Tuesday, May 17, 2016

What some are missing in the oil tax credit discussion ...

Some involved in the current Alaska budget debate -- potentially including some legislators -- appear fundamentally to be misunderstanding one of Alaska's clearest pending fiscal choices.

In a Twitter exchange over the weekend involving oil taxes, one of the most active participants in the debate -- the Alaska Support Industry Alliance (the "Alliance") -- appeared to be oblivious to the fact that the State of Alaska has at least one alternative investment opportunity available to it for the cash currently being paid out ("invested") in reimbursable tax credits.

The state can either (1) continue "investing" the money in some oil projects, by continuing the reimbursable oil tax credit program, or (2) not spend the money in that way, and by doing so, retain the money instead in savings, where it automatically is invested through one of the state's investment funds (the CBR or Permanent Fund). The latter investment option also produces revenue and those two choices potentially have significantly different outcomes.

The exchange began when the Alaska Senate Majority posted a quote from Senator Pete Kelly that said this "We have no business going down a road that's going to reduce production." The post reflected Kelly's view that reimbursable oil tax credits -- which are paid out of the state treasury -- should be continued simply because some of them may result in some production.

In response, Alaskans for Sustainable Budgets pointed out as it previously had elsewhere  that production itself is not the end goal. Instead, when talking about the Alaska budget, oil production is simply a means to the end of producing revenue for the state. If pursuing production costs the state more in cash than it returns, pursuing production actually worsens the state's fiscal situation.

That is when the Alliance weighed in, apparently arguing that production should always be the state's goal, regardless of the alternative. (The full exchange is available at the end of this post.)

That's simply wrong.

It is critical for those concerned about Alaska's fiscal situation to understand that Alaska has two choices with respect to the money currently being "invested" into reimbursable oil tax credits. The money can continue to be "invested" through the credits in chasing production, or the state can choose not to spend the money, in which event it will remain in the CBR/PFER and be invested along with the remainder of the state's similarly retained savings.

The fiscal consequences of the two are different.  According to the Permanent Fund Corporation (PFC) website, the PFC's "goal" is for the Fund "to produce an average annual real [non-inflation adjusted] rate of return of 5 percent over the long term."  Adjusted for current inflation levels that sets the "goal" at about an overall 7.5% annual return and, in fact, according again to its website, the PFC has earned "over 10% historically."

According to the DOR, the state has paid out ("invested") approximately $3 billion in reimbursable oil tax credits from FY 2007, the start of the reimbursement program, through the end of FY 2015. Using the PFC's averages, if that amount instead had been retained in savings and invested through the PFC it would now be producing somewhere between $225 million (at a 7.5% return) and $300 million (at 10%) annually in earnings (i.e., revenue) to the state.

In order for "investing" the state's money in reimbursable credits to be the right decision fiscally, the return on the credits reasonably must be expected to meet or exceed that goal. Because the fiscal results achieved by the credits are shielded from public disclosure due to competitive concerns, it is not possible to make a precise analysis.  But applying some reasonable assumptions it certainly is worth questioning whether they have.

Again according to DOR, of the $3 billion paid out since FY 2007 only $1.9 billion in credits have gone to projects that currently have production.  As a result, in order even to match on a current earnings basis the revenues which would have been achieved had the money instead been invested through the PFC, those projects would need to be producing an annual return of between 12.5% and 16% on the state's investment.

And the long run threshold is even higher.  If the $3 billion had been retained in savings and invested through the PFC, those annual earnings would have started immediately and continued long, long -- indefinitely -- into the future. Oil projects don't have the same earnings trajectory. Instead, revenues only start after the lag required to identify and develop the project and then end when the oil from that project plays out.

As a result, the project must produce a significantly higher return during its productive years -- 15 - 20% is a decent rule of thumb -- in order to achieve an overall net present value equal to that produced by simply investing the same amount up front in an alternative investment. Here the returns from the successful projects need to exceed even that range to match the alternative return offered by investing through the PFC because, at least using the results from FY 2007-15 as a guide, only $2 out of every $3 spent is resulting in production.

Given that the state is realizing a return on the investments made through the reimbursable credit program largely only through the portion of the additional production paid to the state as royalties, we think it is unlikely that the program is even covering its overall costs, much less producing a return which approaches the levels necessary to make it competitive with simply investing the money through the PFC.

In any event, it is unreasonable to argue that any production is sufficient to justify the program's continuation.  The program only can be justified if the financial returns to the state resulting from that production meet or exceed the returns which the state would otherwise receive through available alternative investments.

Frankly, this is not a call that the legislature is particularly well suited to make.  These sorts of "alternative investment" analyses are usually handled best by major investment funds.  Interestingly enough, one of the best in the world -- the PFC -- is located just a few blocks away from where the legislature is sitting now.

Perhaps the legislature should ask their advice on which alternative is in Alaska's best fiscal interests -- or in the words of the Constitution, produces the "maximum benefit" -- before continuing.

But in any event, no one should assume that taking steps which may reduce marginal production -- when that production occurs only because of state investment -- are automatically bad.  It depends on what the alternative use is which could be made of the money, and here -- because of the track record of the PFC -- we have a very good idea it would be positive.

For those interested, the Twitter exchange that triggered these thoughts follow.