Alaska’s Future| Focusing on the end result

A piece in the Fairbanks Daily News-Miner last week deserves discussion.   The piece summarizes recent testimony before Senate Finance and the reaction of one Senator as follows:

“The investment climate in Alaska for oil companies falls in the middle of the pack and is competitive with other spots around the globe, a consultant told a Senate panel Monday.   The government’s share of oil production value here is about the same as in Australia, Brazil and Indonesia, Rich Ruggiero said. The value to companies investing here is also similar, he said.

Sen. Johnny Ellis, D-Anchorage and a committee member, said he suspects many in Alaska will be surprised to hear that Alaska compares well to companies on Gaffney-Cline’s list of investment ‘hot spots.’   ‘That’s counter to what oil industry representatives are saying to us,’ he said.”

Analyst: Alaska oil taxes are moderate, Fairbanks Daily News-Miner, Feb. 22, 2011.

We should anticipate hearing this type of testimony, and this reaction, again as the Legislature continues to evaluate changes to Alaska’s oil tax structure.  There are three things to keep in mind as that occurs.

First, the expert comes from the same firm — Gaffney, Cline & Associates — that in 2007 provided extensive testimony on behalf of DOR in support of ACES.  See Department of Revenue ACES Document Page, Documents by Author (Oct. 3, 2007 – Nov. 9, 2007).  In evaluating the firm’s current testimony, it is useful to consider whether ACES has lived up to the predictions  the same firm made in 2007.

In 2007, Gaffney Cline’s testimony suggested that the proposed ACES tax rates would not materially affect investment levels in Alaska.  For example, see Alaska’s Equitable Share:  Some Further Thoughts, Oct. 31, 2007 (“Drilling program is so profitable that under even the most  extreme net tax structure, oil companies would want to continue their reinvestment program”).  Indeed, at one point the firm even appeared to suggest that the progressivity provisions of ACES, which subsequently have come under significant criticism  (see, e.g., R. Marks, Alaska’s oil and gas production tax severely limits upside profit potential, Oil & Gas Financial Journal, Sept. 1, 2010 ) would stimulate investment (“Greater progressivity (raising the maximum rate and/or slope) can achieve even greater differentiation”).

Neither prediction has come true.  With that history, we should carefully consider whether the firm truly has its finger on the pulse of what drives oil company investment in Alaska.

Second, the analysis appears to be incomplete.   While the files for Senate Finance do not contain a presentation this year by Gaffney Cline, House Resources heard a similar presentation from the firm on Feb. 11, 20110.  In that presentation, Gaffney Cline appears to rely heavily on Alaska’s system of investment tax credits to justify its conclusions about Alaska’s system, and gives no weight to the lack of durability — reliability — in the Alaska system.

Those are important oversights.  Alaska’s system of investment credits focuses heavily on front end expenditures — exploration and early development efforts.  As explained elsewhere on these pages, those types of credits do not create incentives for substantial, long-term investments.

The reason is that is that those types of credits are largely focused on spurring the types of investment made up front, before high levels of production begin. While such investment tax credits may lower the overall tax burden during the early years of field development, they do not have much effect in later years, once production begins.

If the effective tax rates that again become applicable in the later years, once investment declines and production increases, are not competitive with those applicable to alternative investments over the same, long term timeframe, producers will not make those upfront investments at the outset.

The apparent failure of the Gaffney Cline analysis to compare the long run effects of Alaska’s approach with those of other regions, which utilize lower rates from the outset and are not as dependent on credits, is a significant flaw.

The failure of the Gaffney Cline analysis to consider the comparative durability of Alaska’s system is also significant.  In other regions, the level of government take largely is set by contract.   (This includes in US federal lands and waters, where the level of government take is set largely in the lease.)  Subsequent changes in tax or royalty rates related to new developments largely do not affect projects undertaken before the changes, because most of the contracts covering such projects either are excluded from such changes or contain what are referred to as “economic stabilization” clauses, which effectively cap the overall level of government take regardless of subsequent changes in tax or royalty rates.  See B. Montembault, Stabilisation Clauses; see also P. Bernardini, Stabilization and Adaptation in Oil & Gas Investments, Journal of World Energy Law and Business (2008).

Alaska’s system contains no such provisions, effectively exposing investors in the Alaska oil industry to the effects of tax increases imposed after significant investments already have been made.  Open ended approaches such as Alaska’s carry substantially more risk — and attract significantly less investment — than those systems which provide by various means for the durability of a given level of government take once investments have been made.

The failure of the Gaffney Cline study to consider this difference between the Alaska system and others is an additional serious shortcoming.

Third and most importantly, it is important to keep in mind what has happened to actual production levels since the prior testimony.   According to EIA data, in November 2007 — the month that ACES passed and Gaffney Cline made the prediction that ACES would not adversely affect investment — oil production averaged 728,000 bbl/d (the highest rate for the last half of 2007); in October 2010 (the most recent month for which final EIA has reported data), the rate was 608,000 bbl/d (down 16,5% in the three years since 2007).  Preliminary data indicates that, in 2010, November production levels fell below 600,000 bbl/d for the first time since startup.

The significance is this.  Regardless of whatever rationalizations are offered for ACES, the fact is that production has fallen dramatically in the three years since its passage, is continuing to fall at increasingly larger rates and there are no offsets in site under current forecasts.

The facts also are that such a level of decline is unnecessary.  There is a significant amount of resource remaining on Alaska’s North Slope, which if developed could slow the decline in Alaska’s production to 3% per year and extend the life of North Slope production to 2050.    See  Alaska’s Future:  Sen. McGuire’s proposed competitiveness review is important, Alaska Dispatch, Feb. 11, 2011 (“Alaska has the potential to play a significant, continuing role in the global oil and gas industry. As BP’s 2006 testimony explains, by some measures the North Slope still holds roughly as much known oil and gas resource as has been produced since the beginning of Prudhoe Bay. Just last year, Forbes listed Alaska as one of “The Top 10 Oil Fields of the Future.”).

In a famous decision in energy law, the Supreme Court once declared that in some situations  it is the “end result” that the law achieves that is important, not the manner in which that result was derived.  FPC v. Hope Natural Gas Co., 320 U.S. 591, 603 (1944).

The “end result” that is being achieved under ACES is rapidly declining production.

Bottom Line: Keeping our eye on the ball is important.  The ball is production levels.  Despite a significant remaining resource, production levels are declining at an increasingly rapid rate under ACES.  Improving the economic incentives for investment will make a difference.

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