Professor of Oil and Energy Economics Challenges the Governor to Debate

There has been a tremendous amount of press about changing the ACES  (Alaska’s Clear and Equitable Share) oil tax system, and hardly any press for keeping ACES in place. This guest editorial is from Dr. Douglas Reynolds, a professor of Oil and Energy Economics at the University of Alaska, Fairbanks. If the governor really believes his new oil tax plan is for the best, then he shouldn’t mind debating the issue, right?

From Dr. Doug Reynolds

During a recent visit to Juneau and Anchorage, I met legislators, staffers, oil industry employers and ordinary citizens. Talking to all these people convinced me that energy issues are at the top of people’s minds. However, Governor Sean Parnell is proposing to change ACES, the oil tax fiscal system. The main thrust of his changes is the reduction of the top tax rates when the price of oil is above $100 per barrel, reducing Alaska’s take and increasing producer profits. Non-industry Alaskans, with whom I have talked to, though, want the most money from our oil revenues, and Politicians’ interests should mirror their citizens’.

So far in the oil tax debate, there is much misinformation about what is needed and what is not. For example, picture the gold mining companies in Colorado at the time they heard about gold discovery in 1898 in the Yukon. Would it really have mattered to Colorado companies how low mining taxes were in Colorado compared to the Yukon?

No, they would have followed the Yukon Stampeders. Just so, today, oil companies are going to Dakota because of new information and because of new technology that has made North Dakota’s oil shale Bakken fields lucrative. In fact many companies going there are new companies and not companies that have ever been in Alaska. So even if Alaska had much lower taxes, these companies would still be investing in Dakota. It is an improper comparison for the industry to argue for a change in Alaska’s oil taxes just because of a boom in North Dakota. There is money to be made in both states, even with ACES in place.

If you look back, Alaska was often criticized in 1990s because its tax was higher than government taxes in Venezuela, Russia or the Middle East, but now our tax is lower than those because they all raised theirs when oil prices increased. And, you can bet that once oil prices rise again, so too will Dakota tax rates rise. How do we know oil prices will be rising? World oil production hit a plateau starting in 2005, causing a steady increase in the per barrel price; yet up until that point $35 dollars a barrel was considered high.

Today “normal” is now accepted even above $100! If you look at former Soviet Union oil production and American oil production including Alaska, you will see both nations plateaued and had precipitous declines after 1986 and 1988 respectively. The world today is mirroring these trends, but not because of a lack of investment, rather because oil is scarce. Clearly, our future suggests a steady decrease in world oil production, even with slight increases from Alberta oil sands and Dakota Backen shales, and a volatile increase in oil prices, with greater spikes to force oil demand down. Alaska must take advantage of these high prices to get our fair share.

The thing to remember during the oil tax debate is that the industry undoubtedly knows that oil prices are soon to go up into the $200 per barrel range, so they undoubtedly are basing all their investment decision on that fact. We need to base our oil taxes on maximizing revenue in the $200 range. The industry wants to lock in low oil taxes now before the next oil price shock occurs. If we lock in taxes that are too low, and oil prices rise, Parnell will veto any change back to ACES, and Alaskan’s revenues will suffer. The oil industry knows that high oil prices are the future, so the governor’s tax rate reduction for high prices is just what they want.

One thing that the oil industry is constantly emphasizing is that the oil game is full of risks. Such risks require high rates of return to the oil companies before they will make investments. However, many risks are already compensated for in Alaska: oil price volatility is accounted for by the sliding ACES tax rate scale, exploration risks receive tax credit incentives, and environmental damage is about as risky at 500 million barrels a day as at 1 million. A low tax rate does create incentive to overcome these risks and increase production, but since many of those risks are already compensated, then the purpose of ACES is not to increase or decrease investment per se, it is for the state to make money.

As far as the TAPS pipeline, a couple of winters ago there was a shut-down causing a potential freeze up and long stoppage. Alaskans then faced severely diminished oil revenues. The governor has then touted that incident as a cause to reduce oil taxes to raise production so that such a freeze up won’t happen again. What Alaskans need to realize, though, is that this solution will not immediately fill our pipeline with oil. Years will be needed to get that new oil into our line, and in fact new taxes may not even spur more investment than is already slated.

However, to help with TAPS throughput, a straightforward engineering fix is necessary. When there was a potential freeze up, heat was added to the pipeline in order to solve the problem; therefore, we need more analysis for adding heating locations to the line. BP presented the 2006 Alaska Legislature with graphs showing oil production trends dipping to the 200 million barrels a day level. This suggests that BP at least expects to be able to keep the pipeline running at rates well below our current half a million barrels a day.

When changes like the promotion of the use of tax brackets is proposed, they need to be justified. After all, tax brackets is a concept needed for new profit from new projects, not increases in all project profits simultaneously. The idea of the tax bracket is not
needed in the ACES oil taxing because all investments are sunk costs, and the oil tax, changes with changes in oil prices, it does not change with changes in new projects. This is different from the tax brackets in income taxes, because income taxes are for increases in new income sources. The ACES income is irrespective of new or existing sources so there is no need for bracketing. This has to do with sunk costs. All previous investments are sunk, so taxes that change, do not change the sunk costs. However, one reason to use brackets might be to simplify taxation for accounting purposes, but
that is easier done by using an average price for one, three or six month time intervals. Once the average price is determined, then the tax rate for those months is set and can be calculated.

There is confusion too between what defines “oil” and “tar.” Tar is called “heavy oil,” making it sound as lucrative as light oil. No one calls coal, “oil,” and no one suggests that coal be taxed similarly to oil. Just so, no one should call heavy oil, “oil.” It should be called “tar,” or “tar-sands,” or “tar-petroleum” to give the general public the true meaning of what it is: a thick solid, requiring additional processing, which serves to make it less lucrative. It should be taxed differently. However, tar, oil, and natural gas often occur in the same location or in the same field and so capital assets used to produce one product are used for the other, making accounting costs difficult to discern.

If tax rates are different for tar, oil and natural gas, high costs can be assigned to high-taxed products and the industry can use this to reduce their taxes overall. Thus, there is always a tradeoff between simplicity (which reduces accounting costs, auditing costs, court battles, fraud and increases investment) and complexity (which tends to give greater government revenue to the state—what most Alaskans would prefer). The real reason that the industry wants to have this confusion of tar, oil and gas is to be able to say that taxes are too high for oil production projects, like heavy oil projects, but then it makes everyone believe that those taxes affect conventional oil projects, when they don’t.

One option is to leave ACES alone and so tar and natural gas will have the same tax as oil which would reduce the development of tar and natural gas, at least for now, and which may reduce oil production somewhat, but which will maximize present value state revenue.

Another option is to separate taxes for different products, which adds complexity and which may require a new tax system as the senate has already approved. However, since natural gas development is a long way off and the value of tar is limited in comparison to oil, we can wait, and not come to any agreement between the house and senate.

As I recall, Palin campaigned for a change in oil taxes, took a detailed look into all tax options, had multiple independent consultants investigating oil taxes and came out with the best option available, then she went around the state with her consultants to show why the ACES option was the best, something Parnell has yet to do. I suggest that since oil and gas markets will be highly volatile, oil prices will increase and oil producers will all be changing their tax systems, so let ACES stand as it is. Give ACES time to work and see if development proceeds. Then once natural gas is on the verge of
development, try to create another comprehensive fiscal system, call it ACES 2.0, that will better capture the value of tar, oil and natural gas and use what we learned from ACES 1.0 to ensure this tax plan benefits all Alaskans.

If the governor is still insistent on changing the oil taxes, why not have a real debate. The governor has a lot of power, he can say anything he wants about the taxes, so why not say it to someone who knows oil and energy. I propose that the governor designate a debater and that I debate the governors designated advocate. The governor can surely win a debate against me…

Dr. Doug Reynolds is a professor of oil and energy economics at the University of Alaska Fairbanks. He is author of the book, “ENERGY CIVILIZATION: The Zenith of Man.” He can be contacted at dbreynolds@alaska.edu.

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