Editor’s note: This article is one of several taking a comprehensive look at the issues surrounding the upcoming Aug. 19 election that will decide whether Alaska keeps the oil tax reform bill passed in 2013 or returns to the previous system known as ACES.
How do Alaska’s oil taxes work?
Alaska has several ways that it taxes the value of oil production. With the upcoming Ballot Proposition 1 vote, most attention is on the state production tax, which was changed by the Legislature in 2013 with Senate Bill 21.
There are two other special state taxes on oil, however. One is a state property tax on oil and gas production facilities and pipelines; it is Alaska’s only state property tax. A second is a special state corporate income tax on oil producers that operates differently than the corporate income tax on non-petroleum corporations operating in Alaska.
Although it is not a tax, royalties from oil and gas production from state-owned lands are also a significant source of income to the state treasury.
The production tax brings in most of the revenue, however. In the state fiscal year concluded June 30, Alaska received an estimated $2.1 billion from the production tax; $464 million from the corporate income tax and $97 million from the state property tax. Another $1.68 billion was paid in royalties.
Altogether, oil revenues pay about 90 percent of the state’s unrestricted general fund revenues.
Production tax is on net revenue
The state production tax is usually referred to as a tax on net revenue of oil produced. From a practical standpoint it applies only on the North Slope, because Cook Inlet oil producers essentially pay no production tax.
What is taxed is really the net value of the oil, which is calculated by deducting production costs from sales revenues. The sales revenues are derived from income received on the West Coast with deductions allowed for tanker costs from Valdez and transportation costs through the Trans-Alaska Pipeline System.
Because no oil is actually bought or sold on the Slope to indicate actual market sales prices, the state uses this method to derive the value of a barrel of oil at the field for tax purposes as well as for royalty cash payments.
Alaska has had a net revenues tax on oil since 2006, which allows production costs to be deducted.
For most of its years as an oil producing state — in Cook Inlet since the 1960s and the North Slope since the 1970s — the state had a “gross revenues” tax, allowing deductions for transportation costs but not production costs.
The change to a net revenues tax — it was first called the Petroleum Profits Tax, or PPT, in 2006 — was a fundamental shift in Alaska’s oil tax policy. It was proposed by former Gov. Frank Murkowski at the urging of economists in the state Revenue Department who had long argued that a net revenues tax would perform better for the state, over the long term, than the gross revenues tax.
That was because the gross revenues tax performed in odd ways as oil prices fluctuated, and sometimes to the disadvantage of the state. In periods of high oil prices, for example, the producers would capture most of the gains while the state would miss out.
However, the gross revenues system also worked to the state’s advantage in periods of low prices because the price dip affected state revenues less than it did the producers’ incomes.
Although there would be benefits and costs of the net revenue system over time, economists argued the net revenues system was better overall because it allowed the state to gain in the “upside,” when oil prices were high, but also to share some of the pain with producers on the downside, when prices were low.
By keeping more revenue flowing to the producers during a price slump it would encourage them to keep drilling to sustain production, the revenue department argued. It was, overall, a more equitable sharing of the benefits and risks, they said.
Murkowski adopted the idea and pressed the new Petroleum Profits Tax, or PPT, on the producers as a bargaining chip in negotiations over a deal on a natural gas pipeline, which were underway in 2005 and 2006.
The new tax was actually a tax increase on the producers because the deal also ended the Economic Limit Factor, a development tax incentive that had become obsolete and harmful to the state while it benefitted the producers.
The companies reluctantly accepted the tax increase in return for the state agreeing to certain terms in the gas pipeline deal. The Legislature, in a special session, enacted the tax change and increase but not the pipeline deal, however.
One element introduced into the Petroleum Profits Tax in 2006 was a “progressivity” formula that increased the tax rate as the per-barrel value of oil rose. The increases were relatively mild, however. It was indexed so that the base tax rate, which was set at 22.5 percent, went up 0.2 percent for each dollar increase in the net value of a barrel of oil.
The progressivity index was to double the following year, however.
In 2007, Gov. Sarah Palin was in the governor’s mansion instead of Frank Murkowski. Palin wanted her own stamp on the state production tax and asked the Department of Revenue for recommendations. As with any new tax, like the PPT, there were tweaks that the Revenue Department considered necessary, and several recommendations were made to the new governor.
Palin also increased the base rate of the tax from 22.5 percent to 25 percent in the revised tax and also lowered the per-barrel value at which the progressivity formula would kick in from $40 per barrel to $30 per barrel.
Palin introduced these proposals in a bill and changed the name of the tax to “Alaska’s Clear and Equitable Share” or ACES, to put her personal stamp on it.
Overall, the impact of her proposals was relatively mild compared with what was to come.
As the ACES bill progressed through the Legislature in 2007, each House and Senate committee wanted to put its mark on the bill. Oil prices were rising at the time, along with fuel prices at the pump, and legislators were getting heat from constituents over energy costs.
Lawmakers responded by increasing the index of the progressivity formula so that the tax rate went up faster — from 0.2 percent to 0.4 percent — as oil values rose, driven by high oil prices.
Those changes would bring in more revenues to the state from the industry’s “windfall” from high oil prices, it was argued. Later, in 2008, some of the higher state revenues were distributed to citizens in the form of a one-time “energy dividend” payment of $1,200.
However, as the ACES bill moved through the Legislature in 2007 it seemed each legislative committee tried to outdo the previous committee in making it “tougher” on the industry. When the ACES bill finally went to the House and Senate floor that year there were even amendments being made — and decided — by floor votes.
ACES in the hole
The effects of the high tax rates were quickly to be felt. Doyon Drilling, one of the state’s major drilling contractors, saw two of its rigs laid off. Drilling activity dropped from 10 rigs working in 2006 to 8 in 2007 and to 6 in 2010. (Drilling has since increased to 17 rigs working this past winter).
Drilling is a key indicator because it is typically the drilling of new production wells that sustains the producing fields. As the drilling slowed, the decline in production continued at a long-term average of 6 percent per year and even increased to 8 percent in some years.
At the time, the North Slope producers were also making major investments in field maintenance, but the amount of capital spent on developing new oil, which is the important number, dropped.
By 2010 and 2011 only 30 cents of every dollar invested by the major producers was spent on activity like drilling, ConocoPhillips Alaska president Trond-Erik Johansen said. The other 70 percent was being spent on maintenance.
Overall capital investment by the companies, including the major maintenance and any new development, was flat. Exploration drilling also dropped. In the winter of 2011 there was only one exploration well drilled on the Slope.
The aggressive progressivity formula in ACES resulted in an effective “total government take” (combined state and federal taxes) on North Slope production of more than 70 percent at times.
It was one of the highest tax regimes of any oil-producing region of the world among those that used tax and royalty systems (some producing nations rely on production-sharing agreements with producers).
Defenders of ACES argue that the gush of revenues produced by the tax resulted, during period of high prices, in a buildup of state savings that are now cushioning the deficits in the state budget.
Some of the revenues went into state savings accounts but much of the revenue was also spent in hefty state capital budgets. At the time, Sens. Lyman Hoffman, D-Bethel, and Bert Stedman, R-Sitka, said the big state capital budgets helped cushion the state’s economy when the rest of the nation tipped into sharp recession in 2009.
Hoffman and Stedman co-chaired the Senate Finance Committee during some of those years. However, the availability of the ACES revenue also resulted in substantial increases in the state operating budget, Sen. Pete Kelly, R-Fairbanks, the current Senate Finance co-chair, has observed.
The state’s gain was at the expense of the oil producers, who were largely cut out of the benefits of higher prices. For example, in 2007 when crude oil prices were about $70 per barrel, ConocoPhillips, which reports income for Alaska operations, earned net revenues of about $22 per barrel on its production that year. Meanwhile, the state earned about $27 per barrel (state taxes and royalty combined) on ConocoPhillips’ production.
In 2011, oil prices were about $106 per barrel. ConocoPhillips earned about $27 per barrel, $2 per barrel higher, but the state earned $51 per barrel.
Balancing the take
What’s important about this is how it affects the companies’ long-term projections on pending new investments. The companies know that, over time, there will be cycles of high prices as well as cycles of lower prices, and they need to know that when the high price cycle occurs they can share in the gain along with the state.
The best tax, they say, is one where “upside” gains are split 50-50 between the companies and the state. Senate Bill 21 largely does this, they say.
The split doesn’t work that way on the low-price cycle, however. Both ACES and SB 21 have minimum-price floor tax rates that protect the state’s revenues if prices drop too low. The companies say they are willing to accept this as long as the upside is shared. ACES wouldn’t allow that, however.
As designed, the ACES tax led to declining investment in the North Slope fields in the kinds of activity like drilling that makes new oil. Meanwhile, states with less aggressive tax structures, like North Dakota and Texas, enjoyed huge increases in industry investment over the same period and rapid increases in production.