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Department of Revenue suggests oil production tax might need to be changed ELF designed to encourage small field development and ensure large fields aren't shut down early; Revenue recommends allowance for deduction of exploration and production costs to encourage re-investment in state Kristen Nelson PNA Editor-in-Chief
The Alaska Department of Revenue is forecasting increased North Slope production — with new fields and satellite development bringing daily averages back over the 1 million barrel mark through fiscal year 2010.
But, Revenue said in its Fall 2001 Revenue Sources Book, issued in early December, Alaska’s oil production is only about one-half of what it was when the massive Prudhoe Bay field peaked in 1988 and the new oil is taxed at a lower rate than oil than Prudhoe Bay oil, and will not bring the same tax benefit to the state.
The average rate of the production tax on Alaska North Slope crude oil has been falling as a result of the tax adjustment known as the economic limit factor — ELF.
ELF reduces the production tax rate on a reservoir based on the average rate of production and the average productivity of the wells. Production rates and well productivity decline as a field is produced, so the average production tax rate falls. ELF also reduces the tax rate on smaller oil field: most fields producing less than 20,000 barrels per day will pay little or no production tax, Revenue said.
The result is dramatic.
The base production tax rate is 15 percent. In fiscal year 1994, Revenue said, the average oil production tax rate for North Slope fields was 13.5 percent; the rate is projected to be 8.75 percent for fiscal 2002.
ELF a major part of state’s oil and gas taxes ELF is a major part of the state’s oil and gas tax structure. Other taxes include: property taxes; royalty on oil and gas; bonus bids for leases; and corporate income tax.
Estimated unrestricted oil revenues for fiscal 2002 (which ends June 30) include: oil and gas property tax of $43.2 million; oil and gas corporate income tax of $150 million; production tax of $450 million; and royalties including bonuses of $506.1 million.
Estimated restricted oil revenues for fiscal 2002 include: royalties to permanent fund and school fund of $226.7 million; settlements to constitutional budget reserve fund of $100 million; and National Petroleum Reserve-Alaska royalties, rents and bonuses of $1.3 million.
Of an estimated $1.48 billion, the production tax is 30 percent.
Is ELF working as intended? Revenue said that as Alaskans look at the state’s fiscal situation, “it’s also worthwhile to look at existing revenue sources and ask if they are working as intended. “
One of the purposes of ELF was to ensure that the production tax does not discourage development of smaller oil and gas fields. Revenue said the ELF formula is complicated, but the result is that the smaller the field or less productive the wells, the lower the tax rate. The current ELF formula took effect in 1989.
Another idea behind the ELF was that the actual tax rate should decline over time so that the production tax does not cause fields to prematurely shut down as they become less economic due to falling production, Revenue said.
What is ELF? ELF is a multiplier between zero and one that reduces the actual tax rate for a field, “based on average well productivity and the field’s total daily production.”
The oil production tax rate is 15 percent, with a 12.25 percent rate for the first five years of a field’s production. An ELF of 0.5 would yield an effective tax rate of 7.5 percent. There is a minimum tax of 80 cents per taxable barrel. To calculate the effective tax rate, multiply the statutory tax rate, even if it is the minimum 80 cents, times the ELF.
In the ELF formula, Revenue said, “the two factors of well and field productivity are related exponentially” so “the drop in the ELF will be much steeper than if either of the two factors were applied alone.”
Older, larger fields have rapidly declining production and there have been no discoveries of large fields to offset those declines, the department said. Most new standalone fields have production of 50,000 to 100,000 bpd.
How could ELF be changed? The current ELF formula, Revenue said, was established in 1989 and “was predicated on conditions that were in place then. Those conditions have changed. Would it be appropriate to change the ELF as a consequence? While frequent changes in resources taxes creates instability — particularly where the economics are marginal — tax changes made in response to new conditions or structural deficiencies may be in the public interest.”
Revenue said production fell 34 percent from 1990 to 2000. Over the same period, at a hypothetical oil price of $15 a barrel, ELF dropped tax revenues by 53 percent.
“And while we forecast North Slope production remaining relatively flat between 2002 and 2010, because of ELF the average tax rate will fall 52 percent,” Revenue said.
It is reasonable, the department said, for ELF to push the tax rate lower as production and declines because fixed operating costs will increase on a per barrel basis and gas and water handling costs may rise. “In addition, it is reasonable for the ELF to decline to zero by the end of a field’s life.”
But, Revenue asks, does the existing ELF reduce tax rates too quickly?
At Kuparuk the 2002 ELF was 0.6 and production was 212,000 barrels per day. ELF will be zero at Kuparuk in 2010 — but production is expected to be above 100,000 bpd and another 10 years of production is projected for the field.
“Is the ELF going to zero sooner than it needs to ensure maximum production?”
Disparity between large and small fields, satellites Revenue also said that ELF may make too much of the operation cost disparity between large and small fields.
Under the existing ELF, a 50,000 bpd field with average well production of 450 bpd would have an ELF of 0.003. A 200,000 bpd field with the same average well production would have and ELF of 0.493. The smaller field would pay production tax at a rate of 0.045 percent while the larger field would pay at a rate of 7.395 percent.
“It is doubtful,” Revenue said, “that the per barrel operating costs of the two fields would be so different as to justify the larger field paying a tax rate 164 times higher than the other field.
“It is worth asking: Is the ELF formula doing its job the way it should, or does it need changing?” Revenue said.
The effect of ELF on taxes from satellite fields is also an issue, as satellites have been developed in the last 10 years — since the existing ELF formula was set in 1989.
Satellites have lower production, with maximum levels in the 5,000 bpd to 50,000 bpd range, but Revenue said the ELF rates for these fields are “very low, and zero in many cases.
“However, given the degree to which these fields share costs with large, profitable fields, and the degree to which many of these costs have already been recovered, the economics of such fields are not the same as those of similarly sized fields that stand alone.”
ELF components could be separated Revenue said a possible modification to the existing ELF formula “would be to have separate components in the ELF formula for total field production and well productivity.” Both are key indicators of field profitability, the department said, but “they are largely independent. Thus, rather than treat them exponentially, where their effects over exaggerate economic tendencies when mixed, the ELF formula could be modified so that these distinct features could be summed.
“For example, the ELF could consist of a total field productivity component and a separate well productivity component. Each of these components could be weighted 50 percent in the final ELF factor for each field.”
Revenue said this “would result in less drastic swings in tax rates as field or well productivity changes.
“In general,” the department said, “where rates are now high they would be lower, and where they are now low they would be higher.”
And as a side benefit to having an ELF which would decline less drastically over time, Revenue said, the proposed change “would also make the ELF easier to understand.”
Price coul In addition to the exponential problem in the current ELF formula, Revenue said there are two other major problems with the production tax.
The production tax rate is fixed, which means “the government’s share of profits is high when profits are low, and low when profits are high.” This regressive feature of the production tax “creates an unbalanced situation,” Revenue said.
“At low prices or high costs, the burden of the tax creates additional investment risk. At high prices the state’s share of the profits is much less than in internationally comparable conditions and the state leaves money on the table.”
If oil price were incorporated into the ELF formula, the production tax system would be progressive: the tax rate would vary with oil price and the government’s share of profits would be lower when profits were low and higher when profits were high.
“Having the tax rate vary with price is another way to better balance the tax system under a wide range of economic conditions, while maintaining international competitiveness for attracting investment,” Revenue said.
Investment could be encouraged The other major problem with Alaska’s production tax, Revenue said, is that it does not encourage re-investment in the state. The tax system is based on gross revenue at the wellhead.
“Unlike other jurisdictions,” Revenue said, “the regressive system in Alaska does not allow deduction of exploration and development costs. In those other jurisdictions, taxes are reduced by investing there, and companies that invest pay less taxes than those that do not.”
Because Alaska does not allow deduction of exploration and development costs from taxes, its tax system “may induce companies to take their Alaska profits and invest them elsewhere,” Revenue said.
“A tax credit for exploration and development would enhance interest in investing here. The credit could be capped so as not to drop the actual production tax rate too much, but enough to be attractive to exploration and development.”
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