What If Those Predictions Came True?

If you haven’t read Isaac Asimov’s “Foundation” trilogy, you should. He introduced the world to the idea that although the individuals within a system are unpredictable, the general direction a society is moving can be seen coming like dominos falling.

Last post, I offered some of my own psychohistory projections about how I see the next decade unfolding. But, naturally, my fortune telling skills are not as good as Hari Sheldon’s.

To borrow from Plato, some of those shadows I see dancing on the wall will turn out to have been cast by something very different than I imagined from my cave.

Therefore, it is not prudent to set policy based on prophetic wisdom. Predictions can help us understand were things are heading, but the future unfolds on its own terms. It is much wiser to try to understand all of the possible futures. From there, you can set strategy around the most likely outcomes and make contingency plans around the risks you identify. That is what good forecasting is supposed to allow you to do.

So, don’t use the numbers here as a guide from which you can plan the future. After all, the very act of adjusting your actions could change the predictions. Perhaps that is encouraging – if you don’t like where things are headed.

But, just to complete this journey of mythical clairvoyance, what would the future look like if those predictions from last week came true? Let’s take another look into that crystal ball.

The predictions

Recall that I made a few specific predictions that would have significant implications – if they come true. For reference, here are those 8 predictions.

Before the end of 2030:

  1. Alaska’s population with grow to over 800,000 people
  2. Healthcare spending will double
  3. North Slope oil production will increase
  4. ANS will rise to $100 per barrel
  5. ANWR won’t be developed
  6. There will be a global recession
  7. The Permanent Fund will hit $100 billion
  8. No statewide income or sales tax will pass

Obviously, numbers 3 and 4 imply that oil revenues will increase. Number 8 would mean revenues will continue to be limited to mostly oil and investment earnings. Number 6 and 7 would impact the amount of investment revenue we will have. And numbers 1 and 2 will impact the budget needs.

Together, this paints a very different picture than prediction models that rely heavily on past data to inform future expectations. Remember, those forecasts are averages of thousands of possible futures. The numbers here are just one.

How Much More Oil Revenue?

So, the obvious question is “how much more revenue are we talking about here?”

I’ve written before about what the long-term forecast may look like, both in terms of production and in terms of revenue. Of course, those posts are a little dated now, but the general point is the same.

Using some updated numbers, and including every project that has a better than 50% chance of being developed from what we know today, here is what an updated production outlook shows for the next decade:

Chart by Visualizer

The other piece of the equation is the oil price. As I said last week, I think it will take some time before policy generated production shortfalls emerge. But, to make this easy, let’s just allow the price of oil to escalate a little faster than inflation so that it crosses $100 before the end of the decade. Here’s what I used in this model run.

Chart by Visualizer

With those two assumptions in place, and assuming the oil tax system remains the same as it is now, here is what happens to oil revenues.

Chart by Visualizer

For comparison, the next figure compares this hypothetical revenue stream to the risk-weighted revenue projection provided by the Department of Revenue. [note: the near-term difference in these lines is due to a different price assumption]

Chart by Visualizer

As you can see, if all of the good news coming from the North Slope really turns into development; and, if the price of oil rises faster than inflation once it is online; then, there will be a window of significantly higher oil revenues to the state.

Of course, I don’t advise budgeting to the best case scenario. But, it is important to understand the guardrails.

What happens to the budget?

There are a few things to consider about the budget. First, remember the assumption that healthcare costs will double. That implies significant increases in Medicaid payments as well as much higher benefits associated with state employees.

Understanding how rising healthcare spending will impact the State budget and the economy is a much larger task than we can do here. So let’s just assume that Medicaid spending and employer contributions to health insurance will both double in 10-years (7.2% per year). Let’s also assume that the PERS/TRS actuarial valuations already include these increases in the retirement account projections.

Second, let’s assume that agency operations (other than healthcare) increase, by a 2.25% inflation rate plus the population prediction (about 0.7% per year). In reality, we really need to dive deeper into this assumption (I don’t think this is how things would play out), but let’s just use it for now.

Using these assumptions, here is what the UGF budget and revenues picture would look like for the next decade. To be consistent with the prediction that no state income or sales tax is passed, none are included in the revenue number here.

Chart by Visualizer

As shown, the increasing cost of healthcare significantly eats into the additional revenues. However, in this scenario we do return to balanced budgets – without using any Permanent Fund earnings – by the end of the decade. [note: the expenditure line flattens out toward the end as debts are paid off]

However, if you peek a little further into the future, the problems we face today reemerge on the other side of the 10-year window. The trick is going to be smoothing out these peaks and valleys in the revenue landscape.

What about Investment Revenues?

To deal with the prediction of a market crash, let’s impose a 20% market correction in FY21. That works out to a loss of $13.4 billion next year. However, not all of those losses would be realized right away (just look at FY09 for an example of how it plays out).

So, $5.5 billion shows up as a loss in the ERA and another $7.9 billion wipes out most of the unrealized gains currently in the fund. Combined with a $3.1 billion draw on the ERA in FY21, the earnings reserve falls down to $3.8 billion at the end of the year. All told, the total fund balance of the Permanent Fund tumbles to $51 billion (due to the $13 billion loss plus the $3 billion draw).

Now that I’ve modeled these predictions out, it is clear that it would be very hard to have a 20% market correction AND see the fund hit $100 billion by 2030. But, let’s run with it.

To get from $51 billion in 2021 to $100 billion at the end of 2030, while still drawing the POMV amount each year, we would need to see a 12.5% annual return for the remaining 8 years in the prediction window. That’s not impossible, but it would be hard.

With those numbers in the model, here is what the fund balance looks like:

Chart by Visualizer

That dramatic drop in fund value has repercussions on the POMV and PFD calculations. Because each uses a 5-year rolling average, the impact is smaller in any given year, but hangs around for five years. Here is how the POMV calculation works out. The amount of the deficit is provided as well, to show how much of that draw would be needed to balance the budget.

Chart by Visualizer

As shown, the decline in market value results in reduced POMV draws over the following 5-years while the budget grows. This timing would be unfortunate, as oil revenues are also depressed during that window (due to development costs of large projects reducing taxable income).

But, starting in 2025, oil revenues pick up. By 2028, we end up with increasing POMV draws on top of a pure revenue surplus from UGF sources.

The significant losses in FY21 would severely reduce the PFD formula in the following five years. Then, the rapid growth of the fund (due to the generous prediction of $100 billion balance) feeds bigger PFDs going forward.

In this scenario, the current formula would call for each Alaskan (including the increase in population) to receive over $7,000 apiece by 2030. And, in this scenario, there would be plenty of oil money to pay it out (due to increasing oil revenues).

However, there is a problem. Starting in 2027, the PFD formula calls for a larger distribution than the POMV allows. These two laws become in direct conflict (rather than the implied conflict that exists today).

Chart by Visualizer

And so, that $7,000 PFD can’t be paid without changing or violating the POMV law. And in the near-term, the calculated PFDs can’t be paid without a tax in place. Since there is a deficit that needs to be filled; and, since we have to adhere to the prediction that a tax won’t pass; it gets filled from the PFD money.

So, the following figure shows how the POMV draw would be used.

Chart by Visualizer

Now, with all that sorted out, here is how the PFD payments actually play out in this scenario (barring a change in the PFD formula or a larger capital budget).

Chart by Visualizer

Note: The FY21 PFD (which gets paid in October of 2020) works out to about $1,500 here. That assumes a few hundred million dollars of revenue above the current Department of Revenue forecast and assumes another bare bones capital budget. The actual number is probably going to be less – unless there is a draw from the CBR or an extra draw from the ERA. The statutory formula would call for a $3,100 PFD. However, paying that amount would require over a billion dollars of additional draws to balance the budget (passing a tax wouldn’t start generating revenue in time for this budget).

Conclusion

This hypothetical scenario shows how things shake out if all those predictions from last week came true. We know that some won’t, but the reasons are probably not visible to us yet.

Still, this exercise of walking down a discrete and vivid path of one possible future provides some insights. It sets an upper limit on revenue expectations and illustrates how even in that rosy picture we don’t have multi-billion dollar surpluses.

It also demonstrates how the current fiscal problems could be temporary, suggesting we might be ok with a shorter-term solution rather than a permanent one. But, we have to be careful.

Those increased oil revenues on the horizon might look like the cavalry is coming to save the day. It’s not. Right over that hill is another wave of barbarians. And given the tension between oil development and climate activists, these are probably our last reinforcements. We need to deploy them well.

History suggests that an increase in revenues will likely result in budget growth and larger PFD payments – which would set the stage for a real fiscal crisis beyond the 10-year window. It is advisable to address the use of those potential revenues now, because it will be impossible once they are in the bank.

Finally, this scenario highlights some of the peculiarities of some of the current laws. The POMV and PFD laws don’t work together today. As I wrote before, that needs to be addressed. Plus, both of those laws allow for more volatility than static models illustrate – and more than is probably desired.

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