The Alaska OCS and State Fiscal Policy (from the September 2013 Alaska Business Monthly)

In addition to pieces on this page and elsewhere, I write what began as a bi-monthly, and now has evolved into a monthly, column on oil, gas and fiscal policy issues for the Alaska Business Monthly.  The following piece was originally published in the September 2013 print edition and is available online here.

Sometimes state officials and other proponents argue that oil tax reform is needed to keep the Trans Alaska Pipeline System (TAPS) operational “until” oil from Shell Oil Company’s Chukchi Sea or other Alaska Outer Continental Shelf (OCS) projects come online in the 2020s.

The implication is that once OCS oil is flowing through TAPS, the state will be out of the proverbial fiscal woods and once again positioned to spend at the greatly escalated levels experienced over the last few years. The additional suggestion—made by some—is that, believing OCS production ultimately will save the day at the other end, maintaining high spending levels in the meantime is acceptable as a “bridge,” even if it requires drawing down the state’s fiscal reserves.

There are several reasons why this is bad fiscal policy, not the least of which is the highly speculative nature of the ultimate timing and level, if not the existence, of OCS production. Shell’s Alaska OCS experience thus far is not a confidence builder. If the Alaska OCS projects are delayed or, worse yet, deferred until a future generation, the “bridge” visualized by interim spending easily could become a fiscal “bridge to nowhere.”

More important, however, is the fact that, even if the exploration and development of OCS oil goes smoothly from this point forward and production begins to reach TAPS sometime in the 2020s, Alaska state government will receive relatively little from the OCS revenue stream.

In fact, current estimates are, even assuming the best possible outcomes, that the net present value of the state’s total, lifetime take from anticipated OCS development, spread over decades, will barely cover two years of state spending at current rates.

‘Government Take’ from OCS Production

As a result of the ongoing debate over oil taxes, Alaskans are becoming increasingly familiar with the phrase “government take” when talking about oil revenues. As used in the oil tax debate, government take generally means the percent of oil company gross profits (revenues minus costs) that ultimately are paid to government. The government’s share usually is the sum of state or federal royalties plus federal and state income and production and property taxes.

The governmental recipient of the revenues varies depending on the location of the production. The Prudhoe Bay field, for example, is located entirely within the geographical boundaries of the State of Alaska and on state lands. As a result, the state receives both the royalty share (because the oil is produced from state lands) and most production, income, and property taxes (because Prudhoe is located within the state). The federal government’s share of the profits is limited to the portion paid as federal income tax.

The governmental revenue split changes, however, when production is from federal lands. For example, the federal government owns the lands located in the National Petroleum Reserve-Alaska. As a result, royalty from those lands is paid to the federal government. Alaska receives a share of the revenue from any oil produced from the area only through the state’s production, income, and property taxes (because the production still is from within the state).

While important onshore, the differences between federal and state lands becomes even more important when discussing offshore production. Offshore, Alaska’s geographical boundary ends three miles from the shoreline. Up to that point, all offshore government take, except for federal income taxes, goes to the state.

Beyond that point, however, the rules change significantly. The area beyond the three mile limit is entirely the province of the federal government.

That is important because the state’s taxing power does not apply beyond the three-mile limit. As a result, with the small exception noted below, beyond the three-mile limit the state generally receives no share of oil production revenue.

Sometimes as a result of federal law, Alaska shares in the royalty from federal lands. If there ever is production from the Alaska National Wildlife Refuge, for example, under federal law the state will be entitled to receive one-half of the royalties received by the federal government.

Federal law provides for a similar split of some of the royalties received from offshore Alaska. But the split is smaller and the area is confined. The state receives 27 percent of the royalties received by the federal government for any production located between three to six miles from the shoreline.

Beyond six miles—and Shell’s Beaufort and Chukchi Sea prospects are located eighteen and seventy miles offshore, respectively—the state receives no direct share, no royalty share, no production taxes, no income taxes, and no property taxes. All government take goes to the federal government.

The Indirect Effect is Limited

Some argue that even though the state doesn’t receive any direct benefit from Alaska OCS production, it will receive significant indirect benefits. A 2011 study for Shell by Anchorage-based consulting firm Northern Economics and the University of Alaska Anchorage Institute for Social and Economics Research attempted to measure those.

The study analyzed a number of possible knock-on effects from Alaska OCS development that would benefit the state. A few are direct. For example, assuming that development does occur and the oil is brought onshore, there will be some related property located onshore that will be within the state’s taxing purview.

But the revenue potential to the state from those facilities is extremely small. According to the study, the state will realize only an aggregate of $296 million in property taxes from onshore properties related to OCS production over the entire fifty-year period covered by the study.

By far the largest category of benefits estimated by the study are the so-called “indirect revenues” arising out of the effect of OCS oil production on TAPS. As background, the per barrel rate charged by TAPS is calculated generally by dividing total costs by total throughput. Because costs are relatively fixed, the greater the throughput on TAPS, the lower the charge per barrel.

The study reasonably assumes that the addition of OCS production to TAPS will increase overall throughput, reducing the charge per barrel that TAPS otherwise would charge.

From this, the study identifies a number of additional benefits. For example, by reducing the transportation cost component used in the calculation of royalty and taxes, the study assumes that the level of royalties and taxes retained by the state from production on state lands will rise. The study further assumes that, due to the reduction in overall cost, marginal production levels on state lands may rise over time as transportation costs are reduced.

In the end, however, the total additional benefit to the state estimated by the study remains comparatively small. The study estimates that the state may realize an aggregate $15.3 billion in such additional incremental benefits over the entire fifty-year period covered by the study. This fifty-year number may seem large at first glance, but pales when compared to the $6.8 billion annual budget which the governor recently announced as his fiscal plan for the next five years.

At that rate, the total benefit to the state from fifty years of Alaska OCS production will be entirely consumed in slightly over two years of state spending.

Federal Royalty Sharing: The Cavalry Isn’t Over the Hill

Some argue that state revenues—and thus, in their view, state spending—also will be bailed out ultimately by a decision from the federal government to share with the state a greater portion of the federal government’s oil and gas royalties from the Alaska OCS.

Supporters cite as precedent the 2006 decision by Congress to share federal OCS royalty revenue with the Gulf Coast states of Texas, Louisiana, Alabama, and Mississippi.

But that precedent is very limited. As contemporaneous accounts make clear, that decision was based largely on the widespread regional devastation caused by Hurricane Katrina and the region’s need for funds to deal with that and similar future events. As Louisiana Senator Mary Landrieu said at the time, Congress “agreed to the bill because they recognized that a dedicated stream of revenue is necessary for Louisiana to protect itself from future storms. Katrina and Rita showed us what devastation can ensue if our communities remain vulnerable.”

As importantly, the legislation was not simply a grant from the federal budget to the state general revenue fund. The money came with significant conditions, including an obligation to spend the funds on projects associated with “wetlands restoration, hurricane protection, and flood control.”

It is true that since 2006, most coastal states, including Alaska, have worked to expand the concept to other areas and to increase the royalty percentage being shared. But without a disaster to propel the legislation, the efforts consistently have stalled in Congress.

Moreover, since 2006 attention by Congress has increasingly turned to fiscal issues, including the federal budget deficit. Oil, gas, and other mineral royalties constitute the second largest source of federal revenue after the income tax. While understandably a priority of some coastal states, it is difficult to visualize Congress as a whole adding to the federal deficit by reducing the federal government’s share of a significant revenue source.

Finally, even if Congress did reach such a decision, the most likely outcome for Alaska would be simply to mimic the decision already reached for the Gulf Coast states, which is to share 37.5 percent of the federal OCS royalty revenues. Assuming most Alaska OCS leases provide in the range of a 15 percent royalty, this would dedicate only a little over 5.5 percent of the total Alaska OCS revenue stream to the state, well below the revenue levels currently realized by the state from onshore production.

Significant State Spending Cuts are Needed

This is not to say that Alaska OCS exploration and development do not benefit individual Alaskans. In a previous 2009 study for Shell, Northern Economics and Institute for Social and Economics Research found that “Alaska OCS development could generate an annual average of thirty-five thousand jobs over the next fifty years—a 6 percent increase compared to total statewide employment without OCS development,” representing “a total payroll of $72 billion (2007 dollars) over the fifty-year period.”

But unlike in other states, jobs in Alaska do not translate into state revenues. Because Alaska does not have state-level income, property, or sales tax, any benefits flowing to individual Alaskans are not shared with the state. Instead, those individual benefits are retained privately.

As a result, as much as some hope for it, Alaska OCS development will not be a savior for current state spending levels. Instead, significant cuts in spending will be needed to keep pace with anticipated future, onshore revenue levels.

Bradford G. Keithley is the President and a Principal with Keithley Consulting, LLC, an Alaska-based and focused oil, gas, and fiscal policy consultancy he founded. Keithley also publishes the blog, “Thoughts on Alaska Oil & Gas” at bgkeithley.com.