A second "Alaska disconnect" ...

As the state budget increasingly has grown over the last several years to unsustainable and record deficit levels I have spent more and more time focusing on what economists and others refer to as the "Alaska disconnect".

As explained in an exceptionally good primer on the Alaska economy by UAA Professor and ISER Director Gunnar Knapp, "An Introduction to the Economy of Alaska," the "Alaska disconnect" is this:

Alaska’s fiscal structure—specifically the fact that Alaskans do not pay any significant broad-based taxes—leads to a problem which has become known as the “Alaska Disconnect.” 

If economic developments creates more jobs, Alaska’s population grows. As the population grows, Alaskans need more schools and teachers for their children and the other services that state and local governments provide. 

Although the new Alaskans pay local sales and property taxes which support local services, they don’t pay broad-based state taxes to cover the cost of state-funded services such as education and roads. 

The new jobs create new costs for the state but not corresponding new revenues. As a result, except for oil development (which pays high state taxes), many kinds of economic development make the state’s financial situation more difficult.

A news story this past week suggests we also may be seeing the emergence of a second Alaska disconnect -- where even continued success in oil development does not guarantee the health of the state's fiscal situation.

The news story is a KTVA report on the potential effects of the oil price drop on the Alaska oil industry ("Oil projects in Alaska still on track despite declining prices").  The report quotes Kara Moriarty with the Alaska Oil and Gas Association, whose member companies represent most of the oil industry, as saying "Alaskans shouldn’t panic just yet. [Price fluctuations are] the nature of the business."  Even at lower prices, "Moriarty predicts 2015 will be 'a very positive year,' due to new projects and new investments."

But that is where the new, second "Alaska disconnect" comes in.  Because of significant increases in state spending levels over the last five years, even if the oil industry is able to continue to do well at lower oil prices, the state is not.

The reason that oil companies are continuing to invest even in the face of lower prices is because they have positioned themselves to continue to operate at lower price levels.

For example, BP Chief Executive Bob Dudley recently said “We have only sanctioned or approved projects based on an $80 oil price. ... “We’ve been doing that three or four years so there isn’t any project that we’re working on today, particularly those big capital projects, that we have any different view of.”

Exxon has been even more cautious.  Recently in an appearance on CNBC, CEO Rex Tillerson said that "because many of the company’s biggest projects take years to complete, Exxon Mobil tests its investment across a range of prices between $120 and $40 per barrel.  'All of the investment decisions we take have been tested across a range of pricing that accommodates these types of price swings. ... What you do is ensure that you can be successful at the bottom of the price swing.'”

The industry also is well positioned to make even further adjustments if necessary to maintain profitability lower price levels (see "Oil price drops:  don't panic, really").

Alaska is not, however.  At the beginning of Sean Parnell's run as Governor (FY 2011) the Alaska budget balanced at $78 oil.  During his term, however, he and the legislatures serving with him have allowed the budget to get away from them.  The current year budget, FY 2015, requires more than $117 oil to balance.  The "work in progress" FY 2016 budget that Parnell left for incoming Governor Walker requires $120 oil to balance.

Because of that difference between "break even" price levels, Alaska no longer is positioned to do well simply because the oil industry is able to continue to thrive.  As Alaska has allowed its budget to spin further and further out of control, it has put itself in a different position than the state's industry, one much more exposed to price downturns.

As a result, while Moriarty might be right about the industry -- and that Alaskans "shouldn't panic just yet" because the industry is positioned to weather the downturn -- the same does not apply any longer to state finances.

The industry and state have become disconnected.  At these price levels continued health for the industry does not mean continued health for state government.  Alaska state government simply has grown too large.

SMH ...

At one time or another, every state I have lived in during my life has claimed to hold the title of "craziest" state political scene.  Generally speaking, I have always considered Louisiana's claim to be the most accurate in that regard, but an event yesterday afternoon may finally convince me that Alaska has pulled into the lead.

As some will recall, I engaged in an independent expenditure effort this last election cycle focused on certain state legislative races, largely to help publicize the state's fiscal situation.  One of those I supported was Retired Army Col. Laurie Hummel, who was challenging incumbent Rep. Gabrielle LeDoux.  I supported Hummel over LeDoux because, after years of watching, I had become convinced LeDoux was part of the spending problem in the legislature, not the solution.

Somewhat understandably -- this isn't the crazy part, yet -- Rep. LeDoux struck back at my support of her opponent by issuing a press release (above left), among other things calling me a "bully," and on a local talk radio show, a "narcissistic bully."  OK, no one ever said politics wasn't a full contact sport.

But then yesterday -- and this is the crazy part -- I received an email from Rep. LeDoux (who had gone on to win the election, barely).  It wouldn't have been crazy if it had said something like, "nah, nah, na nah, nah, I won, you lost."  Again, no one ever said politics wasn't a full contact sport.

But instead, it said this:

I have quite a bit of campaign debt to retire -- and I need your help to do it. ... Will you join me in continuing to provide strong, conservative leadership in Juneau by visiting voteledoux.com and donating today? A donation of $25, $50, $100, or even $500 would help more than you know.

Hmmmmm, uhhhh, no, I don't think so.  Even if it wasn't for all the campaign stuff, explain to me again why I would want to support someone headed to Juneau to help deal with the state's fiscal crisis -- caused by the very deficit spending that Rep. LeDoux voted for -- that wasn't able even to balance their own campaign budget?  Reading it through the first time induced a sort of Wizard of Oz moment -- "don't pay any attention to that debt behind the curtain; only pay attention to what I say I am."

Even this morning, as I reread the letter again, one of Patsy Cline's greatest hits kept popping into my head.  

I think Alaska may have just pulled ahead of Louisiana.

Important numbers ...

Yesterday while discussing an article from the Wall St. Journal ("Saudi Arabia Sees Oil Prices Stabilizing Around $60 a Barrel") a reader observed at that price Alaska's revenues would meet only one-half the state budget.  The observation was based on previous pieces here that used $120-ish as the oil price required this year to balance the state budget, so half that in oil price means half in revenues also, right?

Unfortunately, no.  A significant part of Alaska's revenues are derived from its production tax.  Because that tax is based on net profits, revenues drop proportionately to the drop in profits, not price.  By the time price reaches $70/bbl, revenues from the production tax are almost gone and at $60 they are.  Largely all that remains at that point are revenues from the state's royalty share of production and roughly $500 million in non-oil related revenues received mostly from a variety of other taxes.

As I was contemplating how to respond to the reader's comment I stumbled upon a section from last year's Department of Revenue Fall 2013 Revenue Sources Book (at p. 88-89) that includes a very helpful chart for considering these things.  As you will see, at $60 oil the state's revenues (we are currently in FY 2015) decline to roughly $2.1 billion, about a third of this year's spend (not half).  While regardless of how low prices go the average for this fiscal year will end up somewhat higher (because the first few months were at significantly higher price levels), sustained lower prices from here forward ultimately will drag the average price down to very low levels.

Interestingly, in reviewing the chart I realized also that the $120-ish figure I (and Dermot Cole) had been using previously for this year's budget "break even" price is somewhat off.  This year's budget is $6.2 billion. Using the chart, that correlates to a break-even price of just slightly under $125/bbl.

Which leads me one more time to a comparison of Alaska's fiscal situation with other Petrostates.  Another Wall St. Journal article yesterday ("Analysis: Oil-Price Drop Adds New Element to Middle East Tensions") contained yet another analysis of the break even price of various oil-dependent nations, this time based largely on an analysis recently done by the International Monetary Fund.

The results are here.  While not the highest in the world (Libya apparently tops the list at $184/bbl), at $125/bbl Alaska's breakeven price nevertheless rests well in the upper tier, on par with Iran ($130), Algeria ($130) and Nigeria ($123), running well ahead of Venezuela ($117), Saudi ($106), Russia ($100 based on other analyses) and Iraq (also $100), and an order of magnitude above the UAE ($77), Qatar ($60) and Kuwait ($54).

Fiscally conservative?  That would be someone else.  During its 2013 session the Alaska Administration and Legislature rightfully spent a lot of time benchmarking the state's oil tax rates against those of other nations.  In the process, however, they overlooked benchmarking their own spending behavior against those of the same peers.

In FY 2011, Alaska's budget balanced at an oil price of $78/bbl. This year (FY 2015), just four short years later, it's $125/bbl.

Incoming Governor Bill Walker faces a huge challenge in moving Alaska back into the range of fiscal reality. Hopefully, these and other numbers they will hear during the coming session will move the legislature to help.

What to look for first in the Fall Revenue Sources Book ...

Sometime in the next few days the Department of Revenue (DOR) will publish this year's version of the Fall Revenue Sources Book, a history and forecast of the state's revenue picture that is a much anticipated annual event by those who care about these things.  When published the Book will be available here.

This year the first thing I will look for when the Book becomes available -- and what I would suggest others do as well -- is the oil price forecast on which the projections of current and future revenue are based.  Unlike in most other years when oil prices have remained relatively stable, that is going to be a tricky thing this year and will greatly affect the usefulness of the forecasts made in the Book.

As Dermot Cole reported at the time ("State budget deficit swells as oil prices swoon, challenging the oil oracles"), the price forecast contained in the Book usually is the result of an exercise conducted in early October.  Unfortunately for this purpose, this year October fell right in the middle of what many now are considering a paradigm shift in the oil markets.

To provide perspective, the following is the price of oil produced from the Alaska North Slope (ANS) over the last several months, as reported by the state here.

Jul 1, 2014:           $111.56
Aug 1, 2014:         $103.52
Sept 1, 2014:         $ 97.06
Oct 1, 2014:          $ 91.28
Nov 1, 2014:         $ 80.44
Dec 1, 2014:         $ 69.86

To highlight the issue, the oil price on October 1 -- about the time of DOR's price forecast exercise -- was roughly $91/bbl; now it's roughly $70/bbl, 25% lower.

The magnitude of the change in price over such a short period has caught many by surprise and resulted in a game of catch up throughout the forecasting community as the reasons behind the shift have become more apparent.

For example, in its October Short Term Energy Outlook (STEO), published at about the same time as DOR was conducting its price forecast meetings, the federal Energy Information Administration (EIA) predicted in 2015 Brent and WTI would average $102 and $95/bbl, respectively.

Reflecting on another month of data and a much better understanding of the forces at work, however, the November STEO substantially revised the 2015 forecast, revising EIA's estimate of 2015 Brent downward by nearly 20% to $83/bbl, "$18/bbl lower than forecast in last month's STEO."  The December STEO is due December 9, six days from now, and many are now predicting yet another downward adjustment in the 2015 forecast.

Alaskans -- particularly the new Administration and Legislature -- should be wary of the resulting future revenue projections contained in the Fall Book if, as anticipated, DOR uses a price forecast based on the price levels in the $90's or even high $80's prevalent or anticipated at the time the forecast was made. Budgets and decisions based on those projections will expose the state to continued deep calls on the state's savings if substantially lower oil prices, now forecasted by others using more current data, remain the norm.

There is precedent in previous years for redoing the forward looking part of the forecast when, as is occurring here, there are significant shifts in oil markets between the time the data is prepared and decisions based on it are to be made.  In 2008, for example, a "Preliminary Spring" forecast was prepared when the numbers prepared the previous fall were overtaken by events.

The Administration and Legislature should consider asking DOR to do the same thing here if, as anticipated, there continues to be a wide divergence between what the Fall Book forecasts and other, similar agencies are saying based on more recent data.  This coming legislative session and budget are going to be difficult enough.  They shouldn't be based on outdated data.

"Irrational exuberance" and the Alaska budget ...

Yesterday following the inauguration of his successor, former Governor Sean Parnell posted a farewell note of sorts to "Alaskans" which contained the following:

Budget Work Turned Over to New Administration
One of my last official acts included making sure a budget proposal was prepared for the incoming administration that is hundreds of millions of dollars lower than the current budget. The budget work I gave over to the Walker Administration includes about $700 million less in spending than a status quo budget. That means the budget proposal I put forward to the new administration currently hits a target of about $5.5 billion for FY 16 (down from status quo spending of about $6.2 billion). The budget work we turn over is a solid starting point for the new administration.

That was the first time I had seen numbers associated with Parnell's final budget proposal.  This morning I did some calculations to put that number in perspective.

At $5.5 billion, the proposed budget Parnell leaves behind is roughly equal to the first budget he had control over (FY 2011) when he began his run as Governor.  It also is the same level that ISER found would have been sustainable if held at that rate beginning with FY 2014.

The budgets in between his first and last, however, were considerably higher, in the aggregate spending in the intervening four years some additional $6.2 billion that otherwise could have been put into or retained in the state's nest egg if he had kept the budgets at the same level during his time in office.  The net result of that overspending is that the sustainability number plunged to $5 billion in FY 2015, and will be lower this coming year, even before factoring in the effects of the ongoing drop in oil prices.

The proposed budget also maintains Alaska's dependence on extraordinarily high -- and in the current oil price environment, vastly unrealistic -- oil prices.  Based on calculations done by the Legislative Finance Division at the beginning of each session, during Parnell's run as Governor the price of oil necessary to balance the Alaska budget escalated from $78/barrel for FY 2011 to roughly $120 for FY 2015.

While a more precise estimate can be made once the Department of Revenue publishes the Fall Revenue Sources Book in a few days, based on some preliminary analysis the proposed $5.5 billion budget appears to continue to require an oil price in the range of roughly $115/barrel to balance.  

In a world where the current price of oil is teetering around $70/barrel and the most optimistic forecasts go no higher than the $80's, continuing to base Alaska's budget on prices well in excess of $100 is the equivalent of what former Federal Reserve Board Chairman Alan Greenspan once termed in his day when talking about the stock market as "irrational exuberance."

To put it another way, at even $85/barrel (much less at current price levels) Alaska North Slope production for FY 2016 will need to exceed 1 million barrels/day in order to balance Parnell's final proposed budget.  At best, the likely projection of actual production for FY 2016 won't top half that.

Some have and likely will continue to argue that Parnell and the related legislatures acted prudently over the last few years in reducing the size of the Alaska budget.   But the cold, hard facts are that the budget spun out of control during Parnell's term and, even at reduced levels over the last two years, still has been far in excess of what Alaska could afford to spend.

Just as finally happened to Greenspan's irrationally exuberant stock market when it hit the wall in 2008, so has Alaska's budget come to a day of reckoning.

Former Governor Parnell has not done the incoming Walker Administration any favors in handing off a final proposed budget that still has not come to grips with the hard choices that Alaskans must face in light of current economic reality.  There is a long, long way to go before the Alaska budget returns to earth.  Hopefully, the new Administration and legislature will be up to the task.