Tuesday, September 4, 2012

The Upside Down World of Alaska Oil Credits ...

An article that I caught up with over the weekend from a week ago Sunday's online edition of the Washington Post -- "Alaska pursuing unconventional shale oil development to fill its pipeline" -- reminded me again of how upside down Alaska's oil policy has become. 

One of the significant policy shifts brought about by the passage in 2007 of Alaska's Clear and Equitable Share ("ACES") was the increased reliance on tax "credits" to direct investment behavior.  Generally speaking, tax credits are a way in which government tilts business economics to incentivize some activities over others. 

Through credits, government favors one class of taxpayers by lowering its tax costs, sometimes to below zero (meaning they actually receive cash from the government).  The offset is that the credits necessarily penalize another class of taxpayers.  Because government does not generate revenue on its own, the credits necessarily are paid for by charging another class of taxpayers a higher level of taxes than would be needed in the absence of the credits.

In essence, credits are a way of substituting government's judgment for business in picking economic winners and losers.  Through tax policy, the government favors investment in some activities -- the winners -- and discourages investment in others -- the losers -- by raising their costs.

At a Federal level, think of wind and solar credits.  At the Alaska state level, think of ACES.

ACES contains a sweeping series of tax credits. As summarized in a recent presentation made by Department of Natural Resources Commissioner Dan Sullivan in Houston, Texas, the tax credits generally include (i) "any losses" on oil and gas operations, (ii) an amount equal to 20% of "capital expenses," and (iii) an amount equal to 40% of the costs of "greenfield exploration."  As used in the presentation, "greenfield exploration" means activity outside of an existing unit.

While the first two categories theoretically are available to producers located both inside and outside existing units, as a practical matter in the current environment only those with operations outside existing units are likely to incur losses.  By its own terms, the "greenfield exploration" credit clearly applies only to operations outside existing units.

As a result, under ACES the bulk of the tax credit structure is built to favor activities outside of existing units at the expense of activities inside of existing units.

As a recent state study concluded, "[t]he structure of the tax credits is such that exploration and new developments receive significant credits (up to 65 percent) and ongoing capital spending in existing fields receives fewer credits (20 percent)."  Alaska’s Oil and Gas Fiscal Regime – A Closer Look from a Global Perspective, Alaska Department of Revenue (Jan. 2012) at 24.

This is where the problem arises.

Usually, government aligns tax credits with its policy objectives.  Tax credits are designed to incentivize those activities that are consistent with government's policy objectives, and penalize those activities which are not.

Oddly given the importance of oil development to Alaska, ACES works in the exact reverse.  The tax credits embodied in ACES penalize oil investment that promises the most significant benefits to the state and, instead, reward investment that offers no clear path to improving state wealth.

As I explained in an earlier commentary in Alaska Business Monthly, there are roughly 24 - 30 billion barrels of known oil in place remaining in largely undeveloped intervals inside the existing North Slope units.  Because of the location of the oil inside existing units, the increased surface footprint required to develop that oil -- and, thus, the permitting burden to develop those resources -- likely is small.  The  economics also are improved by the fact that there is a large segment of existing infrastructure already in place on the surface to help develop and produce the supplies.

The size of the resource is significant.  Even at a 25% recovery rate, there are roughly 6 - 7.5 billion barrels of production potential that lie within these zones.  At the 40% recovery rate initially estimated for the Prudhoe Bay field, there are roughly 10 - 12 billion barrels of production potential.  At the 60% recovery rate now being achieved for Prudhoe, there are roughly 14 - 18 billion barrels of potential production.

Because these intervals contain much more viscous and heavy oil than the intervals which have been the source of Alaska's North Slope production to date, the challenges and costs of developing these resources are substantial.  Significant investments will be required to hone and then apply the new technology required to access the resources.  As the development and production of the even more technically challenging Canadian oil sands make clear, however, with the right investment economics, development is achievable.

On the other hand, the potential 0 - 2 billion barrels of "technically recoverable oil" (which means, even if it exists, the resource may or may not be economically recoverable) discussed in the Washington Post article is in a previously undeveloped portion of the North Slope, will require the installation of substantial and intensive new surface infrastructure and, as a result, will create an entirely new set of state and federal permitting and development challenges. 

Perhaps more importantly, even at its highest, the estimated potential of the new source of supply discussed in the Washington Post article is less than a third of the minimum potential of the heavy and viscous resources in the existing North Slope fields.

From a state policy perspective, the path would seem clear. 

Governor Parnell has said that increasing current oil production is Alaska's No. 1 economic objective.  As a result, if the state was going to favor either resource, the tilt should seem to favor the known and significantly larger resource located within reach of existing infrastructure.  Because of its location underneath an existing surface footprint, that resource holds the greatest promise of increased production in the near term, and because of the greater size of the resource, also over time.

In fact, however, current state policy tilts the playing field in the exact reverse.  Because the larger and easier to access resource is located within existing units, it receives a much smaller tax credit.

Because the smaller and harder to access resource is located outside of an existing unit, it qualifies for the significantly larger tax credit.  In short, ACES substantially tilts the economic playing field against investments in the known and larger resource, and in favor of investments in unknown resources located miles away from existing infrastructure.

The extent of this tilt is shown by its effect on Alaska's budget.  According to Commissioner Sullivan's Houston presentation, the "[c]redits can be used to offset tax liability for the current tax year, carried forward to offset tax liability in a future year, sold to another taxpayer, or refunded for cash."

The only producers claiming refunds in cash are those which otherwise do not have sufficient taxable income to recover the credits by offsetting them against their taxes.  In other words, the only producers claiming refunds in cash are those engaged in activities outside of existing units. 

Since the passage of ACES, the state has allocated over $1.8 billion toward credits to be paid in cash (FY 2013:  $400 million; FY 2012:  $400 million; FY 2011:  $180 million; FY 2010:  $180 million; FY 2009:  $400 million; FY 2008:  $250 million).  More no doubt have been claimed by the same entities by selling the credits to those taxpayers actually incurring tax liabilities.

In total, according to Commissioner Sullivan, the amount of tax "credits claimed since 2007 exceed $3 billion." 

Alaskans -- including the Governor and most legislators -- often express significant concern about the decline of throughput in TAPS and the resulting impact on state finances.  Yet, the tax credit provisions created by ACES have directly diverted at least $1.8 billion which, with the right economic incentives, could have been put toward projects involving known resources, to tax subsidies for the oil development equivalent of "Hail Mary" passes.

No wonder, despite remaining known resources within exiting fields as large in size as the original Prudhoe Bay field, Alaska is suffering continued production declines.  The state's tax policies have been built to discourage any other result.