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?

The Luck of the Draw

In a recent editorial, Senator Kevin Meyer touted the importance of the recently constructed and to be constructed energy projects around Alaska. He stated that there are 66 projects in the pre-construction phase and 58 projects under construction or completed. That’s 124 projects supported by legislators from around the state, 124 projects where legislators brought home the bacon, 124 projects that helped legislators get reelected. Regarding those projects, Senator Meyer suggests that it is “important to monitor the state’s investment. The legislature must remain vigilant, as granting money without strong oversight, review or audit can sometimes be more harmful than investing none at all.”


The problem is that the legislature failed to use the same vigilance, review and analysis when approving the projects. Projects were placed on the Legislature’s renewal energy project wish list with little or no analysis of the future viability of those projects. Most were merely ideas without any analysis of the long term viability of the project after it gets built. Most were not even required to submit a business plan that could show the long-term economic viability of the project.

The result will be that most of the approved projects will fail from an economic standpoint no matter how much vigilance the legislature puts forth. You can’t make a poor project successful merely by auditing it to death. You will, at least, be able to record your own failure in approving the project in the first place. The old adage “fail to plan and plan to fail” will once again raise its ugly head.

As with any appropriation, there is some value in the approved projects. Some projects actually put forth viable business plans and would have been approved on their own merit if the legislature had done the analysis they should have done before approving the projects. The projects will probably succeed because they can prove, at least on paper, that they will be successful and economically viable in the long-term if built. For those projects, I congratulate them for their diligence, their preparation, their analysis, and their willingness to do what it takes to ensure the successful viability of their project. For the rest of the projects that were approved without the proper preparation, without the proper analysis, without a business plan, good luck. Perhaps another old saying “by the luck of the draw” will be your story. Perhaps you will be successful inspite of your own poor efforts.

And to the legislators that approved the 124 projects without the proper analysis, if you approve any more renewable energy projects, at least make sure they have submitted a viable business plan. Even an optimistic business plan, which it inevitably will be, is better than none at all.

My prediction is that 10 percent of the approved projects will clearly succeed, 50 percent will fail, and 40 percent will be hoping for “the luck of the draw.”

Loan Guarantees and Pipeline Economics

In a recent letter to Governor Parnell, Alaska Senator Mark Begich stated that it would be difficult for Alaska’s congressional delegation to get an increase in the federal loan guarantees anytime soon; so, Senator Begich proposed that the state should consider loan guarantees for the remainder of the debt that the federal government would not cover – in the realm of $9 billion in loan guarantees. The problem with his proposal is that it requires a substantial amount of legislative energy, time, and effort and does nothing substantial to change the economics of the gas pipeline.


Loan guarantees tend to reduce the cost of debt and consequently reduce the tariff. This is good, but it reduces the cost of debt only by a small margin making only a minor change to the tariff.

The loan guarantees are important to the pipeline builders, but they do little to create incentives for the shippers. The risk to the shippers is substantially unchanged. The State of Alaska needs to look for solutions that reduce the risk to the shippers and solutions that make a substantial reduction to the tariff and thus increase the economics of the pipeline.

I have two recommendations regarding how to change the economics of a large diameter pipeline: one for the Alaska portion of the pipeline and one for the Canada portion of the pipeline.

Alaska Portion of the Pipeline

Regarding the Alaska portion of the pipeline, I recommend the State of Alaska fund the equity portion of the pipeline, take a debt rate of return, and not start receiving payment on its investment until the original debt is paid off. This funding mechanism could take the form of a financial interest or an ownership interest. That could be determined by discussing the proposal with companies that might want to participate in the ownership of the pipeline.

The benefit of this proposal is that it would change the economics of the pipeline and reduce the tariff more than any other single proposal that has been put forth so far. Combined with other risk reduction actions, it may be sufficient to move the gas pipeline forward.

The cost of this proposal would probably be up to $10 billion for a success scenario but less than $2 billion to see if it would be likely to succeed. The risk capital would be invested to develop a proposal and hold an open season. If the open season was successful, then the project could move forward to a FERC certificate. It is possible that up $3 billion would have to be expended to get to a project sanction decision, but this capital would only be expended after a successful open season and signed precedent agreements from the shippers.

One hundred percent of equity contribution should be invested in the Alaska portion of the pipeline only. That way Alaska gets the full benefit of the investment, and the tariff on the Alaska portion of the pipeline sees the greatest impact, thus providing cheaper gas for Alaskans.

If Alaska decides to make such a commitment to the pipeline, Alaska should approach the federal government to see what they can do to support Alaska’s commitment. The two things Alaska should ask for are 1) Alaska’s fair share of the revenue from federal offshore development, and 2) Alaska should ask for the chance to explore in ANWR.

Regarding AGIA and TransCanada, Alaska should get TransCanada to either agree that the current AGIA plan is uneconomic or get TransCanada to waive their rights to damages under AGIA in exchange for the opportunity to participate in the Canadian portion of the pipeline. I am fairly certain that TransCanada would not want to own a piece of the Alaskan portion of the pipeline under to above plan. I am also not worried about TransCanada threatening to sue under AGIA. It is clear that the present plan is uneconomic; so, there will be no liability under AGIA if TransCanada does not agree to waive their rights.

In addition, contrary to AGIA’s capital contribution, Alaska would get a return on its capital investment and future generations would receive the benefit. Consider the investment a savings account for the future when Alaska may need the return.

Canada Portion of the Pipeline

TransCanada has proposed a 70/30 debt equity ratio (with some modifications). They propose to invest 30% of the cost of the pipeline in equity. The equity rate of return on the pipeline will probably be greater than 12%. The cost of the debt, on the other hand is closer to 5% depending on who the borrower is and their credit rating. Clearly it is better to have more of the pipeline funded by debt and less by equity because the return on the equity is more than twice as expensive to the pipeline as the debt.

Alaska should try to get TransCanada to agree to an 80/20 debt equity ratio. This will lower the tariff by a certain amount and save the State of Alaska and the shippers over the life of the pipeline billions of dollars. In the alternative Alaska should argue to the Canadian government for an 80/20 debt equity ratio. Alaska should also argue for a return on equity of 12% or less on the Canadian portion of the pipeline. Once again this would lower the tariff and make the pipeline more economic. These two terms are not unreasonable. Both were given serious consideration during the initial pipeline negotiations with the producer group.

As a reminder, gas pipeline economics is a major element of achieving a successful gas pipeline, but there are many more elements that must be addressed to move the project forward.

The issues that need to be addressed are:

1) Fair oil and gas taxes
2) Long term fiscal plan
3) Short term annual capital and operating budgets
4) The permanent fund, its present and future use
5) Gas pipeline economics (discussed in this article)
6) Exploration and filling TAPS and the Gas Pipeline
7) Fiscal certainty/stable oil and gas tax environment
8) Point Thomson (hopefully this will be resolved soon by the State of Alaska and the Point Thomson owners)

In summary if Alaskans really want an Alaskan Gas Pipeline, they need commit their resources to its success. They need to be disciplined fiscally. They need to lead instead of follow. They need to take charge of their future. The result is they will be better off by pursuing such a direction. If the pipeline is a success because of their efforts, they will reap the benefits. If the pipeline is not a success then they will be prepared for the new world they will find.