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Staying the course on oil taxes a gamble

Roger Marks

My father used to tell a joke: A man is down to his last $10. He goes to the track and puts all his money on the horse with the longest odds. The race starts and his horse is dead last. The man drops to his knees and starts praying to God. As he prays the horse starts to gain. The more he prays the more the horse gains. By the home stretch the horse is well ahead. At that point the man stands up and says, "Thanks, God. I'll take over from here."

The "It's Our Oil" perspective, which advocates retaining the current production tax, ACES (Alaska's Clear and Equitable Share), is like this gambler.

As part of statehood in 1959 Alaska selected federal lands for conveyance. By 1964 the state had chosen much of this land, and it included acreage that would become the North Slope oil fields.

The state then decided how it wanted to develop the land. It could have started its own state-owned oil company. Rather, it chose to open up its resources to the world through the competitive bidding lease system. The experience, expertise, and capital of multinational corporations would be brought here to explore and develop. The lessees would make the monetary outlays and incur the geological risk. Development would proceed from market forces.

In 1964-65 the state leased North Slope acreage. At that point there were no reserves and the exploration risk was very high. After a number of costly dry holes, Prudhoe Bay was discovered in 1967.

Oil in the ground on state land belongs to the state. Through the leases, which are legal contracts, the producers have the exclusive right to produce it, and once produced they retain ownership of the non-royalty portion. The royalty portion, established in the lease, is the state's oil. On the North Slope this is about 12.5 per cent.

The same production tax also applies to oil on nonstate land. State ownership is not the foundation for the tax.

For 29 years the production tax was under the Economic Limit Factor (ELF) system, which was lower than ACES. ELF was far from perfect, but under ELF production peaked at 2 million barrels per day. In fact the Alaska Oil & Gas Conservation Commission had to impose a production ceiling on Prudhoe Bay. During that period over 30 fields were developed; two have been developed since. Now production is under 600,000 barrels per day, mostly from long-ago investments.

ACES was enacted in 2007. The progressivity structure imposes very high taxes at high prices. Under ACES, investors will lose money in Alaska compared to nearly any other jurisdiction with similar development conditions.

ACES eliminates nearly all upside potential: the ability for producers to make somewhat proportionally more money when oil prices are high. Upside potential is very important in shaping investment decisions, in large part because it offsets low price risk.

When investors evaluate opportunities they incorporate future oil prices. There is much uncertainty about prices so they evaluate projects over a range of outcomes. Economic feasibility depends on upside potential being able to offset downside price risk. So what happens on the upside can have a big impact on results. But if upside potential is suppressed, like it is under ACES, it may not be worthwhile to develop the project.

That's why so much of "our oil" is sitting in the ground unproduced.

Yes, the oil now being produced is profitable under ACES. Yet the five-fold increase in taxes in 2007 could hardly have been foreseen in any business plan. This practice should give pause to investors thinking about doing business here. Bait-and-switch only works once. Now think natural gas pipeline.

Oil investment has soared worldwide in recent years, but has been lethargic on the North Slope, despite abundant reserves. It is hard to see how staying the course, the "I'll take over from here" attitude, will benefit the state in the long-run. Like the horseplayer, once you succeed it is easy to forget the actual source of your prosperity.

Roger Marks is a petroleum economist in private practice in Anchorage with clients in both the public and private sectors. He is a former senior petroleum economist with the Tax Division of the state Department of Revenue.