  but I do believe the governor and the legislature should count the cost before they make such broad sweeping changes to the oil tax. And as far as proposing a plan, I have written close to 40 articles in this blog proposing what the governor and legislature should do, but if the governor doesn’t understand what I am suggesting he is free to give me a call and I will be glad to help him out.

Additional Note

The governor made one comment regarding the large diameter pipeline that is worth clarifying. In referring to the position of the pipeline companies he stated that “Before we commit to buying pipe, we need fiscal certainty.” That would suggest he believes that TransCanada and Exxon or Denali pipeline company needs fiscal certainty before they can commit to buy pipe. Actually the pipeline company does not need fiscal certainty; the shippers need fiscal certainty and they need it before they are willing to commit their gas to the open season. Fiscal certainty has nothing to do with the pipeline companies buying pipe. Fiscal certainty is being requested by the shippers before they are willing to commit their gas at the open season. That is one of the reasons why the open season process has stalled.  I am surprised at this basic misunderstanding of who needs fiscal certainty, when it is needed and the risks associated with moving a pipeline project forward.

THE REAL COST OF THE GOVERNOR’S PROPOSED OIL TAX CHANGE

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.

Berkowitz Oil Revenue Proposal

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. My next article will address how effective his proposal is in accomplishing those goals.