Turning oil wells into money wells

When oil started flowing off Alaska’s North Slope, State leaders knew they had a problem. Because the natural course of an oil field’s life is to decline, it wasn’t hard to imagine that revenues would follow suit. If Alaska spent the money as it entered the treasury, it would cause a boom a bust in the economy.

From this fact grew the idea of the Permanent Fund. Probably the most concise and well-known quip about saving money for the future came from Governor Jay Hammond when he said he “wanted to turn the oil wells into money wells.” The concept Governor Hammond describes is what economists call “consumption smoothing.”

In your personal life, you do this through retirement planning. It’s simply saving money while your income is high so that your quality of life doesn’t radically change when your income stops. Alaska does the same thing. They save 25% of their royalty income for the predictable future in which that income stops.

Intergenerational Equity

The difference between your retirement account and Alaska’s Permanent Fund boils down to timing. While your retirement account needs to pay your bills until the end of your life, Alaska has to plan until the end of time. Concurrently, you have a claim to your income that your great-grandchildren don’t. If you go to work every morning, you’re entitled to the fruits of your labor.

Alaskans that happen to be alive while the oil flows don’t have the same claim over their oil revenue. The current (and past) generation can’t genuinely claim the “fruits of their labor” argument. Being fair to those future Alaskans that don’t have a voice today requires treating them as though they have an equal right to benefit from that oil. That is why the savings account Alaska created is called the Permanent fund — It endures for all time to benefit all generations of Alaskans.

That fact is enumerated clearly is statute:

37.13.020 (1) the fund should provide a means of conserving a portion of the state’s revenue from mineral resources to benefit all generations of Alaskans”

Side Note on the PFD

It’s worth acknowledging the elephant in the room. There’s a lot of historical context around how future Alaskans should benefit from these savings. From a broad economics perspective, it doesn’t really matter if the future generations get to enjoy the same level of government services, low level of taxes, or distributions of money to the people as past generations received. The only thing that matters in this context is that the benefits are carried into the future. What the future generations do with that money is a different question. If you’re interested in that debate, I wrote about it here. So, I won’t duplicate that effort today.

Consumption Smoothing – Concept

To start, imagine that you win the lottery and get a windfall of $10 million. As you contemplate your unfathomable luck, you decide that you want your kids, grand kids, great-grand kids, and all future generations of your family to benefit from it. Instead of going on an unsustainable spending spree buying mansions, Mercedes, and minks for yourself, you will transform your new found wealth into an endowment for your family.

So, how much money can you spend this year without taking away from those great-grand kids that haven’t been born yet? The answer is simple. You can spend the interest that endowment earns. It’s easy to see. If you want your grandchildren to have the same benefits as you, they need access to the same wealth as you ($10 million in inflation-adjusted terms). If the balance of the future endowment is smaller than it is today, their benefit is smaller. If the balance grows, their benefit is greater than yours.

That means that once you increase the balance to account for inflation, you can (and should) spend whatever is left. If the endowment has a good year and earns 10% above inflation, you can safely shell out $1 million across the current family members without injuring the benefits of future generations. If the fund only earns 1% above inflation, you can still distribute $100,000. But, if you spend more than that you’ll leave a smaller balance for your grand kids — Which will have less earning power than you enjoy today.

Income Smoothing

Perhaps your family’s finances are difficult to manage with such dramatic changes in income. You have two equivalent options to smooth it out. The first is to have a separate holding account to place your earnings. Then, you can make stable withdraws from that account. For example, rather than distributing $1 million one year and $100,000 the next, you can spread those distributions out over time. Perhaps you distribute only the average earnings over the last five years and ensure the rest is off limits. Doing so would smooth out a lot of the volatility while remaining fair.

Another option is to distribute money based on a flat expected return rather than actual returns. For instance, if you manage the fund to earn 5% per year above inflation, you can distribute money as though you earn 5% regardless of whether the fund earns 10% or 1% in the specific year. Over the long run the surpluses and deficits balance out (assuming you exactly hit your target return on average).

This Percent of Market Value (POMV) approach converts that $10 million one-time windfall into a steady stream of $500,000 per year forever. To use Governor Hammond’s analogy, in either case, those invested dollars become money wells pumping out a stable amount of cash year after year.

Adding Expected Future Deposits

This idea of turning temporary revenues into permanent ones gets a little more complicated when the money isn’t in the bank quite yet. To illustrate this point, let’s change the payout of that $10 million prize. Rather than getting one big check today, let’s say you get half now and the other half in 10 years.

Under this scenario, you have an additional challenge in creating intergenerational equity. The problem is that we know today that earnings are going to be greater in the future. If we use the 5% POMV approach, the first ten years get $250,000 of distributions while every year after than will get twice as much. Because everyone in the future in better off than we are today, the situation isn’t quite “fair.”

Ideally, we want the distributions to be flat over time (inflation adjusted). This step function doesn’t get us there. So we need to pull some of those future benefits into the present to smooth it out. The process economists use to achieve this is called discounting.

When we discount that future $5 million payment, it is equal to having about $3 million today earning 5% interest. To be fair to the current generation, you can use 5% of that discounted value now. While this process creates the appearance of “overdrawing” the fund in the present, it’s not. In fact, it is ignoring the future payment that would result in inequity favoring the future over the present.

Smoothing Out Alaska’s Oil Revenues

Now we can talk about Alaska’s problem. When oil started flowing in 1977, the physics of oil production was well known. The basin would ramp up over a few years, but then it would begin a long and steady decline. The fact that North Slope oil is down to a quarter of it’s peak rate should not surprise anyone that understands the basics of oil production.

Knowing that production rates would decline, the equitable thing to do was to save some of the windfall for the future generations of Alaskans. The question was how much to save. For those standing in 1977, there was no way to know what future oil prices would do. Nor could the people of the past have known what rate of return any savings could generate. The best they could do was make an educated guess. If they did, it would have looked something like this.

The above graphic assumes that oil prices would increase with inflation, savings would grow at 5% per year above inflation, oil production decline was predictable, and the state would collect 16% of the gross value. Using these assumptions, we can determine the “correct” rate of saving vs. spending.

In case you’re interested, here’s what the balance of the fund would look like (in nominal dollars) under this plan. By the way, the target balance in 2021 would be about $88.6 billion.

Standing in the shoes of the 1977 decision-makers, it would have been reasonable to expect the state treasury to receive about $163 billion in inflation adjusted revenues during the life of the North Slope oil basin. Because much of those funds would appear in future years, the proper consideration would be the discounted value of those future revenues. Using a 5% discount rate, and adjusting for inflation, a consumption smoothing plan would suggest that the equitable use of funds was $3.6 million per year (in 2020 dollars).

From the graphics above, you can see that the plan would have been to borrow money during the ramp-up phase, then start saving during the peak production period. The plan would also call for reinvesting earnings during that time.

As production declined (and oil revenues with it), there would be a point at which savings would stop. Using the assumptions above, policy makers in 1977 would have expected that to occur around 1997. From there, the plan would turn to those money wells to replace decline oil revenues.

How did things turn out?

The above graphic shows how oil price volatility impacted the actual revenues Alaska received. The two notable periods created enormous, but unsustainable revenue levels. Other than those periods, actual revenues mostly oscillated around the expectation line. Overall, Alaska received even more money than it could have dreamed. In fact, the state has already received the equivalent of $235 billion from its oil. Additionally, the money in bank outperformed expectations.

If oil prices and investment returns were known in advance, those legislators could have adjusted the smoothing plan accordingly. Consequently, the improved revenue picture during the 2006-2014 time frame justified spending from savings during the 1990s. Savings would primarily occur during the high revenue years, but those saving would have to be significant. Here’s what the plan would look like:

Again, success would be visible as a flat spending line across all time (in inflation adjusted dollars). In the graphic above, you’ll notice that the revenues would have justified equitable spending of $6 billion per year in 2022 dollars. That is, properly saving in the past, would have allowed the equivalent of $6 billion per year forever (plus any revenues collected from traditional government means).

How did we do?

It turns out, we didn’t do too bad. The 90s were hard, which meant that a correct consumption smoothing plan didn’t call for much savings during that time. In reality, legislators in the 90s had no way of knowing about the record oil prices coming. So they ended up making more than their required contributions to the savings accounts (although this was purely by choosing not to dip further into savings than they did). But then, during the high revenue years that followed, legislators spent money as though oil would always by over $100 a barrel and production wouldn’t decline.

They were wrong. Oil prices cratered in 2014 and legislators could not unwind the increased spending to which Alaskans had become accustomed. Consequently, by spending more than the equitable rate Alaska fell far behind its target savings plan.

Path Forward

There is no doubt that Alaskans overspent the equitable use of funds during the 2006-2014 time frame. As a result, they are leaving a smaller than equitable endowment for future generations. Unfortunately, you can never make up for an inequitable use of funds. Trying to do so would unfairly burden the present generation for the benefit of past and future Alaskans. Instead, the right approach is to recalculate the equitable spending rate from here forward.

Doing so requires looking at the money wells already have flowing and the oil wells that are still pumping. Then, they can determine the most equitable path forward, ignoring the fact that present and future generations will not get the same benefits past Alaskans did.

The result is the green step-down line on the graphic above. That amounts to $5.07 billion in FY22, including the $1.1 billion of unrestricted oil revenues projected by the Department of Revenue and roughly $4 billion from investment earnings.

Doing so likely requires a draw beyond the POMV set out in current law. But, that’s OK. It’s perfectly equitable to future Alaskans from a consumption smoothing perspective. Higher future oil revenues offset lower investment earnings, so long as they limit the use of funds to an equitable amount.

This point highlights the weakness in the current fiscal plan (which allows a legislature to use all unrestricted oil revenues plus a percentage of the market value of their endowment fund). While it addresses limiting the use of investment earnings, it fails to account for the volatility of oil revenues. The approach we used here fixes that problem by converting future oil revenues into their net present value, then including that value in the POMV calculation.

If you really want to convert oil wells to money wells, you have to do so proactively. That requires a change in the way we think about annual cash flows. Rather than simply saving a small chunk of revenues as they flow in, we have to transform those oil wells before they start declining.


Comments

Leave a Reply