Busting the “Myth Busters”: Where the Alaska Dispatch Went Wrong

[Please also read the Addendum following the article added Feb. 28, 2012.]

In a highly-promoted two part series last week titled “Myth-busting claims in Alaska’s oil tax debate,” the Alaska Dispatch identified what they “consider the most duplicitous oil-tax myths being perpetrated surrounding the oil-tax debate raging in Juneau.”  Part 1 of the Dispatch piece is published here; part 2 is here.

The series doesn’t attempt to address “myths” existing on both sides of the debate – and there are.  Unabashedly, the Dispatch focuses only on what the authors identify as those “myths that have arisen, one way or the other, from the oil industry and their allies.”  So much for balanced reporting.

Later in the week, Andrew Halcro took on the Dispatch’s alleged myths one-by-one in his blog in a piece titled, “C’mon.”  Interestingly, while the Dispatch has run other of Halcro’s pieces on its pages, to date it has not published this rebuttal.  For those interested in balance, Halcro’s piece is a good beginning.

For my part as I worked through their sources and the math, I realized that the Dispatch’s “myth busters” created more than a few myths of their own in writing the article.  The result is, instead of bringing clarity to the the oil tax debate among Alaskans, the Dispatch has only made the debate even more murky and myth-ridden.

Four of the Dispatch’s so-called “myths” stand out in particular – “Myth No. 2:  Alaska oil companies are taxed 80 to 90 percent,” “Myth No. 3:  North Dakota is so much rosier than Alaska,” “Myth No. 5:  The pipeline is running dry,” and “Myth No. 6:  Alaska is running out of oil.”  We bust each in turn.

Busting Myth No. 2:  It turns out the Alaska oil companies ARE taxed 80 to 90 percent

The Dispatch piece claims “Alaska’s tax rate is not 80-90 percent. … [A]t $100 a barrel, Alaska taxes the oil industry about 40 percent.”

Interestingly, even the source data that the Dispatch offers to justify its claim shows that the tax rate is much higher.  In a public exchange following the publication of the articles, the Dispatch forwarded me a chart which one of the authors said supports its numbers.  (The writer said, “I took the numbers directly from the Alaska’s tax analyst at DOR.  Nearly word-for-word.  And I asked her three times. That’s not my spin on them. They also have prepared a chart, which I’ll email to you and which they presented to the Legislature.”)  The chart follows:

(For a larger version, click on the slide.)

The first thing that should strike the reader about the chart is that the Dispatch’s alleged state tax rate of “about 40%” or anything near it doesn’t appear at the $100/barrel level which is the purported focus of the Dispatch’s analysis.  Instead, the chart shows that the Alaska’s portion of the profit share (shown in green) at $100/barrel is “53%.”  Much more importantly, in order to arrive at the Dispatch’s percentage figure, the writers ignore the effect of federal taxes on the producer’s profit share.  Thus, in stretching to “bust” what it views as an industry myth about tax levels, the Dispatch created a gigantic myth of their own – that only state tax levels matter to producers.

The Dispatch appears to derive its number (“about 40%”) by taking the percent of state take stated on the chart at $100/barrel (53%), times the profit level on which the chart is based ($74), and then applying the resulting number ($39) as a percentage of the gross revenue on which the chart is based ($100).  But that is a serious distortion of how profit based taxes universally are stated (Norway’s for example, is stated as 78% of the producer’s profit).  It also is a distortion of how the number has been used in Alaska.  Changing the methodology in order to create a point – comparing a number calculated based on gross revenues to numbers based on after-expense profits – does not “bust” a myth; it creates one.

At the end of the day, the point is simply that taking the state tax level from the very chart on which the Dispatch claims to rely (and calculating federal taxes at the marginal rate, see the Addendum following this commentary) demonstrates that, in fact, “Alaska oil companies are taxed 80 to 90 percent.”  The Dispatch is the one creating the myth.

Busting Myth No. 3:  It turns out that North Dakota IS much rosier than Alaska

The Dispatch piece claims “… here’s what you really need to know:  The total state take — including taxes and royalties — in North Dakota is about 33 percent. The total state take in Alaska, is about 39 percent. That’s a 6 percent difference, nowhere near a ‘double and triple the rate in North Dakota.’”

Again, the Dispatch focuses only on state take levels, but let’s accept that for the moment.

In North Dakota, the Dispatch reports that the “state’s severance take is 11.5 percent, equaling $11.50 a barrel on a $100 barrel of oil.  The state’s corporate income tax ads another dollar or so to that, and then there’s another small sales tax.  All told, North Dakota’s take is roughly $13 on a barrel of oil.”  Converting that to numbers comparable to those on the chart above, that $13 amounts to a tax of 17.6% stated on a “profit” basis (for those doing the math, 17.6% is the percentage resulting from dividing the level of tax [$13] by the level of profit [$74]).

In the article, the Dispatch takes Arctic Slope Regional Corp. Senior Vice President Tara Sweeney to task for asserting that “the ACES tax rate … imposed double and triple the rates of … North Dakota.”  (The full Sweeney quote relied on by the Dispatch is here at page 13.)  Well, that turns out to be true using the Dispatch’s own numbers.  The 53% Alaska tax rate contained on the chart is, in fact, “double and triple” the 17.6% state tax rate in North Dakota.

The Dispatch claims that such a comparison is unfair, and that a reader needs to add to the North Dakota number an additional amount for royalty.  It is not clear why that is the case – in North Dakota, royalty goes to private land owners, not the state, and so seems largely irrelevant in calculating the effect of government actions on the industry.  Moreover, the Dispatch claims that in comparing the state’s two royalty regimes, the reader needs to use a higher, 20% royalty rate for North Dakota (which is the marginal rate negotiated for new leases, but is much higher than the rates contained in the older leases which cover the larger part of the production), compared with the 12.5% rate for Alaska which is the level used in the calculations underlying the chart discussed above.  But, again, let’s accept those assumptions for the moment.

Even adding the 20% royalty rate to the North Dakota calculation only produces an overall combined “take” rate in North Dakota of 43.6% compared with Alaska’s 53%.  Adding in federal income taxes results in an overall take rate of 78% for North Dakota compared with 88% for Alaska.

Even that 10% — or over $7/barrel – gap understates the difference in take levels between the two states, however.  Let’s use for a moment an oil price of $120/barrel, rather than the $100/barrel level used by the Dispatch.  In that event, the state take on Alaska production (again, using the chart) rises to 59%.   In North Dakota, however, the state “take,” even including royalty at 20%, declines to 40.5% of profits.  Thus, in a rising oil price environment, the gap between Alaska and North Dakota expands even further, something the Dispatch fails to mention.

And, what if you compare apples to apples and use the royalty rate which applies to most of North Dakota’s production, the same as the Dispatch does for Alaska?  The gap between Alaska and North Dakota grows to 19% (or $14) at $100/barrel, and 23% (or $22) at $120/barrel.

The net result?  Well, it turns out that North Dakota is rosier than Alaska.  As for the use of the term “much rosier,” that appears to be in the eye of the beholder.  Even assuming only the $10 difference in profit/barrel that exists at $100/barrel oil and compares apples to oranges on royalty levels,  at 600,000 barrels per day that difference adds up to nearly $1.3 billion annually.  Comparing apples to apples at $100/barrel results in a difference of over $2.6 billion annually.  That certainly satisfies the definition of “much rosier” in my book – and more importantly, in investors’ – if not the Dispatch’s.

Busting Myth Nos. 5 and 6: It turns out that the state’s (financial) pipeline IS running dry

The Dispatch’s Myths Nos. 5 and 6 are actually the same thing, stated differently.  Myth No. 5 is “The pipeline is running dry;” Myth No. 6 is “Alaska is running out of oil.”  In both cases, the Dispatch purports to be busting the “myth” that Alaska is running out of oil, in the case of Myth No. 5, through the pipeline, and in the case of Myth No. 6, on the North Slope.

Actually, in my experience the producers always have been very open and bullish on Alaska’s remaining potential.  In 2006 testimony before both the House and Senate, for example, BP testified clearly that more known oil and gas resources remain on state lands on the North Slope than have been produced since the beginning of production from Prudhoe Bay.  The “myth” that the resource potential is other than substantial, if it exists, has been self-induced.

To be fair, I agree with the Dispatch that some myths have grown up around the date that the pipeline might shut down for mechanical reasons.

Focusing on those two arguments, however, badly miss the greater point.  The greater point is that the State’s financial pipeline – which is tied to the oil production rate, not reserve life – is running dry.  To suggest that Alaskans do not need to be concerned about the current state of the industry because of the potential of the North Slope resource or because the life of TAPS may stretch out longer, creates a much more dangerous myth than any the Dispatch otherwise seeks to dispel.

Two charts from the most recent 10-year forecast by the State’s Office of Management and Budget tell the story.

The first assumes that the rate of state spending is held below recent levels, but that oil prices continue to increase at the robust levels forecast in the Governor’s most recent budget.

That scenario is about as close to a “best case” as you can get.  The chart nevertheless shows that continued production declines send the state into the red by 2016 and keep it there from then on.  (Spending levels are shown by bars; revenue levels are shown by a line.)

The second chart lowers spending even further, but bases oil revenues on $90/barrel oil.

Under that scenario, continued oil production declines push the state into the red beginning next year and keep it in that position thereafter.

In short, regardless of the level of overall resource potential or the potential life of TAPS, if the production rate does not stabilize – and soon – Alaska is facing a very difficult future.  Or, as I put it to the Senate Resources Committee in recent testimony, the effect of a longer life for TAPS may mean that the “person that turns the lights off on Alaska’s economy can stay a few more years, but the remainder will have left long before.”

In short, by focusing only on the potential resource base and the life of TAPS, the Dispatch masks the much more important point.  What is mythical is that Alaska is doing fine.   Alaska may not be running out of oil potential and, due to the ability to accommodate low flows, the pipeline may have a longer life than some have argued, but due to increasingly lower production rates Alaska’s financial pipeline is running very low.

Busting two more “Myths” that the Dispatch added along the way

In the course of their series, the Dispatch has created two other “myths” that matter.  The first is the claim that Alaska’s producers have an obligation to invest and develop in Alaska, even if there are other locations in the world that provide better economic returns.  The second is the implication arising from the Dispatch’s first myth, that the State of Alaska is a reliable business partner.  We bust each of these in turn.

The producers have an obligation to develop in Alaska in preference to other locations that produce better economic returns

In the course of responding to comments following the publication of the second article in the “Myth busting” series, co-author Amanda Coyne made this statement:

… at some point, and to some people who understand the law, comparing Alaska to Angola to North Dakota, et al, should [become a] pointless exercise. The leases read that if there’s a reasonable expectation of profit, they [the producers] have a duty to produce. It doesn’t matter how much more money they can make elsewhere.

Interestingly, that theme adopts virtually verbatim a recent line of argument that Senator Bill Wielechowski – and only Senator Wielechowski – has been suggesting.

The statement it is just flat out wrong.  As I explained in a commentary on these pages responding to Senator Wielechowski that predated the Dispatch series, the leases that cover most of the existing fields on the North Slope — including Prudhoe and Kuparuk, the largest two — simply do not include the term “reasonable expectation of profit” or indeed, even the word “profit.”  Instead, the leases provide only as follows:  “This lease contemplates the reasonable development of said land for oil and gas as the facts may justify.  Upon discovery of oil or gas in paying quantities on said land, Lessee shall drill such wells as a reasonably prudent operator would drill having due regard for the interests of the Lessor as well as the interests of the Lessee.”

For those that truly “understand the law,” the term “reasonably prudent operator” is a facts and circumstances test that fully takes into account other opportunities a producer may have.  In short, a “reasonably prudent operator” is not expected to forego alternatives offering higher economic returns in order to pursue others that offer lower, or more uncertain, returns.

To her credit, Ms. Coyne posted a second comment following my note to her pointing out the error.  The note reads “Let me make a correction/clarification on my comment above.  Only the new leases have the profit clause.  The old ones, which include most of the North Slope leases, read like this [quoting the reasonably prudent operator language].  Sorry all.  This just came to my attention.”

In making the “correction/clarification,” however, Ms. Coyne left her first post as well, leaving to the reader to figure out how to reconcile the two and leaving the “pointless exercise” language untouched.

In fact, the two statements cannot be reconciled; the first is just wrong and by leaving it, the Dispatch has repeated and publicized yet another myth.

The State of Alaska is a reliable business partner

In the published series, the Dispatch’s first myth was that the “Oil companies are always trustworthy business partners.”  Frankly, whether someone – or some company – is “trustworthy” is in the eye of the beholder.  If the Dispatch thinks that the producers are not reliable, so be it.  But if the Dispatch’s standard of reliability applies, the converse proposition implied by the Dispatch – that the State of Alaska is a reliable business partner – is similarly mythical.

At the core of the relationship between Alaska and the producers is a contract.  Like any contract, the agreement between Alaska and the producers – termed an “oil & gas lease” – sets forth the terms that are intended to govern their relationship.  Most of the leases that cover the relationship between Alaska and the North Slope producers were entered into in the late 1960’s and early 1970’s.

The fundamental economic trade they reflect is simple.  Alaska leased the covered lands to the producers for the development and extraction of any oil and gas that the producers found on it.  In exchange, the producers agreed to (1) pay the State of Alaska an upfront cash bonus regardless of whether they found any oil or gas on the lands, (2) pay for all of the investments made to develop the lands and (3) pay over to the State of Alaska, either in kind or in cash, one-eighth (12.5%) of all the oil and gas that the producers found and produced from the lands.  In order to permit the producers’ to realize the benefit of the investments they make, the parties explicitly agreed that the contract would continue as long as oil and gas is produced in paying quantities.

While otherwise somewhat unique in the world, the bonus and royalty approach to the development of oil and gas is common in the U.S.  In cases in other states, courts sometimes have referred to the “fair share” doctrine when addressing oil and gas issues.  The doctrine usually comes into play when determining what each owner’s share of production should be.  When disputes arise between the owner of the lands and its lessee, courts commonly refer to the lease terms as establishing the “fair share” between the two parties — in other words, the courts enforce the contract.

For over three decades, Alaska respected its side of the bargain.  While the state imposed a production tax in addition to receiving its royalty share of production, the level of and method used in calculating the production tax roughly stayed in line with that used in other states as a means of funding the oil producer (and lessor’s) share of the costs of state government.

That balance changed dramatically in 2006 and 2007, however.  Under the banner of obtaining Alaska’s “clear and equitable share,” Alaska legislatively increased its “fair share” from that agreed in the contracts, plus a customary and common level of production tax, to something much, much greater.  Importantly, the state did so unilaterally, without even attempting to renegotiate the revised terms with the producers to maintain the overall balance contemplated by the contracts.  One alternative, for example, would have been for the state to take a larger share of the results of production in exchange for making some of the investments.

Frankly, as an oil and gas lawyer with then nearly 30, and now nearly 35, years’ experience, I thought then and continue to think now that the state’s actions in 2006 and 2007 breached the terms of its contracts with the producers.  In a number of respects, Alaska’s actions in 2006 and 2007 – unilaterally increasing the level of the state’s “fair share” – closely resemble those of other governments which have attempted in their own ways legislatively to override the terms of previously negotiated contracts.  The result in those situations often has been that those governments have found themselves on the receiving end of an expropriation suit.

Regardless of whether Alaska’s actions rise to the full level of breach, however, they certainly meet the Dispatch’s standard of unreliability.  The State said – in this case, agreed — in its leases to one level of “fair share,” and subsequently has done another.  The failure of the Dispatch equally to call balls and strikes on both sides of the relationship is disappointing – and myth making – in its own right.

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Addendum (Feb. 28, 2012):  A sharp-eyed reader has pointed out that the original version of the above commentary appeared on occasion to confuse two numbers on the chart referenced above entitled “Profit Share Under Status Quo.”   In determining the level of federal tax for purposes of calculating the combined federal and state tax rates at a couple of points, the reader pointed out that the commentary appeared to use the percentage in the chart designated as the “Producer” share instead of the percentage designated as the “Federal” share.  The reader is correct and I have revised the commentary today to correct the error.  In correcting for the error, I have used instead the marginal federal tax rate of 35%, rather than the slightly lower rates for federal taxes I originally used.  As I have explained in another piece, the marginal federal rate is the correct rate to use in the analysis because the current debate is focused on whether the current tax structure discourages new investments, and the marginal rate is the rate used by most investors to determine whether to make new investments.  That is because the incremental income produced from new investments is taxed at or close to the marginal rate unless the investments create additional federal tax credits sufficient to reduce the long term marginal rate.  Because expansions of existing producing areas especially seldom generate additional credits that materially affect the long term tax rates applicable to incremental production, the normal rule is to assume that the income produced from the incremental investments will be taxed at the marginal rate.  The tax rate shown on the chart for “Federal” taxes appears to be the weighted average tax rate resulting from including in the calculation the tax effect of past investments, and thus, is not forward looking in the same way that investors consider in making new investments.  The same adjustment is not made for the state tax rates used in the chart.  That is because, under ACES, the marginal production tax rate applicable at any given oil price automatically applies to all production; thus, for the most part, the state tax rates at any given oil price on the chart already reflect the marginal rate.  Correcting for the error does not change any conclusions contained in the commentary.