Permanent Fund principal, not oil royalties, drives most of its growth

Dermot Cole
OPINION: One of the most misleading statements against the oil tax repeal effort is that increasing the amount of oil royalties collected by the state is the key to increasing the size of the annual Permanent Fund Dividend check. Images_of_Money photo / cc via Flickr

FAIRBANKS -- One of the most misleading statements put forward during the course of the debate over the oil tax repeal effort is that increasing oil production, and therefore the amount of oil royalties collected by the state, is the key to increasing the size of the annual Permanent Fund Dividend check.

It reflects a basic misunderstanding of the size of the fund, its future potential and the key factors influencing its growth. It also adds to the confusion between the dividend, which is important, and the fund, which is more important.

The future of the $50 billion fund depends more on the value and growth of investments around the world than on the future development of royalty oil. It also depends on how we handle the growing state deficit and whether we can agree on cutting state and local government services, two enormous challenges.

This is not to say that there is no link between oil taxes and the future of the fund. Oil is a non-renewable resource, and it doesn’t take a professional seer to understand that earnings of the fund will have to play into the Alaska budget picture in the long run.

It could happen within a decade, as the state savings accounts are likely to shrivel in the years ahead regardless of what happens in the election Tuesday.

Under an amendment to the Alaska Constitution approved in 1976, at least 25 percent of the value of state royalties — the portion of the oil owned directly by the state — are deposited into the Alaska Permanent Fund. In practice, about 30 percent of royalties are added to the account each year. 

As of this week, the fund owns about $21 billion in stocks, $12.5 billion in bonds, $6 billion in real estate and $10.5 billion in other investments, along with $443 million in cash.

In a debate on repealing the oil tax law Monday, a reporter asked former state Sen. Chancy Croft whether the SB 21 tax cut or the old ACES tax law would lead to larger dividends. Croft said he thinks it would be under ACES, “but I don’t think that’s the important thing in terms of this policy debate.”

He’s right. It’s the wrong question. If you think everything  can be reduced to an argument about the size of the dividend check -- under the false notion that the dividend defines Alaska -- there’s no hope for an informed electorate.

That didn’t stop Sen. Lesil McGuire, arguing on behalf of preserving the oil tax cut, from saying “your check stands the best chance of going up under SB 21.”

“It is royalties that lead directly from production into the Permanent Fund. It’s 25 percent of those royalties, so without new production we cannot grow that Permanent Fund.”

She said under the ACES tax system there were “seven years of no new production, which equals no new royalties, which equals no money into the Permanent Fund.”

Royalties do not drive Permanent Fund

The situation is far more complicated than that, as royalties are not driving the major growth in the fund. That’s been true for many years. In a way it's a good thing, a step toward the perennially popular notion of diversifying the economy.

The Permanent Fund has reached the point where its major engine is the principal, not the annual deposits from oil royalties. If royalties doubled or tripled, they would still not be as important to the future of the fund as the earning power of its principal.

This doesn’t mean that the fund never runs at a loss. The fund lost more than $7 billion in 2008-2009 on its investments during the economic collapse, while it gained $1.5 billion from oil royalties during that time, which helped offset the decline.

The fund went on to earn $21 billion from 2010-2014, a span during which it received $4.1 billion in royalties.

The state deposited about $779 million in royalty oil payments into the fund in the fiscal year that ended in June, while it earned a record $6.84 billion on its investments.

The state expects to pay $1.2 billion in dividends this year, about double the amount from last year. The growth stems largely from improved investment returns and that the disastrous losses of 2009 have now dropped off of the floating five-year average in the dividend formula.

Over the next decade, the Permanent Fund expects to receive about $7.18 billion in oil royalties. While that is a significant total, it is about one-seventh of the amount the fund expects to collect if it achieves a real return of 4.2 percent over that time on its worldwide investments.

If the investment policy succeeds, the growth in the fund will be about seven times as much as the royalty deposits over the decade -- $49 billion.

Using the dividend formula of allocating about half of the annual earnings averaged over a five-year period, the fund would pay out about $17.5 billion in dividends during that time and end with a value of about $83.8 billion in 2024.

If the fund grows to that size, it will be because of a diversified portfolio of investments, the performance of which depends upon the health of the U.S. and world economies, not because of the flow of royalty oil. There are no guarantees.

One big reason it may not reach that size is that the state may choose to use earnings from the fund to pay for public services such as education. Alaska has enjoyed an unparalleled period in which the fund has been seen largely as a dividend machine, not as a means of paying part of the bill for government services.

At some point I think that will change. It will be a far more divisive political fight than those we have witnessed this summer.

The views expressed here are the writer's own and are not necessarily endorsed by Alaska Dispatch News, which welcomes a broad range of viewpoints. To submit a piece for consideration, email commentary(at)alaskadispatch.com.