Occam's razor can cut Alaska's budget problems to the bone

As our legislators gather in Juneau to consider Alaska's budget and how to bridge the billions of dollars of shortfall between state income and spending, there are a few key points I would like them to keep in mind. I have twice listened to presentations on the various budget proposals and have each time believed that the principle of Occam's razor was not being applied.

Occam's razor is a problem-solving principle that says when you have competing hypotheses, you should select the one with the fewest assumptions. Budgets are the state's hypotheses of what the fiscal situation will look like over the next year and beyond. In every case, the budget proposals I have seen are based on copious assumptions about future states of numerous variables, two of which I will discuss here. When a budget proposal begins making assumptions about variables a decade or more into the future, it stops being reality and moves into the realm of fantasy. Making assumptions about how we hope the future will be without considering actual facts is irresponsible at best. We need a solution with fewer and more rational assumptions.

The first of these problematic assumptions is the price of a barrel of oil both in the next year and in the longer-term future. Every budget proposal I have seen assumes $60 per barrel oil that rises substantially and consistently over the next 10-plus years. Yet, according to Llewellyn Consulting, during 118 of the past 155 years, in today's dollars (that is, adjusted for inflation) the price of a barrel of oil has ranged between $10 and $40 per barrel (see David Cottle's article on this issue, "Why Crude Oil Prices May Stay Lower for Longer" available online). No Alaska budget proposal should assume a short- or long-run price of greater than $40 per barrel. The $100-plus per barrel oil we experienced in the recent past was an anomaly and will not come back anytime soon.

At least one proposal assumes that all the state has to do is bridge the budget gap until oil prices rise and the gas pipeline comes online. While I have already addressed the price of oil, the gas pipeline assumption is loaded with assumptions itself. It assumes the pipeline is the best alternative for delivering gas to the market and that it will be completed on time, which anyone who remembers the oil pipeline will tell you is unlikely. It also assumes that we will be able to sell natural gas at the price we will have to charge, which as of this writing is above the market price. Although natural gas demand is likely to increase, the market is already flooded with gas and we are competing with other producers who can add additional gas at a much lower cost than we can. Alaska gas will be expensive.

To give you an idea of the price difference between Alaska gas and other producers, the Federal Energy Regulatory Commission estimates that in December of 2015 the landed price of LNG in Japan, a country we are strongly targeting for Alaska exports, was $7.16 per million British Thermal Units (mmbtu). For Alaska to be able to sell gas from its pipeline within the marketplace, Charles Ebinger, senior fellow at the Brookings Institution in Washington, D.C., estimates the price will need to be at least $16 per mmbtu for a sustained period of time. Why? A pipeline adds significantly to the cost of delivery, thereby reducing the overall viability of a pipeline project. If, in fact, the cost of Alaska gas is much higher than the prevailing market price, we will be unable to sell the bonds required to build the pipeline without using Alaska assets to guarantee those bonds. The only asset large enough to support that guarantee is the Permanent Fund. Are you willing to risk the entire Permanent Fund to develop a gas pipeline for gas we may either not be able to sell on the open market or may have to sell at a loss?

The gas pipeline assumption can be handled in three possible ways. First, we could remove the assumption and plan for the budget realities of an Alaska without a natural gas pipeline and then enjoy the windfall if and when it comes online and adjust budgets and taxes accordingly. Second, if we continue to utilize the pipeline as a budget assumption, there should be comprehensive annual benchmarks that need to be met, and if they're not, a "no pipeline" approach to the budget needs to kick in automatically. Or, finally, we could conduct some in-depth cost/benefit analyses on alternative methods of delivering gas to market and pursue the method with the lowest cost of delivery. For example, would Alaska gas be more competitive if it was collected and liquefied on the North Slope and shipped using tankers during the ice-free season? At this point we don't know because no one has done the analysis. I personally do not believe the state has fulfilled its fiduciary responsibility to its citizens to explore delivery alternatives to ensure the most efficient, lowest cost of delivery option is chosen.

Returning to the budget, the state would also benefit from some long-term scenario budgeting in which multiple assumptions are tested and planned for. I would recommend exploring four scenarios:

Scenario 1: No gas pipeline; oil well below $40 per barrel
Scenario 2: Delayed pipeline; oil between $20 and $40 per barrel
Scenario 3: Oil above $40 per barrel; pipeline comes online as scheduled; market available for Alaska-priced natural gas
Scenario 4: Short-term sustainable budget solution for two years while pipeline alternatives vetted; oil between $20 and $40 per barrel

It appears that all of the current budget proposals lean toward the best-case scenario assumptions described in number three above, which may not be representative of the realities of Alaska's future. When I do some back-of-the-envelope calculations under all the other scenarios, which frankly are either more likely or, in the case of scenario four, more responsible, the realities of our short-term fiscal situation would require us to cut the budget this year by a billion dollars, redirect 100 percent of Permanent Fund earnings to the state after inflation protection, as well as potentially introduce new taxes (although taxation of 730,000 residents will never be a significant source of income). These are the realities we need to deal with and the sooner, the better.

Holly A. Bell is an associate professor at the University of Alaska Anchorage's Mat-Su College in Palmer, where she teaches courses in business, finance and economics. She is also a contributing scholar with the CATO Institute and the Mercatus Center, both in Washington, D.C.

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Holly Bell

Holly A. Bell is an associate professor at the University of Alaska Anchorage’s Mat-Su College in Palmer, where she teaches courses in business, finance, and economics. She is also a contributing scholar with the CATO Institute and the Mercatus Center, both in Washington, DC.