Mike Pawlowski on what SB 21 really does

Revenue department fiscal advisor reviews background of oil tax change, ACES problems identified by consultants over several years

Steve Quinn

For Petroleum News

Around the Capitol Halls Mike Pawlowski is known as “Fish,” a name his lives up to with his recent trout and salmon hauls out of Alaska’s waters. But he’s equally known as a numbers guy who can bring financial understanding to complicated measures such as an operating budget or a bill with fiscal consequences.

As a newly minted Department of Revenue advisor, Pawlowski has been a lead voice for Gov. Sean Parnell’s efforts to bring reform to the state’s tax regime. He’s spent much of the interim delivering presentations to groups throughout the state.

Some in the audience don’t support Senate Bill 21, and he knows it, but he brings a less confrontational approach to his presentations.

His official title is advisor for petroleum fiscal systems with the Department of Revenue. Pawlowski, who has also been lead staffer for finance and resources committee chairs, sat down with Petroleum News to discuss his interim work on bringing clarity to the new law, which takes effect Jan. 1.

Petroleum News: What’s been your approach in your presentations?

Pawlowski: I will not talk about the politics surrounding the question. What I will talk about is what SB 21 is, what the Legislature and the administration was considering when they undertook oil tax reform and why they made the changes they did. Those are the three areas I try to cover in the presentations.

Petroleum News: How do you find that the approach works for you?

Pawlowski It sparks a good dialogue, I think a healthy level of disagreement, and it gives people the opportunity to look at the whole picture. One of the problems in a complex subject is the legislative process focuses on pieces of the problem. The Resources Committee might focus on the detailed resources issues and the Finance Committee approaches it through a finance lens.

It’s when you’re able to go back and look at the discussions across of all the committees which are very thorough and all of those reports to those committees, you’re actually able to tell a story. Unless you were following each step in something this complex, it was actually difficult for a lot of people. So when I give my presentation, people appreciate seeing the progression of the thoughts and the problems the committees went through to arrive at the conclusion that they did.

Petroleum News: How did you come to arrive at those three criteria?

Pawlowski: I looked at what was really important to talk about. There are a lot of statements thrown around about oil tax reform, really on both sides. But oil tax reform itself isn’t something that just started in January. It’s been something that’s been going on for several years with discussion. It’s important for people to see the why of it and what SB 21 does to address the problems consultants frankly for years have identified. It’s important to give the public the details they need to understand what happened during the legislative session. I leave the arguments around it really to other people. There are other people who are engaged on this issue who can make arguments. As a department it’s important for us to stick to the progression of things we presented the Legislature during the debate and the deliberations, describe what the consultants said and describe what the legislation does.

Petroleum News: Do you find you have a more receptive audience by taking the politics out of the discussion?

Pawlowski: You always have a receptive audience just because people are interested, at least at the venues I’ve spoken at. When you take a step back from the rhetoric, people want to listen to a methodical discussion.

Petroleum News: You’ve used the word reform. Why is this a reform and not rebate or a giveaway?

Pawlowski: Whether SB 21 raises more money than ACES depends on three to four variables: the price of oil, the level of production; the cost of transporting that oil and the direct lease expenditures in producing it. The combination of those four variables dramatically changes how SB 21 relates to ACES. There are many scenarios — we are projecting one for FY 2015 — where SB 21 raises more revenue for the state at $105 a barrel than ACES. To start off saying that it’s a rebate or a giveaway, it depends on what point on the price chart of those variables you want to talk about. Consultants for years identified the five key problems with ACES. We were more focused on what was broken about ACES and how do you address the problems.

Petroleum News: Would you recall those five please?

Pawlowski: High levels of government take reduce competitiveness for capital, especially at high prices; high marginal tax rates; complexity makes meaningful economic analysis and comparison difficult; significant state exposure to low-price environments, and for high-cost developments; impact on large-scale gas sales and tax rates. When you think about those five problems, every one of them is based on the combination of the interaction between progressivity and qualified capital expenditures. These are very similar to what Pedro van Meurs said in 2011. The reason this is reform is because we addressed all five of these problems. We provided downside protection while preserving some of the upside reward, and making it a more competitive, predictable place to invest.

Remember the governor gave us four key principles to oil tax reform: it had to be fair to Alaskans; simple, so that it restored balance to the system; that it encouraged new production; that it was competitive and durable for the long term.

Petroleum News: So you’ve got nine variables. You’ve got the five problems the consultants identified with ACES and you’ve got the governor’s four guiding principles. Do you think SB 21 addressed all nine?

Pawlowski: Absolutely. The five key problems are technical issues. The four guiding principles are principles to approach each of those five problems.

Petroleum News: Another criticism of SB 21 is the state is rewarding production already slated to occur?

Pawlowski: First of all, rewarding it depends on the cost of production and the price of oil, that’s actually happening. So if prices are where they are today or lower, SB 21 isn’t much of a reward. I think we’ve been proved right in the change in investment we’ve seen announced by companies. ConocoPhillips already announced capital investment in Alaska to $1.7 billion from $600 million in 2012. We’ve seen new rigs already going up to the North Slope. Whether they would happen anyway, it’s a level of confidence we weren’t seeing. The new investment the state is seeing is really significant and will lead to new production.

Petroleum News: The state has tried for decades to boost production. What gives you confidence this new law that starts Jan. 1 will stem the decline?

Pawlowski: I think part of it is the incentives built into the system, which have been shifted to production away from capital spending on per barrel credits. The system provides a more targeted incentive for production. The steady tax rate provides a more predictable environment. The investments being talked about do have the potential to offset the decline. Part of the dilemma Alaskans face, is that as we’ve waited — remember the governor began approaching tax reform several years ago — production decline materially since then. I’ve looked at the fall forecasts 2010, the ones oil tax reform started around. They predicted 100,000 more barrels a day than we will see. We continue to take conservative forecasting methodology into our projections that we released publically. If you look at the upside potential we see, they say there is a real opportunity for flat to increasing production. Even getting production from the 8.2 percent decline to even zero is a major feat.

Petroleum News: On the regulation defining new oil, there is a concern that ultimately all oil produced would qualify as new oil. Do you see that as true and do you believe the new regulation holds the industry accountable?

Pawlowski: I think the new regulation does that. I think the new regulation attempts to provide the most clarity to industry who is planning on investing and making decisions and to Alaskans about what’s being accounted for. That’s a careful balance that through the public process, the department looks at and looks to in designing the regulation. I think the notion that all oil becomes new oil is frankly a misunderstanding of the geology on the North Slope and the way the new oil provisions are structured. New oil can easily be drilling in the legacy fields in Prudhoe and Kuparuk, and the existing participating areas. It is not GRE/GVR eligible oil, which is the new oil in the legislation. But it’s still additional oil and new oil being brought out of those legacy fields. For all oil to be new oil, the existing participating areas — the core of Alaska’s production, Prudhoe and Kuparuk — all of that production has to go away for the eligible new oil to take up all of the production. When they started developing Prudhoe Bay, the original estimate for recovery was 9.6 billion out of the 24-plus (billion) in place. Now with the application of technology, expertise, reservoir work, the operator and the industry have increased that recovery toward 50 percent of the oil in place. As they continue to work to get more and more oil out of that reservoir, that doesn’t qualify as “new oil” under the regulation or new statute because it’s not a new unit, it’s not a new participating area and it’s not an expanded part of the unit. This is in the core of the Prudhoe Bay producing area, and that does not qualify. That today is still the largest geologic prize on the North Slope. It’s increasing the ultimate recovery in Prudhoe through the prudent and excellent work that the operator and industry does.

Petroleum News: If you sort the back and forth talking points and even rhetoric, what is the simple explanation for defining the differences between SB 21 and ACES?

Pawlowski: Where ACES had a complex tax system, where the tax rates changed every month and provided credits based on spending, SB 21 provides a fixed tax rate and credits based on production. That’s the difference between the two.

Petroleum News: With that in mind, why do you believe this is a simpler bill?

Pawlowski: A net tax system will always have its own inherent complexity because costs are deductible and it does provide a degree of alignment with investors to promote development. It’s simpler because under ACES you had a tax rate of 25 percent plus the progressivity factor. That progressivity factor depended on four areas: price of oil; transportation costs; the level of production; the direct lease expenditures. Those factors changed and the tax rate under ACES changed on a monthly basis, which made long-term planning extremely difficult. One of the largest incentives under ACES was what a lot of people called the buy-down effect, the ability to invest in Alaska to reduce my tax rate. That’s valuable if I have any idea what my tax rate is going to be.

While I can get a pretty good idea what my tax rate is going to be the next few months — because I have a good idea what the price, production, transportation cost, lease expenditures are — making a multibillion three- to five-year investment, those variables are too complicated to predict with any degree of confidence. So I think one of the largest problems was the complexity and predicting both the negative impact of progressivity and the positive impact of the buy down was impossible for a company to make a long-term investment decision based on it.

SB 21, by going to a flat rate of 35 percent, solves that problem and provides the simplicity and predictability of the tax rate at 35 percent.

Petroleum News: OK, let’s go to a few of your points from the presentations that you believe drive the need for change. One is capital expenditures by area. What do you want the takeaway to be?

Pawlowski: What I want people to see are a couple of things. If you look at 2003-2006, as oil prices were rising, the growth of investments in Alaska was tracking relatively consistent with upstream investment in the United States and worldwide. In 2007 and 2008, ACES goes into effect and prices spike. In the United States and worldwide, investment increases dramatically. Prices fall in 2009, but in 2010, 2011 and 2012, as prices climb, investment in the other regions picks up materially while remaining relatively flat in Alaska. Yes, we can see investment pick up in Alaska even under ACES. We frankly just lived through one of the greatest commodity booms in history in one of the greatest basins in the world, and as prices rose, we did not see the commensurate level of investment in Alaska that we saw in other places or that we saw in 2003-2006.

Petroleum News: The other point you stress is production and how other states are overtaking us. Could you discuss that please?

Pawlowski: I get this discussion a lot. When taxes were low the decline was there. But if you look at 1999-2003, and Gov. Knowles started talking about no decline after 1999, but yes there was North Star and yes there was Alpine, but there were a lot of other developments and a lot of other satellite fields that flattened the decline. It’s not conjecture. The state of Alaska has done this before. In fact a lot of the production we see today comes from investment made back then. In 2004, Prudhoe Bay satellites were doing 103,300 barrels a day; this next year we are expecting them to be 40,100 a day.

In my speeches, I’ve been looking at other states because at the time the focus had been too much on North Dakota and Texas, and it isn’t recognizing how broad based the renaissance in the United States really is. In 2010, ANS prices diverged from WTI prices, and put a major premium on Alaskan oil. Remember we have that premium while we have ready access to a fairly empty pipeline whereas other places relied on trucks and rail for transportation to get the oil to market. Alaska didn’t see the investment in production. It should have come along with that $15-plus premium. That’s a huge premium. Part of the reason was the marginal tax rates under ACES made it look like from the investor perspective, prices didn’t really rise because the state took a greater and greater share.

Petroleum News: Were there any other points you needed to stress?

Pawlowski: One more. I call it the declining value of progressivity. You look at it. The fiscal year of 2008, oil prices were $96.51 and we earned $6.8 billion in oil tax production tax revenue. By 2014, oil is $13 higher and we are making $3 billion a year less in production tax revenue. As production declines, the cost of production gets spread over fewer and fewer barrels. The less oil moving through the pipeline increases the tariff on each of those barrels and ultimately what happens is the value of progressivity, which is based on the value after those costs, goes down. So the tax rate under progressivity goes down. What we are seeing in the Revenue Sources Book today where changes in production assumptions, price assumptions, investment assumptions and transportation costs, drive much lower revenue projections. That’s where the 35 percent tax rate does a lot to protect the state. Remember ACES is 25 percent plus the variable tax rate; whereas SB 21 is 35 percent.