Alaska Oil Policy| Understanding Investment (the sixth in the Alaska Business Monthly Series, from the May 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 sixth column, originally published in the May 2013 print edition and available online here.

Alaskans heard the word “investment” a great deal during the recent legislative session.  They likely will hear more of the word in the months and years ahead as the state continues efforts to bring increased investment to the North Slope, and others evaluate whether those efforts are successful.

In that context I thought it would be useful to write a column on oil investment.

The Chart

To do that, I have borrowed a chart from a company called Petoro.  Those who read my January column (“Alaska Oil Policy:  Achieving Alignment,” Alaska Business Monthly, Jan. 2013), will recognize Petoro as the arm of the Norwegian government engaged in co-investment with industry in the development of that country’s oil and gas resources.  I chose to use a chart from Petoro because it is viewed largely as a neutral entity, not likely to tilt the information playing field one direction or another.

The chart shows the relationship over time between investment and production in the development of a typical oil field.  The bars are investment levels, by year.  The higher the bar, the greater the investment made in that year.

The blue line is production level, again by year.  The higher the line, the greater the production level for that year.  The bars and production line go out 26 years, a useful proxy for a significantly sized field.

The bump in the line beginning about the eighteenth year represents the application of improved oil recovery (IOR) methods that often are employed in mature and aging fields.  Depending on the characteristics of the field, the application of such methods can boost both then-current production levels and the ultimate recovery of oil from the field.

As also shown on the chart, however, such increased production and recovery rates require added investment.  The substantial increases in investment levels shown in years 17, 18 and 19 are directly tied to the increased production and recovery rates depicted by the bump in the line.  Those increases would not occur but for the increase in investment.

As complete as the chart is, there are two additional events that are useful to visualize to help understand oil investment in Alaska.  One comes before this chart begins.  A producer must find a field to produce before bringing it into development.

This chart only depicts the development phase.  There are several years before this chart begins that are involved in the exploration phase.  All that occurs in those earlier years is investment; there is no production.

The second is in the later years of the development phase.  This chart shows one cycle of improved recovery.   Actually, some major fields, like Prudhoe, go through a number of such cycles as techniques and technology are developed that offer the potential to increase ultimate recovery rates even further.

Indeed, Prudhoe is something of the global poster child for such efforts.  When first discovered, the owners estimated that they ultimately would recover 40 percent of the oil contained in the Prudhoe Bay Field.  With the application of the initial set of improved recovery techniques, the estimated recovery rate grew to 50 percent.  As the owners came to understand the field better – and continued to make investments – they have developed additional techniques, equipment and tools which lead them now to estimate ultimately recovering 60 percent of the oil contained in the Prudhoe Bay Field.

And there remain other ideas which, with timely investment, may push the ultimate recovery rate even higher.

This chart helps in several ways to better understand oil investment in Alaska.  The following will point out three.

Understanding the Importance of Predictable Tax Levels

First, the chart helps explain why investors are focused on the predictability and certainty of tax and other so-called government take levels.

Following the chart from the left it is clear that a producer commits a large part of the money required for a major project in the first few years.  Most production – and revenue – come later.   Despite the fact that it comes later, however, it is that anticipated revenue stream on which the investment is based in the first place.

Generally speaking, the producer estimates the return it anticipates earning from the revenue stream, compares that with other opportunities and then invests in those providing the best return.

Because the revenue stream is still several years into the future at the time the investments are made, the investor must make projections about what the revenue stream will look like, and what deductions will apply.  One of the factors in making that projection – indeed, often the largest factor other than the price of oil — is the amount the applicable governments will deduct from the stream in royalty, taxes and other assessments over the first 15 years or so of the project.

In making that projection, the investor necessarily will assess the relative certainty of what the government take level will be over the period.  Some countries provide for government take by contract, backed up with various arbitration provisions.  Others essentially negotiate take levels on a case by case basis with the investor during its evaluation of the project and, while not set by contract, nevertheless respect the terms of the negotiated results once the investment is made.

Alaska and others, on the other hand, set take levels in large part by statute, reserving the right to change the level during the life of the project.

Projects where the government reserves the right to change the take level during the life of the project present special problems in projecting the level of the anticipated return.  Usually, the investor will include a risk factor to account for the potential that the level of government take will increase during the life of the project.

In areas where the government has demonstrated a propensity to exercise that ability, the investor usually will assume in its economics some upward change in government take levels during the term.  That also is the case where the current take levels include a “sunset” or similar provision, automatically adjusting the levels in certain situations.  Investors generally will be cautious and assume it is more likely that the events will occur than not.

The result is to put major, long term investments in those areas, like Alaska, where the take levels may be changed at a competitive disadvantage.  Even if the actual government take level at the time the investment is being evaluated is lower than competing alternatives, the project may still go unfunded if there is concern that government take levels may increase sometime during the life of the revenue stream.

The Difference between Long and Short-Term Investment

Second, the chart helps explain the difference between long- and short-term investment.

Following the chart from the left, it is clear that the first set of investment, made in the early years of the project, is significant and produces a long revenue stream.  On the other hand, the second set of investment, made in the later years for improved recovery, is smaller and produces a relatively short revenue stream.

This difference between long-term and short-term investment is significant.  Because they have a limited time horizon, short term investment projects are subject to somewhat less risk than long-term projects.

For example, in evaluating a short term project the period over which an investor is required to project the anticipated level of government take is much more compact.  Investors need to assess the likely level of government take only over a five to eight year period, roughly half that appropriate to a long-term investment.

Because the likely outcomes tend to be more predictable over shorter periods, the risk factors associated with short-term projects usually are lower and enable those projects to compete better for capital than long-term projects in the same area.

For this reason, Alaska tends to compete better for short-term investment than it does for long-term investment.  Adoption of tax reform likely improves that position.  Investors will assume that the changes will remain in place for some period of time.

Even with tax reform, however, Alaska remains at a competitive disadvantage for long term investment because of continued uncertainty around its long-term tax structure.

As the chart makes clear, the downside of shorter-term projects is that they involve much less investment, result in much lower production and last over a much shorter time frame.

Why Capital Credits Seldom Work Well

Third, the chart helps explain why tax credits tied to capital spending generally fail to encourage significant new oil investment, as happened under Alaska’s Clear and Equitable Share (ACES).

In the oil industry, taxes usually are tied to production, once investors have income.  Sometimes, as Alaska tried under ACES, the tax structure also will permit investors to reduce their taxes through credits tied to capital spending.

The idea behind such credits is to encourage investors to pursue projects by reducing the effective cost of their investment.  That approach seldom attracts major projects, however.

As the chart demonstrates, capital spending on major oil projects usually occurs ahead of production.  Investment is heavy at the front end, then tapers off as production begins to ramp up.

As a result, tax credits tied to capital spending largely are only available early in the life of the project, before production – and thus, production taxes – begin.  Unless the time period for which the tax credits can be used is extended, they largely expire before any taxable income occurs.

Of course, some tax schemes permit the credits to be carried forward or, as ACES did for some taxpayers, permits the credits to be turned into cash payments to the investors.  Even then, however, the use of tax credits seldom significantly help a major project.

Even if carried forward, all that the tax credits do is reduce the effective tax rate of the project.  The investor still pays taxes, but the rate is lower than the identified rate because the taxpayer is able to apply credits.

But the resulting effective rate largely is unknowable at the front end of the project, when the decision whether to make the investments is made.  That is because the production level – which generates the tax obligation – is uncertain.  Investors generally will have some estimate of the anticipated production level, but most investors believe, once they gain experience in a field, they likely will be able to increase production levels significantly.  As the investor is successful in doing that, the benefit of the earlier tax credits, which is not tied to production, will diminish.

As a result, few major investors are significantly incentivized to undertake a major projects by capital tax credits.  Instead, their decisions are driven much more by the levels of government take that will apply to production, once it begins.

Attracting investment is not rocket science

The characteristics that attract long term investment to a region that otherwise has significant resource potential are not difficult to identify.  Investors look for good returns, but as important is predictability of the factors that affect their returns.

Major investments are rarely motivated by artificial tax measures designed to provide credits for specific types of investments.  Those measures can be changed and seldom are significant enough to justify a long-term investment.

Alaska is positioned to compete for short-term investment projects.  Whether it is positioned to compete for long-term investment, however, will depend on whether investors are comfortable predicting that they will be able to earn competitive returns over an extended time horizon.  Under Alaska’s current approach to establishing government take levels, that is a question that remains to be answered.

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).