Alaska Oil Policy| “Maximum Benefit” (the fifth in the Alaska Business Monthly Series, from the March 2013 edition)

As noted on these pages previously, I write a bi-monthly column on oil & gas issues for the Alaska Business Monthly.  This is the fifth column, originally published in the March 2013 print edition and available online here.

Article VIII, Section 2 of the Alaska Constitution requires that “[t]he legislature shall provide for the utilization, development, and conservation of all natural resources belonging to the State, including land and waters, for the maximum benefit of its people.”

As we have often heard during this legislative session, many read this provision as having significant relevance to the current oil tax debate, arguing that the provision requires the state to tax oil production at high rates in order to derive the “maximum benefit” from the oil for the state’s citizens.

That argument overlooks an important part of the constitutional provision, however.  The provision does not say “for the maximum benefit of its current people.”  Instead, the provision requires that the state’s natural resources be used for the maximum benefit of its people – all of its people – both in this and future generations.

That is a critically important point in the current oil tax debate.

Some argue that the Governor’s proposed bill fails because it will result in an immediate reduction in state revenues, which may last for a few years.  Admittedly, that may adversely affect some of Alaska’s current people who benefit from marginal state revenue.

But that is not the relevant point.  Instead, the relevant point is whether tax reform will result in a greater benefit to all Alaskans, both in this generation and the next.  That is the true constitutional test.

Potential Scenarios

Remaining Life at Various Investment Levels
Click to enlarge

For me, a graphic from the 2006 phase of the oil tax debate – yes, it has been going on that long – makes the point best.

That graphic shows the potential cumulative effect over time of three different investment scenarios.  Starting in 2006, the line to the left (in red) depicts the potential effect of making zero additional investment in the North Slope oil fields.  That results in a 15% annual decline in production, with production falling roughly to 300,000 barrels per day – a potential shut down point for the Trans Alaska Pipeline System (TAPS) –  within a short timeframe.

The line in the middle (in green) depicts the potential effect of continuing to maintain investment levels at the then current rate, which in 2006 was roughly $1 to $1.5 billion per year.  Essentially, it is the status quo case.  That results in a 6% annual decline in production and reaches the same 300,000 barrels per day point several years later, in the late 2020’s.

The line to the right (in blue) projects the potential effect of doubling the then current overall investment level to roughly $2 to $3 billion per year.   That results in a projected decline rate in the range of 3%, and extends field life – the point at which production reaches the same 300,000 barrels per day point – to nearly 2050.

Obviously, the differences between the various lines start out small.  Focusing on the middle and farthest right lines, the differences in production levels in the first few years are minor.

Over time, however, the cumulative effect becomes significant.  That is best shown by the circle charts in the upper right of the graphic.  Those charts estimate the number of barrels which would be produced after 2006 at the different investment levels.   The amounts are simply an aggregation of what is captured under each of the decline curves shown in the lower portion of the slide.

The charts estimate that 1.3 billion barrels of additional oil would be produced after 2006 under the no investment case and 3.6 billion barrels of additional oil under the status quo case.  The amount of additional oil, however, jumps to 7.5 billion barrels – or more than twice the “status quo” amount – by doubling the investment levels.

These numbers provide an important means for understanding the potential impact of a reduction in oil taxes.

The Importance to the Tax Debate

Assume for example that the government’s (state and federal) current overall tax and royalty share of the value of oil production is 70 percent.  Assume also that in order to spur the added investment contemplated by the third scenario it is necessary to reduce the government’s share to 50 percent.

Charting those changes, it is easy to imagine that during the first few years annual revenues resulting from the reduction in the government’s tax rate will fall below current revenues under the existing rate, even as production levels increase because the production levels under both scenarios remain relatively close.

Over time, however, the proposed rate will produce substantially more value for Alaskans of all generations.  Assuming, for example, the net oil value against which the government’s share is assessed remains constant at $70 per barrel, the higher tax rate will produce approximately $175 billion in additional revenue to the government over the remaining production life.  This is the result of taking $70 per barrel, times the tax rate of 70 percent – for an overall level of government take equal to $49 per barrel – times the 3.6 billion barrels of cumulative production anticipated by the higher tax/lower investment scenario.

Using the same chart, the lower tax rate will produce approximately $260 billion in additional government revenue over the remaining production life, or nearly 5o percent more in value, notwithstanding the substantially lower tax rate.  This is the result of taking the same $70 per barrel in assessed value, times the lower tax rate of 50 percent – for an overall level of government take equal to $35 per barrel – times the 7.5 billion barrels of cumulative production anticipated by the lower tax/higher investment scenario.

Of course, some argue that there is no guarantee that a lower tax rate will result in increased investment.   That is a misleading argument, however.   Given the imperative of maximizing returns, at some rate private investors will find it appropriate to increase the level of investment they are making in Alaska.  The challenge is finding the appropriate rate.

Given the potential size of Alaska’s resource – and the prize Alaska could realize from increasing investment – Alaska’s policy makers have a great deal of flexibility in finding the appropriate rate.  Based on the assumptions identified earlier, Alaska could reduce the government’s share all the way to 35 percent – or half the existing rate – and still come out dollars ahead over the remaining field life if that was necessary to spur the levels of investment required to achieve the higher production levels.

Tax Policy Approach

Of course, I am not suggesting that Alaska adopt the lowest tax rates it can in order to come out a little bit ahead.  If increased investment – and production – can be achieved at higher rate levels, then maintaining the higher rates is likely justified.

By the same token, however, Alaska’s policy makers should not be driven by an obsessive desire to keep current tax rates at a level which are designed to maintain state revenues at or near current levels.  Achieving “maximum benefit” for the state means the largest cumulative benefit, not that measured only in one or two years.  As demonstrated above, sometimes that means accepting lower current revenue levels for long run benefit.

Additionally, Alaska’s policy makers should not become excessively cautious by attempting to determine – and set Alaska’s tax rates at –the precise point at which Alaska becomes competitive.

The global oil and gas investment environment, like most other global business environments, is a constantly changing place.  What may be marginally competitive today may become uncompetitive tomorrow as a result of the development of other investment opportunities or changes in policy elsewhere.

As the graphic shows, the downside for Alaska of missing the competitive window is significant.  Cutting Alaska’s current tax rates some, but not enough to make the state consistently competitive, puts at risk the recovery of the approximately 4 billion additional barrels potentially available through increased investment.

This is not a time to nickel and dime the state’s response to the challenge.  The potential rewards – and the potential lost opportunity costs – are sufficiently great that Alaska’s policy makers should make certain that any reform puts Alaska squarely within the zone of competitiveness and not try to play the edges.

What should drive Alaska’s policy makers is the desire to identify the tax rates necessary to keep investment at the level required to achieve the greatest possible overall revenue levels from state lands on the North Slope.  That is what produces the “maximum benefit” to all Alaskans, not the levels that may produce merely the greatest revenue levels in the next two, five or even ten years.

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” (bgkeithley.com).