Crude oil has been flowing off Alaska’s North Slope for 40 years now. In 1977, the monumental achievement known as the Trans-Alaska Pipeline System (TAPS) was completed. It was the largest, most complex, and most expensive engineering feat of its time. As we celebrate its 40th birthday, we hear heart warming stories about the construction days, we remember the blood, sweat, and tears that were shed over that 800 miles of arctic tundra.

We recognize and commemorate the profound change that oil had on our State, our economy, and our culture. There should be no doubt that oil shaped the Alaska we now know. It built our roads and schools. It paid our taxes and distributed billions of dollars to our citizens. It gave us the financial strength to go from a colony to a State.

The oil that came out of our lands had tremendous value. In fact, oil has been the single most valuable commodity over the last 40 years. And we had a lot of it. As of July 2017, almost 17 billion barrels of oil have been produced off the North Slope. Surely, that great of volume of the most valuable commodity in the world must have generated enormous profits.

So, when I read “The Last Alaskan Barrel” by John Miller, I was a little skeptical of his assertion that the oil producers wish they never invested in Alaska.

But his book peaked my interest enough to run my own numbers and see just how profitable an investment the North Slope really has been. To my surprise, he was partially right. While North Slope oil development has been profitable, it hasn’t spun off an incredibly high return on investment. That said, I do take issue with some of his assertions.

The Highlights

North Slope oil production peaked in 1988 at right around 2 million barrels of oil per day (BOPD). It has been following a natural decline of roughly 5% per year as the reservoir energy is depleted. In 40 years of production, 16.9 billion barrels of oil have made the 800 mile journey from the North Slope to Valdez.

During that time, the global marketplace has undergone significant changes and has experienced several disruptions. The most familiar to most of us occurred in the period of 2009-2014 in which oil prices soared to over $100 per barrel. But through the peaks and valleys, oil price has averaged about $55 per barrel in inflation adjusted terms. A price familiar to those watching the current market activity.

Those 16.9 billion barrels represented a gross revenue stream of $546 billion over the years, or $913 billion when adjusting for inflation. A tremendous amount of money to be sure.

However, those dollar amounts do not represent profits to the oil companies. From that revenue stream they must recover the initial investment, pay interest to their investors, pay for the labor and materials required to keep the operations going, and of course, pay taxes. Anything left over, we could consider profits.

Costs

The cost of initial investment to develop the Prudhoe Bay oil field is reported to be roughly $6 billion in the years leading up to TAPS, or $29 billion in today’s dollars. TAPS itself cost over $9 billion in the early 1970’s, the equivalent of $44 billion in today’s dollars. That is a lot of money.

After developing Prudhoe Bay, North Slope producers continued to develop the region once their anchor field was online. Just a few years after oil began to flow, another giant oil field was being developed to the west of Prudhoe. Kuparuk is dwarfed by Prudhoe Bay, but is still one of the largest oil fields in North America. With the infrastructure in place, the exploration and development of several smaller fields continued over the next couple decades. All told, 25 additional fields of various size have been added to the mix so far, with a handful more identified prospects on the horizon. Over the 40 years following Prudhoe Bay development, North Slope producers have spent $69 billion ($113 billion adjusted for inflation) on capital projects.

Once TAPS was built and the facilities at Prudhoe Bay were up and running, the costs to operate and maintain production kicked in. Some argue that these costs should be included as company profits, as the companies are “merely paying themselves.” However, this naïve logic misrepresents reality. The payments that are made to employees in exchange for their labor are not company profits. Neither are the payments to contractors, or the purchase of equipment, products, or materials necessary to produce oil. It is the revenue in excess of these payments and purchases that go to shareholders.

The reported costs of operations over the lifespan of the North Slope to date appear to be in the range of $61 billion ($88 billion in 2017 dollars). Based on available data, it appears that operations on the North Slope run right around $3 billion per year in inflation adjusted dollars.

Next, we have to acknowledge the cost of transportation. When federal legislation allowing for the construction of TAPS was being debated, it was decided that investors would be allowed to collect a 15% return on their investment. The agency in charge of determining the allowable charge is FERC. Alyeska is the name of the pipeline transportation company that operates TAPS, its owners being the 3 major produces of oil in the State.

While it is true that payments to Alyeska is a “movement of money from one pocket to another,” we must again recognize that the payments to employees and vendors are real costs that subtract from the ability to pay dividends to shareholders. Therefore, the owners are not agnostic about these costs, even though they are fully recovered. Because a federal agency is in charge of controlling the economics of the asset, I will simply treat the tariff payments as the full cost of TAPS transportation.

The cost of shipping 17 billion barrels of oil through an 800 mile pipeline come out to about $75 billion ($147 billion in 2017 dollars). That includes the cost of building the pipeline, paying a 15% return to investors, and 40 years of operating, security, and maintenance costs. Another $58 billion ($128 billion in 2017 dollars) was spent on transportation either to the TAPS entry point, or on shipping the oil from Valdez to the refineries on the West Coast.

The Breakdown

So, what we have so far is a breakdown of revenues and costs, generating a net revenue number before taxes:

 

Nominal Real (2017 dollars)
Gross Value  $        546,800,000,000  $  912,626,625,739
Capital Costs  $           75,000,000,000  $  142,822,493,601
Operations and Maintenance  $           60,600,000,000  $     87,593,420,682
Transportation Costs  $        133,000,000,000  $  275,677,612,824
Net Revenue  $        278,200,000,000  $  406,533,098,632

 

Next I address payments to the government. The gross payments are relatively easy to find. These are published by the Department of Revenue in what they call the “Revenue Sources Book” each year. Digging through past editions, I found that the State government has collected $135 billion ($202 billion inflation adjusted). These payments are generated from 4 sources, royalties, production taxes, property taxes, and corporate income taxes.

 

Nominal Real (2017 dollars)
Royalty (including PF contributions)  $     59,800,000,000  $     90,194,288,896
Production Tax  $     59,300,000,000  $     85,516,453,469
Property Tax  $       3,900,000,000  $       7,697,740,173
Corporate Income Tax  $     11,500,000,000  $     18,923,771,888
Total State Payments  $  134,500,000,000  $  202,332,254,426

The federal government also takes a cut of corporate profits with its own tax. While those tax payments are not public, we can get a fair estimate by taking a percentage of the apparent profits in each year. While the marginal tax rate on large corporation is 35%, I will assume that deductions reduce that to more like 30%. That calculation yields an estimated payment to the federal government of about $44 billion ($66 billion real).

Nominal Real (2017 dollars)
Net Revenue  $        278,,200,000,000  $  406,533,098,632
State Payments  $        134,500,000,000  $  202,332,254,426
Federal Taxes  $           44,000,000,000  $     66,305,171,600
After Tax Profits  $           99,700,000,000  $  137,895,672,606

$100 billion is a lot of money, to be sure. But we haven’t yet allowed the investors a return on their money. We also don’t yet know whether or not those profits are “excessive” or “fair.”

For grounding, if the $6 billion was invested at 7% interest in 1977 rather than in oil development, it would be worth $90 billion today. By contrast, if they invested that money in the stock market, it would be worth $147 billion today. The money that investors could have made by investing elsewhere is what we economists call an “opportunity cost.” It represents an intangible cost that must be accounted for, usually by allowing a like return on the initial investment.

The best I can say right now is that the revenues received by the investors seems reasonable and does not appear to be excessive. The revenue that the State of Alaska has received for its resources also appears to be “fair” the a historical context, collecting roughly half of the net revenues over time and almost all of the economic rents.

Conclusion

I disagree with the conclusion that Mr. Miller draws about the economic returns of North Slope oil. Those developments have been a stable source of cash flow for decades, both for the producers and for the State. His assessment errs by not accounting for the terminal value of the cash flow, abruptly ending his analysis in 2005. In reality, the producers have added over $40 billion to their balance sheets since then. And, the continued production from the North Slope will continue to return positive cash flows on those investments, and many others since Prudhoe Bay, for many years to come.

His logic is also a little faulty. Decisions should not be evaluated in hindsight. Regret analysis is a much different tool than decision analysis, and it has very little place in business. Whether or not the producers regret making their investment, or whether the would have made it with clairvoyance, are not valid claims in a well run company.

Good companies evaluate the decision-making process itself, given the information at hand and readily available at the time of the decision. Bad companies evaluate the outcomes that follow from decision, good or bad. Consistently making good decisions will ultimately prevail over getting lucky after bad decisions. So, the argument is flawed on its face.

However, I find merit in the reality check Mr. Miller provides. The profits off the North Slope have not been excessive and the returns have not been as lucrative as one might think. The costs of development were far higher than anyone imagined and the actions of the State have created uncertainty around the potential profits of new investments.

That results in far lower returns than should be observed. This is especially true given the nature of the oil business. These companies consistently take large risks. In doing so, there are several investments that are a total loss. In order to create a net return on their portfolio, their wins must be big.

Put another way, in this business you should see a lot of projects with a 0% return and a few successful projects in the 20% or higher range. This is vastly different from other industries in which you see several product lines making 8-12% returns. Because we are observing the success leg of the Prudhoe Investment, we should see returns in the 20% realm, instead a preliminary assessment shows it is looking more like 13%.

Alas, the relevant question facing us today is not about the past, but about the present and future. There is still much work do to if we want our resources to be fully developed. But that is a story for another time.

 

 

 

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