Juneau, Alaska

(907) 699-6788 ed.king@kingecon.com

Fighting Over Invisible Milk

In the event you have been hiking the Brooks Range for the last six months, let me briefly get you up to speed.

We have a fairly serious battle going on in Alaska right now. By way of an oil price crash a few years ago, we’ve burned through all of our traditional savings accounts.

Attempts to reduce the budget have created a bloody conflict in the legislature, complete with friendly fire, defections, and the comradery that develops in the trenches.

The last vestige of safety – the Permanent Fund and its dividend – is under attack. The capital building is a dystopian parliament with ghosts of legislators lost in battle haunting the halls and committee rooms.

Angry mobs are carrying torches and pitchforks, demanding the heads of those seeking to destroy their cause (be it the PFD or their favorite government program).

If you believe the social media accounts, Alaska is on the verge of an apocalyptic event. The righteous are either defending our social fabric from demonic greed, or defending liberty from those with the insatiable appetite of a socialist state (depending on the author).

But fear not. Six brave legislators volunteered as tribute. They make up the “Bicameral Working Group on the PFD.” Through their heroic actions in the face of fierce criticism, they will draft a peace treaty for the legislature to consider.

The sad thing is, all of this bloodshed may have been caused by a simple misunderstanding and some bad advice.

The Problem

At the heart of this battle, there is one inciting issue. It is simply this. Oil production has been declining for 30 years. We are now producing only 5% of the nation’s oil. And, with lower production comes lower revenues to fund government.

20 years ago, this issue presented itself as needing addressed, but a meteoric rise in oil prices bailed us out. That mana from heaven solved the budget problems of the day, engorged the state’s savings accounts, and funded billions of dollars of capital improvements across the State.

When the price of oil returned to normal levels starting in 2014, legislators used a combination of living off those savings and clawing back some of that budget growth to try to make ends meet. But spending reductions have proved more difficult than additions.

Legislators also held back some of the distributions to the public, and transfers to the principal, in case they need it. That caused the Earnings Reserve Account balance to swell.

But, even with as much hard work as has been done over the last 4 years, the budget still doesn’t balance – not now or in the future. Well, at least not if you use the assumptions being presented to the legislature.

The Assumptions

The entire problem we are trying to solve relies upon the assumption that there is not enough money.

But, what if the assumptions generating that conclusion are wrong? What if we’re not only fighting over spilt milk, but milk that spilled from an empty glass?

Oil Price

The State’s finances are more sensitive to the price of oil than anything else. An oil price change of just 1% results in a $25 million impact to the general fund. And the price forecast given to the legislature each year is notoriously wrong (to be fair, all oil price forecast are very wrong – even mine. But, the State’s forecasts have an average error of 31% over the last 15 years.)

Why then are we so confident that the problem is so significant that we need to make a permanent change to the system?

Wouldn’t it make more sense to understand the risk that a problem even exists, rather than relying on a single number (that we can be certain is wrong) to conclude that the whole system needs an overhaul?

Here is a graphic that shows how high the price of oil needs to be in order for the problem to not actually exist at all. This graphic uses the DOR forecast, and the budget as vetoed by the governor, as a baseline. Then it adjusts the price to balance the long-term budget under different scenarios, and assumes the CBR is fair game to deal with the immediate problem.

And that’s assuming all the other variables are correct (hint: they’re not).

Expounding on Balancing Price

The figure above sheds some light on many of the things we’ve heard over the last year. First, there is a problem under the baseline assumptions. Without the vetoes by the Governor, we would need a long term average oil price of around $80 to pay the statutory PFD without drawing on savings.

With the vetoes, some of the problem goes away. But, we would still need a price of $75 to balance the budget with a full PFD.

At the $67 price forecast, another $700 million of vetoes would be required to solve the problem without taxes (in whatever form – be it income, sales, property, PFD reduction, oil, etc.).

PFD Reduction Plans

There’s another interesting thing to note in the figure above. Notice that a higher investment return does not solve the problem. Ironically, earning more money actually makes our money problems worse. And, oddly, we will be able to balance the budget and pay the calculated PFD next year if the market crashes.

This is a consequence of have a PFD calculation tied to earnings and a draw limit tied to the fund balance. The disconnect from actual earnings doesn’t allow us to spend the money when we need it, even if we have it.

Changing the PFD calculation is one way to correct that disconnect (I’ll explore other options in a future article). Changing to 50% of the current POMV law would require a price of $74.76 without the vetoes, or $69.57 with them, to balance the budget.

The idea of paying a flat $1,600 PFD goes further. In that case, we would only need $68 to afford the legislature’s budget and $61 with the vetoes.

Oil Production

Another issue is the oil production forecast. While DNR rightfully includes risk weighting in their forecast, it does lead to some miscommunication when those outputs are plugged into a scenario model (risk-weighted forecasts are good for budget decisions, not policy discussions).

The “official” forecast of production is not a scenario. Therefore, it is not something that will actually happen.

For example, the risk weighted call on the flip of a fair coin is 0.5 heads. If you actually flip the coin, you are guaranteed to be wrong (it can’t land on half a head).

But, your error is minimized (the maximum error is half a head no matter what, while you can be off by a whole head if you call heads and it lands on tails).

So, the problem that exists is based on a scenario that doesn’t. There is a better way to approach this, but that’s a topic for another day.

But, regardless of any of that, things have changed in the last year. Most notably, the Pikka project is looking better and better. This is a field projected to reach over 120,000 barrels per day, and carries a 16.67% royalty to the State. That’s a big deal.

The 2018 production forecast had that project significantly risked away. Given what we know now, the State’s forecast this Fall should start to resemble mine.

As I’ve said before, new production won’t solve the entire problem. But, it will do a lot of good. So again, better information next year will probably reveal that paying that full PFD isn’t nearly as “irresponsible” as it appears.

Investment Earnings

Another factor to consider is the amount of earnings flowing from the Permanent Fund. The legislature has decided to limit the draw off the fund at about 4.5% of the fund balance (the calculation is currently 5.25% of the 5-year average balance, which works out to a little under 4.5% of the current year balance – the math is $2.9 billion out of $65 billion for FY20).

The actual rate of return during the last 30 years, adjusted for inflation, is just about 6%. And, the target return for the fund is 5% above inflation. So, the current restriction on the draw is probably lower than it needs to be.

That’s good, in that it will allow more fund growth. But, that comes at the expense of being able to pay our bills today – even though we have the money to do so.

Combined Assumptions

All of this means is that we currently have a conservative long term oil price forecast, a conservative production forecast, and a conservative investment earnings forecast.

Why are we fighting so hard over whether the arbitrary numbers in a spreadsheet balance when we know they are wrong?

This is not the way to manage a multibillion dollar organization that employs nearly 20,000 people.

Complexity

The State’s fiscal situation is complicated, but its also complex. Turning any gear in the machine causes all of the other gears to move as well. It’s far too complex to rely on a single point estimate of something that is impossible to forecast.

Oil prices are extremely volatile and naturally unpredictable. Stock market returns are at least as bad. Oil production is easier to forecast, but the State hasn’t really done well in the past. Plus, things are always changing, so forecasts need to be adaptive.

Right now, the legislature is trying to solve problems that could simply be caused by forecast errors and bad advice. There may not be an actual problem at all. If there is, it may be a temporary problem that will resolve itself.

Yes, we should be aware that a future problem may exist. And, we should plan around our tolerance for that risk. But, the way the government is approaching these issues is a terrible way to lead. Using point estimate forecasts rather than risk exposure is a recipe for low decision quality.

There is a better way. And, one of the missions of this website is to improve the quality of information available to decision makers. Not to persuade, but to inform. I’m offering it for free, should someone wish to see the value.

The Bottom Line

I’ve said before that the PFD reductions imposed over the last 3 years were probably unnecessary. The collapse in oil revenues prompted action, but reactive policies are often inferior to proactive ones.

CSV  

By overreacting to the bottom of the commodity cycle, and by ignoring the actual investment returns that were taking place, we ended up growing our balance sheet by cutting the PFD and the budget during the last two years.

 

  Source: Department of Administration audited financial records.

 Here’s some more detail:

CSV  
  Source: Department of Administration audited financial records.

You read that right. We’ve actually collected more money than we’ve spent for the last two years – during a “fiscal crisis”.

That pattern looks like it may continue for another year. And, that’s unfortunate. There is no reason the state can’t pay out the full PFD. We just need to make a plan around that strategy.

Pulling back on the money that was added to the budget during the high oil price years is one approach. And that’s a political decision. But, debates around the cost effectiveness of programs, and the willingness to pay for them, is a conversation that should happen regardless.

Every dollar pulled out of the budget is one that earns investment returns in the future. Reducing the budget (or the PFD) provides a direct proportional reduction to the risk exposure on the state’s long term financial health. So does raising tax revenues. But, the math won’t answer which of those options is best. That’s up to decision makers.

All I’m saying is that there is no reason for these battles over the PFD to ensnare us. The financial problems facing Alaska are extremely manageable. We just need to better understand the problem before fighting over invisible milk.

6 thoughts on “Fighting Over Invisible Milk”

  1. This is all fine and dandy but to my understanding the PFD capital is not to be touched. The only payout is suppose to happen on its earnings/interest earned. That is why the amount is different every year. If the capital is being touched/paid out to the state, isn’t that against the bylaws from when it was originally set up? I don’t remember a time the people voted to change things. I do remember when we the people voted to NOT take a payoff and give all the money to the state.

  2. You are correct that the Principal of the fund cannot be touched. However, all earnings from the fund are fair game. That was established by the constitutional amendment that created the Fund (article 6 section 15) which says “All income from the permanent fund shall be deposited in the general fund unless otherwise provided by law.”

    There are currently $19 billion of such earnings plus about $4 billion per year being added. The principal holds a separate $40 billion. There are also $6 billion of earnings that have not been “realized” yet.

  3. Thank you Ed for posting the Info. Does the graph “Inflation Adjusted UGF Revenues vs Expenditures” include the cost of the State paying the Permanent Fund Dividend. So for example, the 2018 UGF shows $4.39 billion. Did that include the amount sent out in dividends which I’m guessing was somewhere around $800 or $900 million?

    1. It does not include the PFD on the expenditure side or the Permanent Fund earnings on the revenues side.

  4. This is probably way beyond the scope of what you can do – but it would be neat to having a bunch of sliding scales of the various scenarios you highlighted and the result being what oil price is needed. For example – able to choose how much budget vetos and pfd and investment return then see what required oil price for that combination of scenarios.

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