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Business/Economy

Alaska's financial dilemma: Reserve funds lately have earned more money than oil

  • Author: Dermot Cole
  • Updated: September 28, 2016
  • Published March 16, 2015

Second of three parts

For Alaska state government, the richest renewable resource is cash in the bank. A year ago, the Constitutional Budget Reserve, flush with more than $12 billion, earned more than $1 billion for the state treasury.

But continued withdrawals over the next two to three years are expected to devour most of the account and its earning power.

The lost renewable revenue would add up to more than $600 million a year, which is about what a moderate state income tax would generate. In a line that the late Gov. Jay Hammond once employed, "It's like keeping the home fires burning by feeding it the home."

The state now expects that earnings from the Constitutional Budget Reserve in 2016 will be about $357 million.

How long the account might last after that will depend on oil prices, state spending and tax policy.

Established as a "rainy day" fund in 1990, the CBR helped balance the state budget through the 1990s and early into this century, with annual cash infusions from a few hundred million to more than $1 billion.

Sporadic reports on the impending demise of the CBR led to several failed attempts at long-range fiscal planning, each of which succumbed when oil prices trended upward.

When oil prices skyrocketed during the Palin administration, the Legislature replenished the fund with added revenue collected under the former ACES tax system. But with the collapse in oil prices since last summer, the CBR is again an endangered species.

A year ago, the Legislature transferred $3 billion to cover shortfalls in state retirement funding. The state is on track to withdraw $7 billion more by mid-2016 to pay for operations.

Despite this dramatic decline in the state's second largest investment account, Alaska today is more dependent on investment income than oil.

Alaska's financial dilemma - read all three stories in the series

Earnings on investments -- from real estate to shares of Apple and ExxonMobil -- have emerged as the largest source of state dollars. That shift has gone largely unnoticed in Alaska, but it has important implications for the future.

Three major factors are at work -- oil prices and production are down, while the Alaska Permanent Fund continues to grow. The fund now contains more than $53 billion and is poised to remain the largest source of state revenue even if oil prices bounce back.

While the role of investment income is not well known, it should come as no surprise. Projections produced by the state going back to the late 1980s showed that the Permanent Fund would one day overtake oil and remain the biggest source of cash for Alaska.

It first happened in the late 1990s, when oil prices fell below $10. But oil prices shot up and stayed high over most of the last decade only to crash in the final days of the Parnell administration.

In the fiscal year that begins next July, the state predicts oil production taxes will generate about $308 million, about $50 million less than the state expects to earn from the shrinking Constitutional Budget Reserve.

Total state oil income, including royalties, corporate income taxes and other sources, is expected to be about $2.1 billion.

With oil bringing in less and investments bringing in more, Alaskans will face major decisions on government finance.

The stocks, real estate and financial instruments in the Alaska Permanent Fund are expected to generate about $3 billion in the next fiscal year, 10 times the oil production receipts.

But as with oil prices, the returns of the Permanent Fund are uncertain and subject to change. Investments carry risk, as demonstrated during 2009, when the fund lost far more in a year than the general fund budget spent.

Recent years have been much better. The fund earned $6.8 billion in the fiscal year that ended last July, while during that year total oil revenue pumped $5.7 billion into the treasury.

Anchorage economist Scott Goldsmith says the investment and oil revenue statistics reinforce the urgent need to abandon the way we have long looked at state finances -- as a year-to-year proposition that excludes Permanent Fund earnings.

"We need to look beyond the immediate question of how we deal with the current year's deficit and we need to be thinking about how we manage our biggest asset, which is the Permanent Fund," said Goldsmith, a professor emeritus of the Institute of Social and Economic Research at the University of Alaska Anchorage.

"The danger and downside risk is that we'll just bump along from year to year and gradually eat up all of our financial reserves," he said.

He advocates a transfer of additional state cash reserves from the Constitutional Budget Reserve into the Permanent Fund to increase its earning power and set a strict spending limit.

He also suggests changing the way the fund pays out its earnings. The payout should be revised to follow the example of most endowment funds, he said, in which the allowable withdrawals is based on a percentage of its total value -- the so-called "Percent of Market Value" approach, or POMV.

Anchorage Rep. Mike Hawker has introduced a constitutional amendment for the 2016 ballot for a POMV change, but lawmakers have been slow to push for it.

For more than 30 years, Goldsmith has made the case in academic and research reports that the state should treat nonrenewable resources and its renewable reserves as part of a complete package, with the goal of setting a sustainable spending target.

He said that the state should look at its financial reserves and the estimated future oil reserves in the ground to derive a level of spending that can be sustained for the long term. Every year that the state exceeds that level makes it more difficult to reach that goal as oil reserves are depleted.

Placing a value on oil still in the ground is an uncertain exercise, Goldsmith said, but is important for restoring stability.

Failing to make the effort now puts the Permanent Fund and the Alaska economy at risk, he said.

It also ignores the reality of a nonrenewable resource and the continued decline of the largest oil field ever found in North America.

Petroleum revenues and investment earnings are unpredictable from year to year, which is why the state bounces from surpluses to deficits based on the 12-month calendar. It's a terrible way to budget, he said.

"The calculation of petroleum revenues and financial earnings should be based on a moving average of several years to smooth out those gyrations," he said.

He estimates the state can spend $5.4 billion a year -- including $1.4 billion for the Permanent Fund dividend -- and sustain that into the future, basing the estimate on the revenue potential of $66 billion in various savings accounts and $69 billion of oil in the ground.

The short version of his formula is that the state has $135 billion in oil and financial assets. It can afford to spend about 4 percent of that each year, he said.

Under the Alaska Constitution, the principal of the Alaska Permanent Fund cannot be spent, but the earnings are available for appropriation by the Legislature. The state has traditionally spent about half of the earnings on the Permanent Fund dividend program, which is not part of the Constitution.

Gov. Bill Walker has proposed a budget with about a half-billion dollars in cuts, but it's $1 billion above the sustainable level, according to Goldsmith.

Goldsmith argues that spending cuts, new taxes or some combination that adds up to roughly $1 billion per year are needed.

That sounds hard, but Goldsmith said it is not nearly as scary as this year's $3.5 billion deficit. It's a more manageable point at which to start discussions, he said.

"But it does require discipline and moving forward right now. The longer we spend beyond our means, the less we have in the bank," he said.

He acknowledged that a transition would not be without negative effects on the economy. But the state is better positioned today to deal with reductions than it was during the tumult of the oil crash in the mid-1980s, when thousands of people lost homes to foreclosure when the construction boom collapsed. Alaska has a more diversified economy, with tens of billions of more in savings.

Excluding investment earnings, the state deficit is about $4,500 per person. Adding investment earnings and adopting Goldsmith's sustainable target, it is closer to about one-third that amount.

Goldsmith, who began writing about all this when the pipeline was young, said he was off on the exact timing of the state's arrival at the fiscal cliff, but he believes the underlying argument remains sound.

"Alaska is poised for either a safe landing or a nose dive," he said in 1992. "Whether we land safely or crash depends on how Alaskans deal with declining oil revenue."

There have been numerous close calls in the past, triggered by world events that drove down oil prices. State leaders worked on plans to restrain spending each time, only to drop the subject when oil revenues rebounded.

One critic of Goldsmith's "safe landing" theory, the late Hugh Malone, who served as revenue commissioner and was a key legislator who worked to create the Permanent Fund, questioned reliance on estimates of future reserves.

Those estimates had proven to be far too conservative, Malone said in 1992, with billions of barrels added as the years went by. He also raised the prospect of oil tax increases as a way of adding revenue.

Malone said the "safe landing" proposed by Goldsmith might apply to government institutions and workers and maybe the oil industry, but "it might be argued that the rest of us would be better off with a crash."

Goldsmith says that the information about oil reserves, future prices and production levels were always uncertain and remain so, but he worked with the best data available at the time.

The oil production figures from the North Slope have in fact doubled the early projections and the pipeline has remained in operation for many years beyond the original projections, with decades more expected.

But oil production is now one-quarter of what it was when Malone offered his critique. The fiscal gap has become a more immediate concern, one that won't go away even if oil prices climb above $100.

Malone, who died in 2001, acknowledged two decades ago that a fiscal crisis could face the state because it relied so much on oil income, but "the difficulty is predicting when and how much."

It is far less difficult today to make the prediction that a fiscal crisis is at hand because of lower prices, lower production and higher spending.

In a recent discussion with the House Finance Committee, State Budget Director Pat Pitney said she thinks the state needs to have two important conversations about the future.

The Walker administration has asked departments to prepare plans showing what those agencies would look like if they are reduced by 25 percent over the next three or four years.

She said there are going to be areas where the state will not accept cuts of that magnitude but with "drastic change," it is possible in others.

But spending cuts alone won't eliminate the deficit.

"The reality of the funding in a deficit environment of $3.5 billion -- even a 25 percent reduction -- leaves us far short," she said.

She said the second conversation for Alaskans is an important judgment call: "What is the right size of government in the state of Alaska for our citizens, for the services we expect -- given the uniqueness of our state?"

"Are we going to be fortunate with the price of oil or are we going to have to pull out different tools going forward, knowing that the right size of government is unlikely to be $3.5 billion less than what it is today?" she said.

In a presentation to credit ratings agencies earlier this month, Walker and top officials said they are preparing for additional budget cuts. "The state is discussing how to increase available revenue," they said.

Tomorrow: The success of the Alaska Permanent Fund, and whether its earnings should fund state government

About this series: Oil taxes and royalties have been the source of about 90 percent of Alaska's unrestricted general revenues, but with oil prices flagging and production way down, they're not coming close to matching state spending. Alaska is staring down a $3.5 billion deficit and the state's long-term prospects are bleak.

One bright spot: Investment income from state savings has shown remarkable resiliency and has overtaken oil-production taxes in their value to the state. But the deficits will require the Legislature to spend down those savings accounts, eliminating any help they could provide. Only one giant savings account is protected by the state Constitution: the Alaska Permanent Fund.

Veteran Alaska Dispatch News reporter Dermot Cole has written extensively about state spending and the Permanent Fund from his base in Fairbanks. Now, in this three-part series, he examines how we got to this point and what we can do to move forward.

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