Providing coverage of Alaska and northern Canada's oil and gas industry
February 2010

Vol. 15, No. 9 Week of February 28, 2010

ACES war continues

Industry says tax hurting investment; admin consultant says it’s in range

Kristen Nelson

Petroleum News

Testimony to the Senate Finance Committee Feb. 22 and 23 provided insight into the battle over Alaska’s oil and gas production tax.

The committee had been hearing from the administration on how the state’s current tax, Alaska’s Clear and Equitable Share or ACES, is working.

On Feb. 22 Rich Ruggiero of Gaffney, Cline & Associates, a consultant for the administration, compared fiscal systems and provided the committee with some questions they should ask when they are presented with fiscal comparisons.

On Feb. 23 the committee heard from Marilyn Crockett, executive director of the Alaska Oil and Gas Association on concerns the trade group has with ACES and from Wendy King, ConocoPhillips Alaska’s vice president of external affairs, on ConocoPhillips’ views on some of the numbers the committee has seen from the Department of Revenue on expected production trends and on recent expenditures.

AOGA’s primary concern, Crockett said in prepared testimony, is “that we believe the tax rates under ACES are too high and overshoot the optimum point where total state revenues, Alaska jobs and economic growth are maximized” for the remaining life of the fields.

Ambiguity an issue for AOGA

Crockett’s discussion of clarity and issues around non-operator working-interest owners highlighted some of the issues AOGA has with the tax.

Whatever the tax rate, ACES and the Department of Revenue’s regulations, “must be as clear and transparent as possible” in order for the tax to work “and have its full beneficial influence on investment decisions”; Revenue’s “regulations fail this test,” she said.

The 20 percent tax credit for capital investments can make a project more attractive. But the person making the investment decision must be confident that the dollar invested will have the expected return and that 100 percent of the capital investment will be recognized. At a 50 percent tax rate, and a 20 percent tax credit, would mean a 70-cent return, she said.

“And the key point here is: This adverse impact on the investment decision will occur even if the Department of Revenue, after audit, would have ultimately found 100 cents of that dollar to be completely justified and proper,” Crockett said, because even if the tax benefit actually turns out to be 70 cents on the dollar, that benefit plays a role in investment decisions only if the decision maker is confident in that return.

The ACES tax has clarity issues and the regulations Revenue has adopted and is in the process of adopting “are compounding and re-compounding the uncertainty and lack of clarity,” she said.

The non-operating WIO issue

Crockett said that a related clarity issue is that Revenue has “totally failed to address the question of how the non-operating working-interest owners in a unit or other oil and gas property are supposed to comply with all these requirements.”

Non-operating owners are required to report and pay estimated taxes each month and to “true up” estimates with actual results for the year on March 31 of the following year. But all they have available are billings from the operator which the non-operators haven’t had a chance to audit.

“This puts the non-operating working-interest owners in an even worse spot than their operator in terms of clarity about how much of what they pay for costs being billed to them will end up actually being deductible under ACES,” Crockett said.

And the uncertainty on ACES also affects approval of unit projects, she said, because non-operating working-interest owners can vote “no” on a ballot to approve a new project, so they need to be comfortable with how ACES and its regulations work, or projects to increase production may be voted down on the basis of uncertainty about “the tax burden and benefits” under ACES.

The solution would be for Revenue, instead of ignoring joint-interest billings from operators, to “embrace them as the starting point for reporting and paying tax” and “rely on the non-operators to enforce discipline on the operator’s billings in much the same way that the Department relies on the IRS to audit the companies federal taxable income, which is the starting point for Alaska’s own corporate income tax,” Crockett said.

The investment issue

ConocoPhillips’ Wendy King talked to the committee about the need for investment to keep production flowing from the core fields on the North Slope — Prudhoe Bay, Kuparuk and Alpine, which account for 90 percent of production.

She noted that in presentations to the committee by the administration the impression was that a 6 percent decline in North Slope production was the worst case scenario. But, she said, over the past 10 years that 6 percent decline rate required an investment of $40 billion by industry, including capital and operating expenditures, taxes and royalties.

King said the companies have different estimates of production decline rates and she’s seen 10 percent to 16 percent, so production decline could be significantly higher than 6 percent.

That 10 to 16 percent decline would be “without well-related activities, maintenance and other facility projects,” the caption on one of King’s slides said, while the historical 6 percent decline rate will require some $40 billion in investment over the next decade. The Department of Revenue, she noted, is forecasting a 2.5 percent production decline for 2010-19.

King told the committee ConocoPhillips is concerned about the level of taxation because the total government take is 65 to 75 percent, so for $100 in net cash flow, only $25 to $35 goes back to the investor.

Rig count dropping

King said that the rig count in Alaska’s largest fields, Prudhoe Bay, Kuparuk and Alpine, is dropping. And while the U.S. rig count tracks the price of oil, Alaska drilling is falling behind as the U.S. rig count is rising, with core field rig trends flat over 2005-08, and declining in the third and fourth quarters of 2009.

And in 2008, when U.S. rig counts started to increase dramatically, that didn’t happen in Alaska, she said; it also didn’t happen in the third and fourth quarters of 2009 when the U.S. rig count rose.

The conclusion, she said, is that core field drilling activities are not tracking with oil price. King said the progressivity factor in ACES is probably a key component in what is happening to Alaska’s rig count.

Investment decisions are not made from any single indicator, she said. Industry looks at a balance of risk and reward, but where reward has shifted substantially it does affect how the industry views risk, King said.

She also said that an increase in capital and operating expenditures that Revenue has shown has been a run up due to inflation. A slide she showed the committee for fiscal years 2007-10 said that capital and operating expenditures are flat when adjusted for inflation.

Historical perspective

Rich Ruggiero of Gaffney, Cline & Associates began with some history of fiscal systems.

In the early 1980s, with the first run up in oil prices, there were limited places for companies to invest, he said, calling the 1980s the decade of companies in search of countries. By the early 2000s, however, almost all countries were open to investment.

But by 2010 a number of countries had become less friendly to investment and raised taxes or inserted themselves as equity partner, which Ruggiero characterized as just another form of state take.

Another change is competition from international national oil companies. While national oil companies formerly operated within their own borders they are now investing elsewhere and have become very large and very key players, he said.

Countries as well as states are continually assessing internal needs as well as international competition. The idea is to attract investment, generate revenue and create jobs, Ruggiero said.

There is a problem with comparing fiscal systems because there are about as many systems in place today as there are countries; and because some countries operate different vintage systems there may be more systems than countries, he said.

Ignored in rankings

Ruggiero also said there are items which tend to be ignored in ranking fiscal systems, such as the time value of money. He said Alaska is very generous to investors, allowing all eligible costs to be deducted immediately from revenue, plus providing capital and exploration credits for those expenses.

The economic value of immediate write off is significant, he said, and a fiscal regime with immediate write offs and investment credits can compete favorably on some financial evaluations with regimes which have lower government takes.

Ringfencing is another thing which is typically ignored.

Most international contracts or licenses are ringfenced — each field is treated separately and higher costs at one field cannot be offset by profits from another field.

Because the North Slope is within a single ringfence, Ruggiero said the higher costs of heavy oil projects, for example, are merged with more profitable conventional oil projects, effectively lowering the tax rate for the more expensive heavy oil.

Hidden drivers

Ruggiero also said that while things may have changed since he worked in the oil and gas industry, typically budget items fall into three categories: mandatory, should and discretionary.

A lot of capital may be directed toward the first two categories as oil prices have come down, he said.

2008 was a big spending year for industry. Oil prices have now fallen and the global economy is in recession.

Ruggiero said one question legislators need to ask is how much of the lack of discretionary spending in Alaska is because of ACES and how much is because spending is being directed to items required to keep a license and to items which should be done and which produce monetary penalties or lack of production if the money isn’t spent.

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