As noted on these pages previously, recently I agreed to write a bi-monthly column on oil & gas issues for the Alaska Business Monthly. This is the third column, originally published in the November 2012 print edition and available online here.
As Alaska finishes this year’s election cycle and starts looking toward the coming legislative session there are several steps which are needed to restore Alaska as an attractive location for oil investment.
One of these steps, upon which the Legislature has focused for the last two sessions, will be in the spotlight in the coming legislative session as well: the current level of oil taxes.
While an important part of the overall puzzle, oil tax reform alone may not be sufficient to overcome the inertia that has settled into Alaska’s oil and gas industry. Alaska also is out of alignment with maximizing the development of its oil resources in other significant respects.
As a result, fully realigning Alaska’s interests with maximizing the development of its oil resources likely will require more steps than simply tax reform.
In order to appreciate Alaska’s challenge in increasing future oil development it is important first to understand Alaska’s current approach. In many respects, it is similar to back seat driving—and sometimes just about as successful.
Under the leases entered into between the producers and the state, the producers make all of the investments and bear all of the expenses necessary to develop the lease and produce oil and gas. Because the costs of development are born entirely by the producer, the lease understandably provides that the producer generally is entitled to determine the pace and amount of the investment.
As a result, Alaska is at risk when, due to market and competitive factors, opportunities elsewhere provide a better return on investment. In those instances, the producers have retained the right to defer investments in Alaska in order to pursue other opportunities.
Deferral is exactly what has happened to Alaska over the last few years.
For various reasons, Alaska has become a less attractive investment opportunity over the last several years. Some of the causes are self-inflicted. For example, by some estimates, the 2007 passage of Alaska’s Clear and Equitable Share, or ACES, increased oil taxes on Alaska producers by over 400 percent. That change materially reduced the competitiveness of investments in Alaska compared with those in other parts of the world.
Other factors are external and beyond Alaska’s control. For example, substantial advances in drilling and production technology have made investments in shale formations elsewhere in the United States and—increasingly—the world, more economically attractive than they were previously. Also, the opening of vast new parts of the world to private investment—such as large parts of Africa, Central Asia and Russia, and even the Alaska OCS—have significantly increased the range and number of investment opportunities available to producers.
In the past few years, Alaska has attempted to use two tools to reverse the decline in investment and stimulate development. In reality, however, Alaska’s application of the tools has made matters worse.
The two primary tools that Alaska has used to attempt to reverse the decline in industry investment have been tax credits and direct regulatory intervention.
Most realize that ACES significantly increased oil taxes. What fewer realize is that another component of ACES created incentives for certain types of investment through the use of tax credits.
Through the use of special tax credits, ACES subsidizes the cost of exploration activities in areas outside of existing North Slope oil and gas units. The credits may fund up to 60 percent of the costs of such activities.
The credits come at a significant cost, however. In order to provide the money to fund the credits, ACES assesses higher tax rates from production within the existing North Slope units than would otherwise be necessary. The result is that the incentives for further investment and development in the existing units are depressed at the same time the tax credit system attempts to stimulate investment outside of the units.
The problem with this approach is that there are significantly more undeveloped resources remaining inside the existing North Slope units than have been identified outside. Indeed, the areas within the existing units hold at least as much remaining oil in place—and may hold more—than the original Prudhoe Bay field.
On the other hand, the potential of the areas outside of the existing units is largely speculative, and to the extent it has been estimated, represents a significantly smaller potential than that remaining inside the existing units. The estimated potential oil in place of the shale oil play currently being pursued by Great Bear Petroleum, for example, is roughly one-tenth the size of that known to remain in undeveloped intervals located inside the existing North Slope units.
Yet despite the lower potential, ACES creates a significant tax credit designed to encourage investment in areas outside of existing units, and effectively penalizes investments inside the existing units. Responding to this bias, a not insubstantial portion of the investment made recently on the North Slope has been in areas outside of the existing units, away from the larger known resources, exactly the reverse of the result needed if the objective is to maximize production.
Direct Regulatory Intervention
The second tool that Alaska has used in an effort to spur development is direct regulatory intervention. The Point Thomson dispute is a good example. There, in 2006, the state instituted legal proceedings to terminate the Point Thomson leases because, in the state’s opinion, the owners, led by Exxon, had not taken adequate steps to develop them.
While many saw the state’s efforts to terminate the Point Thomson leases through other lenses, the proceedings essentially were an effort by the state to punish the owners for failing to invest in a specific project. The result was a settlement, with the owners agreeing to pursue the development of the leases.
Like the tax credits, however, the effort has created unintended consequences. The effect essentially has been to focus investment in one project on the North Slope, likely at the expense of others offering significantly greater potential.
As operator, Exxon already has spent in excess of $1 billion on the Point Thomson project and estimates that, before completion, it will spend billions more. At the same time, investment in the development of the oil available in other existing North Slope units has declined.
In the absence of developing a major gas market, the maximum production anticipated from Point Thomson is 10,000 barrels of liquids per day, which is significantly smaller than other potential opportunities available in the existing units and a minor offset to the anticipated net loss of 50,000 barrels per day of production projected by the state between 2011 and 2015.
It is doubtful that Point Thomson was the most productive use of the investment dollars it has required.
The Problem & a Potential Solution
The fundamental problem that creates these results is the state’s lack of perspective. State government does not view oil development in terms of obtaining the biggest return—in terms of production and revenues—on the investments being made. Instead, under the current approach, state government views these issues politically.
For example, the Legislature created the ACES tax credit scheme largely because it wanted to encourage the development of independent oil companies on the North Slope, to counter the perceived weight of the existing producers.
The state pursued the Point Thomson lease termination proceedings initially because it wanted to jump start the development of Point Thomson’s gas resources at a time when it appeared there might be a market for gas in the Lower 48. When that market disappeared—and the producers started limiting their own, discretionary investments in gas related projects—the state nevertheless continued pressing for Point Thomson development because of the proceeding’s high political profile.
Beginning with this coming legislative session, the state should revise its approach to better align its actions with maximizing development opportunities.
Alaska is not the only government which owns oil and gas resources. When faced with similar issues—declining investment and production—other similarly situated governments have elected to co-invest alongside industry in the development of their resources.
Done in the right way, co-investment directly aligns the economic interests of the producers and the state in the development of the state’s resources at a level not possible under Alaska’s current back seat approach. Using common information and with the same objective, both entities focus on developing the opportunities offering the greatest opportunity for economic returns and production.
Co-investment already has been used successfully in Alaska. On a smaller scale, Anchorage’s Municipal Light & Power has invested alongside producers in the development of the Beluga Gas Field, located in Cook Inlet. The result has been a shared focus on maximizing development of the field, which has proven critical to meeting Southcentral’s gas supply needs.
The co-investment model may be a good model for Alaska to apply on a broader scale. It certainly is one worth investigating further in an effort better to improve Alaska’s alignment with its objectives.
Bradford G. Keithley is a Partner and Co-Head of the Oil & Gas Practice at Perkins Coie, LLP. He maintains offices in both Anchorage and Washington, D.C., and is the publisher of the blog “Thoughts on Alaska Oil & Gas” (http://bgkeithley.com).