Alaska Oil| Misreading the Signals

Senator Joe Paskvan (D-Fairbanks) issued a press release yesterday in response to an article that appeared in this week’s edition of Petroleum News (“North Slope Booms:  Upcoming exploration drilling season shaping up to be busiest in decades“).  Sen. Paskvan’s press release includes the following statements:

It appears that Alaska’s tax credits under its production tax system are working to promote capital expenditures, including new exploration wells. Good news for the industry and the state, which relies upon the industry for revenues to its treasury. Exploration should mean increased oil production and increased throughput down the pipeline.

The names of the well drillers may not be familiar to many Alaskans. They include Great Bear Petroleum, Linc Energy, Repsol, Brooks Range Petroleum and UltraStar. This is strong evidence that the independents in the oil industry are both looking at Alaska as a place to do business and that they are actually coming to Alaska to develop our abundant oil resources.

This is good news, but I do not want to be overly optimistic until I have the opportunity to talk directly with the companies.  As we all know, there is always the potential for a gap between the plan and the performance.   I hope that the Alaska public will join me in learning more about today’s announcement.

The caution reflected in the last paragraph is highly appropriate.  Some observers are beginning badly to misread the signals that are being sent by recent developments and Senator Paskvan should be careful about falling into that group.

To understand why some are misreading the signals, it is important first to take a moment to understand how the current Alaska oil tax system works.    Basically, the system vastly overtaxes one set of oil assets — the so-called “legacy” fields like Prudhoe, Kuparuk and Milne — in part to provide “credits” (in other words, give money to) exploration projects.  (The excess tax on the legacy fields also is used to fund other things — such as an Alaska film industry through the so-called “film credits” — but that is a column for another time.)

That isn’t simply my analysis.  None other than Forbes recently had this to say about the current Alaska system :

“So the state government created some sweetheart deals for [smaller] oil and gas companies to spend money here. Among these goodies is a 40% state refund on money spent for drilling and exploration costs — paid in cash to the operator [whether or not it results in production]. There are other laws in place that could refund as much as 20% of other costs and 25% of net losses incurred. For a small operator looking to get a sweet return on a moderate-sized pot of money, Alaska is like the El Dorado of oil and gas.“

The problem with that? A large part of the oil remaining on state lands — and the oil that can be developed and brought into production the soonest — is the viscous, heavy and otherwise economically challenged oil sitting at various depths in the legacy fields, the very fields that the current system overtaxes.  To quote from testimony presented before the Legislature in 2006:

To date we have produced 15 billion barrels [from North Slope fields], but there are 17.5 billion barrels remaining that we already know about [as of 2006]. … We’re not only looking to develop  … the 17.5 billion barrels, we’re looking to make it even bigger.  To put that in perspective, every time we increase the recovery efficiency by just 1% we access an additional 600 million barrels.  … Every 1% is equivalent to another Alpine!

The testimony then goes on to discuss what it takes to achieve that potential:

To develop the … [additional] barrels we know about would require well in excess of $100 billion.  And that kind of investment can only come from the Major oil companies of the world ….

As for the potential effect of exploration on state lands?

The scale of [the] known resource greatly exceeds that expected from future exploration.  Future discoveries are expected to be of the order of 50-150 million barrels.  It’s not to say you should stop exploring, but you cannot rely on exploration to stem the decline of the North Slope.

So, if Alaska’s goal is to achieve substantially increased production, the current tax system is doing the exact reverse of what is needed. Through exploration “credits” (which subsidize drilling regardless of whether it results in additional production), the current system is focusing investment on the search for the smallest potential sources of additional production, while at the same time significantly depressing investment in the very locations where the largest potential additional sources are known to exist.

This consequence may be good for some segments of the Alaska economy — for example, drillers and service companies engaged in the new exploration activities — to the extent that they and are their employees are Alaska based.  (Note, however, that this is exactly the industry segment that Senator Egan recently identified as being located largely out of state.  “Egan and other lawmakers said the major oil companies have a good local hire record, but some of the sub contractors do not.  One company, Egan said, employs a couple hundred people and not one is an Alaska residents.”)

The policy also potentially results in huge windfalls for independents, because they only spend a small amount of their own money, but receive ownership of 100% of whatever they find.

Because the policy, however, incentivizes investment in the smallest potential sources of additional production and disincentivizes investment in the largest remaining resources, it produces very bad policy results for the state overall.  To use Senator Paskvan’s words, it may mean some “increased oil production,” but the outcome is not especially “good news for the … state, which relies upon the industry for revenues to its treasury.”

That is because the state is passing up the “biggest bang” for its tax policy buck, in order to chase the smallest.

To some degree this outcome is predictable.  At various times throughout its history,  Alaska has become enamored of the oil companies that aren’t here at the expense of those that are.  Another familiar policy theme of some at times has been to “punish” Big Oil for various perceived sins.

In this era, however, this approach is cutting off Alaska’s nose to spite its face.  Consistent with the last paragraph of his release, hopefully Senator Paskvan will continue to ask hard questions and realize that before going too much further down the road.