Alaska's economic future:
Berkowitz gets it, Parnell doesn't

Thoughts on Alaska Oil & Gas - October 28, 2010
Brad Keithley's Blog

As the campaign for governor enters its final days, both candidates are focusing on the future of Alaska oil. That is a good thing, because as Gov. Parnell admits, “oil remains the backbone of Alaska’s economy” and that backbone is weakening rapidly.

By now, most are familiar with the basic statistics. Oil provides roughly ninety percent of state government general fund revenues and is responsible for one-third of the Alaska jobs.

Most also are familiar with the fact that oil production from the North Slope is down more than two-thirds since its peak in the late 1980s, and continuing to decline at a fairly rapid rate.

What many are not aware of, however, is how rapidly the decline is occurring.

In 2003, the Department of Revenue predicted North Slope production for the fiscal year beginning July 1, 2010, would average 941,000 barrels/day (bbl/d). In the spring of 2007, immediately before the passage of Alaska’s Clear and Equitable Share — or ACES — the Palin/Parnell approach to oil taxes, DOR still was predicting North Slope production for FY 2011 would average 754,000 bbl/d.

Thus far, however, actual production for FY 2011 has averaged less than 600,000 bbl/d, and DOR now estimates average annual production will only reach 607,000 bbl/d — more than 35 percent below what was estimated in 2003 and nearly 20 percent below what was estimated for FY 2011 as recently as three and a half years ago.

On these rates of decline, Alaska may be approaching the point at which oil ceases to be capable of serving as the “backbone” of the Alaska economy much sooner than previously anticipated. In a speech before the Alaska World Trade Center in September, Kevin Meyers, a former head of ARCO Alaska and a current senior executive with ConocoPhillips, warned that the Trans-Alaska Pipeline System could reach minimum operating level s in four years.

“Even if the state’s more optimistic production forecast is used, which assumes some small discoveries and new developments near existing fields, TAPS operating life would be only stretched to eight years, or 2019,” Meyers concluded.

Alaska doesn’t have to be approaching this cliff. There is roughly as much known oil and gas remaining on state lands on the North Slope as has been produced since the beginning of Prudhoe. Even focusing only on oil, there still is roughly about 50 percent as much known resource remaining.

As testimony before the Legislature in 2006 outlined, the development of these resources could extend oil production from state lands for a long time.

By doubling the then-current levels of investment in oil development and going after the more expensive to produce viscous and heavy oil resources known to underlie portions of existing North Slope infrastructure, the decline rate could be slowed to 3 percent, production life extended to nearly 2050, and as importantly, more than 6 billion barrels of additional oil recovered.

At current market prices, that additional 6 billion barrels would produce an additional $450 billion in gross revenue.

What then is causing the decline? The answer is simple — lack of investment. As oil is depleted from existing wells and developments, continued investment is required to drill new wells and pursue new developments. Since 2007, however, investment in new Alaska development has declined precipitously. Put simply, Alaska isn’t running out of oil, it is running out of investment.

What has caused the decline in investment? Again, the answer is simple — Alaska has lost its competitive position in the global investment market. As a result of increased state taxes resulting from the 2007 enactment of ACES, the share of oil revenues taken by the government at current price levels now approaches 80 percent. By at least one recent measure, Alaska now ranks 129th out of 141 worldwide fiscal systems.

Investment dollars that otherwise might come to Alaska to bolster production instead are going to Brazil, Australia, Angola, the Gulf of Mexico and dozens of other more favorable economic zones.

Under assault from these facts, both candidates for governor have proposed plans to restore investment to Alaska. Ethan Berkowitz was first, proposing his “All Royalty” plan from the opening of his campaign. Sean Parnell has come much later to the game.

Last fall, Parnell at first said that ACES was doing “just fine.” Then, last spring during the legislative session, Parnell proposed some marginal changes in ACES that were so weak even the Republican dominated House did not take them up. More recently, in the last two weeks (18 days before the election), Parnell again has modified his approach by proposing more significant changes to ACES.

As we head into the last days of the campaign, the question then is which candidate offers the better vision for Alaska’s future on this critical — perhaps the most critical — issue facing the state.

To someone who has been active in the oil industry for 30-plus years and has been involved firsthand throughout that time in numerous investment decisions by major and independent oil companies, the answer clearly is Ethan Berkowitz. Indeed, Sean Parnell’s responses have been — and continue to be — so weak that one has to question whether he actually understands the problem.

There are two fundamental problems with ACES. Berkowitz addresses both; Parnell addresses neither.

Fiscal certainty

In 2007, ACES did more than simply raise tax rates on producers. The legislation demonstrated that the Alaska government was more than willing at any time retroactively to change the tax treatment of investments that had been made by producers in past years.

Such an approach — to the degree pursued by ACES — is relatively rare in the oil and gas industry. Usually, when governments change tax policies, they do it on a prospective basis, affecting the revenues produced only from investments made from that time forward. ACES, however, increased taxes on the returns being generated from all investments, both those made in the past as well as going forward.

To some degree, this is the governmental equivalent of the old Peanuts cartoon, where Lucy pulls the football away from Charlie precisely at the moment Charlie becomes committed to kicking the ball — leaving Charlie laying in the dust as Lucy laughs. With ACES, the Alaska government pulled away the revenue stream that the producers had invested money to earn, precisely at the time those investments were about to produce the distinctive returns that oil companies are in business to realize.

Undeniably, the uncertainty that approach engenders has chilled investors’ desires to sink further money into Alaska.

Berkowitz has proposed a different approach. In Alaska, royalties are based in contracts. By proposing to convert to an All Royalty system, Berkowitz has proposed a system designed to provide investors with assurances that Alaska will not again act like Lucy. As Berkowitz said in response to a recent question from the Alaska Journal of Commerce, “(a) contractual approach … gives assurance that the rules will not change once investments have been made and production begins.”

Parnell’s approach, on the other hand, does not even recognize the concern as an issue. Instead, his proposal simply modifies ACES, retaining intact the fundamental approach of applying the tax both prospectively and retroactively. It’s difficult to see how retaining Lucy’s right to pull away the football encourages renewed investment.

Effectiveness

Parnell most recent plan proposes to “cap” one component of ACES, presumably to protect against the level of government take rising beyond a certain level. But he has not specified the cap level, inspiring Tim Bradner to title his story in the Journal of Commerce on Parnell’s proposal “Parnell says he will reduce oil tax rates, but details on proposal are sketchy.”

The second component of Parnell’s October plan is to provide “tax credits for technically challenged fields.” But capital tax credits of the type proposed by Parnell are of little help in attracting significant investment to major new projects.

Most investments in oil development projects are made at the front end, before production starts or when it is just ramping up. To the extent they have been explained, Parnell’s tax credits would largely expire just about the time production starts to reach its peak, exposing the greatest share of production to the full set of taxes under ACES. Knowing that production from a given project largely will not be protected from the full effects of the tax, producers will avoid starting down that road in the first place.

Berkowitz, on the other hand, proposes to tailor the level of government take to new projects as part of the negotiation of the royalty contract. Such an approach is relatively common in international projects, enables the government to set the take level at a rate which captures the investment, and also include other conditions, such as work commitments, which benefit the state.

In the recent KTUU debate, Parnell complained that Berkowitz’s approach would frustrate development. The approach has not failed in other international contexts, however. As Berkowitz puts it in response to the question from the Journal of Commerce, the approach “is tested, proven and competitive.”

One of the problems in military strategy sometimes is that the generals plan tactics to fight the last war. They lose because they fail to adapt to new situations and demands. By attempting to continue to tinker with ACES, Parnell is continuing to fight the last war. Berkowitz is visualizing the one that is on the horizon.

http://bgkeithley.com/2010/10/28/alaska%e2%80%99s-economic-future-berkowitz-gets-it-parnell-doesn%e2%80%99t/#more-386

Reprinted from Alaska Dispatch, Commentary (Oct. 27, 2010) (http://www.alaskadispatch.com/voices/tundra-talk/7299-alaskas-economic-future-berkowitz-gets-it-parnell-doesnt).