Juneau, Alaska

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

Tackling Some Questions about the Fair Share Act

Many Alaskans have probably heard something about the oil tax initiative called the “Fair Share Act.” You may have been asked to sign a petition while shopping, or you may have read something about it in one of the media outlets. You are likely to see it on the ballot when you vote this November.

But, what is it? Here is a brief description of how we see the issue.

What does the initiative do?

The initiative does a lot of different things, but there is one clause that matters more than any of the others. The “Fair Share Act” eliminates the per barrel reduction in tax payments for the three largest oil fields.

Right now, taxes are determined by multiplying the price of oil by the number of barrels produced, subtracting the cost of production, and then taking 35% of that taxable value. From there, you subtract an additional $0 to $8 per barrel (depending on price) to arrive at the tax that is due.

The process is similar to the standard deduction on your federal income taxes. Although there is a nameplate tax rate that you pay, you only really pay that rate on a number less than your total income. So, your effective tax rate is far lower than what the law says. That is the same process in Alaska’s oil taxes.

Just like the Federal government isn’t “giving” you $12,200 as a standard deduction, Alaska is not “giving” money to oil companies. It’s just part of the calculation.

In effect, the initiative removes that “standard deduction” at Prudhoe Bay, Kuparuk, and Alpine. Consequently, the effective tax rate for the producers of those fields goes up – by a lot.

The initiative also increases the minimum tax on these fields, turns all fields into separate tax groups, changes the tax law from an annual tax to a monthly tax, and makes all company tax information available to the public.

Who would the initiative impact?

On the surface, the initiative only impacts the Prudhoe Bay, Kuparuk, and Colville River fields (which include the small oil pools surrounding the large oil pool). However, the implications reach beyond these fields.

  • The Pikka field would be impacted as soon as it produces its 400 millionth barrel of oil. That changes the economics of the project. Plus, the investors are likely to anticipate another change in the law as soon as another budget deficit emerges.
  • The Willow prospect would also be impacted the same way, but faces an even larger change to its economics due to the “ring-fencing” provision. By slowing down the recovery of capital, ConocoPhillips would need to reevaluate the project.
  • Hilcorp would need to consider the consequences of going over 40,000 barrels per day at Milne Point. That might defer investment in those new drill pads and polymer flooding facilities.
  • Exxon would need to reconsider how much money they are willing to lose at Point Thomson each year, seeing as those losses would no longer be write-offs at Prudhoe Bay.
  • Oil Search would also see the economics of Horseshoe and other opportunities change, due to the new ring-fencing rule.

In short, it impacts a lot more than first assumed.

What would happen if the initiative passes?

There are two things we know for sure. First, the State of Alaska would see an immediate boost in oil revenues.

Our estimates peg the increase at $1.347 billion next year. That number is a combination of higher severance taxes and lower corporate income taxes. It comes primarily from increased taxes at Prudhoe Bay, Kuparuk, and Colville River, but also comes from an increase in ConocoPhillips taxes due to the inability to write off costs associated with Willow.

There is also a knock-on effect in the large oil fields. By reducing the amount of money the working interest owners are willing and able to invest, they have fewer deductions to their taxable income. This results in a higher near-term tax.

That brings us to the second point – The economics of every development decision would be negatively impacted, resulting in less investment.

The most likely outcome would be that projects within Prudhoe Bay, Kuparuk, and Colville River would lose out to projects in areas with lower tax rates. And, with less cashflow comes less money to invest in new developments.

Therefore, ConocoPhillips would most likely focus its attention and remaining capital in the NPRA. Without partner alignment in Prudhoe Bay, Hilcorp would not be able to do what they do best. That would probably shift Hilcorp’s attention and capital to Liberty, Milne Point, NorthStar, Endicott, and Cook Inlet.

We would then see an accelerated decline in the state’s largest oil field, as the higher tax rate forces the working interest owners into “harvest mode” (in which they stop investing in the field and allow it to naturally decline).

ConocoPhillips would similarly lose interest in rate adding activities in Kuparuk and Colville River. In Kuparuk, they may abandon the Nuna, ENEWS, and Cairn prospects. In Colville River, they would likely be motivated by the perverse incentive to slow down production until it falls below 40,000 barrels per day (which would take about four years). And, the Narwhal development opportunity would probably be pursued from a drill site outside of the Colville River Unit, rather than by expanding the unit.

How much do oil companies pay in taxes?

There are three separate oil taxes that Alaska charges on oil companies. A property tax, a severance tax, and a corporate income tax. We tax oil production that is owned by the Federal government, Alaska Native Corporations, and that we have leased to oil companies. Taxes have nothing to do with ownership.

According to Department of Revenue data, here is the history of oil tax payment (after deductible credits).

It adds up to about $85 billion since statehood. There were also $59 billion in royalty payment to the state that are not included here, as well as additional taxes to local and federal governments.

Notice that taxes fell dramatically since 2014, which happens to coincide with a change in the tax law. This coincidence tends to give the impression that the tax change caused the drop in tax revenue. That is a false correlation. SB21 did not cause a drop in taxes.

To understand why, it is helpful to understand how the value of oil production has changed over time. Taxes are a percentage of value. So, if the price of oil falls, or if the amount of oil being produced declines, the potential tax revenue falls – regardless of the tax law. This figure shows the gross value of oil production by multiplying the oil price by the number of barrels produced.

Regardless, the oil industry has never paid a “negative tax rate.” That assertion is a misrepresentation of reality. In fact, the companies paid taxes even when they lost money on the year.

How much do oil companies keep as profits?

The concept of profits can be a little more confusing than people first think. Most people confuse positive cash flows with profits. Or, they confuse accounting net income reported by companies with their profits.

Profits occur when you earn more money than you spend. But, it may take several years of earning positive revenues before you make a profit. When an oil company invests a billion dollars in a project, they don’t make a profit until they recover those costs. And, it might take years of receiving positive cashflow just to break even (before paying interest on that money).

The last time we estimated company cash flows, we pegged the companies at taking in $2.1 billion more than they spend in a year. That number changes every year, depending on what happens with oil prices and production costs. But, that’s the ballpark we are playing in. It works out to something like a 13% return on investment, or roughly $100 billion of profits over the life of the basin so far (over the same period, Alaska collected $138 billion).

Is that a Fair Share?

Let’s do some simple math. If oil companies invest $10 billion in a new project, they would need to earn positive cash flows of at least $2 billion a year to get their money back in 5 years. After that, they would be making profits. Then they need to make enough profit to make the investment worth their while.

If you only let them keep $1 billion per year, it would take 10 years to recover their investment. That’s too long for most investors to wait. There are better ways to invest that money. So, there is some amount of profits that we must allow in order to have anything to tax.

The mere existence of profits (and especially not positive cashflow) does not signal that our taxes are too low. We also need to consider what is fair to the investors for risking their capital. And, we should be careful about renegotiating contract terms through taxation.

What is the total impact?

We see the “Fair Share Act” as a temporary solution, which exacerbates a long-term problem. While passing the initiative would solve the immediate financial problems facing the state, it would create perverse incentives to reduce production, push the major oil fields into harvest mode, and shift capital to federal lands (where the state does not receive the royalties).

The increase in tax collection would then decrease each year – as the accelerated decline in production offsets the gains from a higher tax rate. Within a few years, the higher tax rate is applied to a low enough volume that the state collects less money than it otherwise would have. At that point, the budget deficit resurfaces and the financial problems reemerge. Given the demonstrated willingness to raise taxes as a way to tackle financial problems, investors are likely to view Alaska as a negative investment climate – which locks the basin into a death spiral.

We estimate the total lost production at 800 million barrels – from known resources – over the remaining life of the North Slope. That life is shortened by about five years stemming from the reduced investment in rate replacement. Additionally, the actual number of lost production may be much higher given that we can’t know what future exploration efforts would have added to the potential investment pool.

Those lost barrels result in fewer dollars flowing to the future treasury, leading to fewer tools for future Alaskans to deal with the financial problems that were deferred. And, the reduced production from state lands implies that fewer royalty dollars would flow into the Permanent Fund – thus creating even less revenue for future Alaskans.

Conclusion

The Fair Share Act is a viable option for addressing the immediate financial problems plaguing the state. Passing the initiative would likely result in more government services, avoided taxes, and larger PFDs for the next few years. If someone has a short time preference, the bill may be beneficial to that individual.

But, for a person that cares about the future of our state, a “No” vote is likely to be more aligned with their views. Forgoing higher tax collections in the near-term allows more development to occur. Those developments will generate taxes, royalties, and jobs for years to come.

It is also worth pointing out that passing the initiative is likely to result in less total oil production. If a person is motivated to “keep it in the ground,” passing this law may have a desirable outcome.

Or, if a person is convinced that the end of oil is near, it might make sense to grab as much of the value as possible before everything shuts down. In this frame of mind, no investment is lost because the investment was not going to occur regardless.

In the end, it appears that the Fair Share Act serves as a fork in the road. A “Yes” vote signals that it is time to turn away from oil, and that we should collect as much as we can as we transition away. A “No” vote signals that we want to continue walking the path of increased investment – which leads to a stream of long-term financial and economic benefits.

One thought on “Tackling Some Questions about the Fair Share Act”

  1. Ed,

    Interesting outline. Have you compared the dollars required to be invested (net of profits) that keep production growing? Have you calculated the values on fereral lands, reducing our royalties to 50% shared with the feds?

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