Regulations not taxes hurt Alaska oil

Doug Reynolds

Guest Columnist

Alaska Rep. Vic Kohring in a Petroleum News commentary (April 17 edition, page 5) says that Economic Limit Factor (ELF) tax changes implemented by Alaska Gov. Frank Murkowski probably caused BP and ConocoPhillips to reduce investment into the Orion satellite oil field near Prudhoe Bay. Rep. Kohring shows that the state’s expected gain from changing the ELF will be $150 million to $190 million a year from existing wells, but that because of a lack of fiscal certainty this gain will be offset by a reduction in new investment in Orion. With less investment, Alaska stands to lose $450 million of revenue from potential future production.

While Rep. Kohring’s analysis could be considered one good reason to reinstate the ELF severance tax breaks on Orion and leave ELF alone in the future, another issue that may be more important is the state Department of Natural Resources regulation for the opening of North Slope tundra to winter oil exploration and drilling. Let us first examine the effects of a change in ELF and then address DNR regulations.

Before we can decide if a reduction in tax breaks was the sole cause for BP and ConocoPhillips to limit their investment in the Orion satellite, we have to determine if the profitability of producing oil has changed. In early 2004, BP and ConocoPhillips started to implement their development plan, (see PN, Feb. 8, 2004), with the understanding that the ELF would be used to reduce severance taxes.

The price of oil at that time was $30 per barrel, minus tariffs, and it was expected to remain at that level. (See PN, Dec. 14, 2003.) Likely the producers during this plan approval stage assumed a $25 per barrel price at the wellhead and a zero severance taxation regime. With state royalties of 12.5 percent, Orion would have been forecasted to fetch a pre-income tax value of $22 per barrel. See Table 1.

Now in May 2005 with ELF eliminated, producers will expect to pay a severance tax of 15 percent plus the 12.5 percent royalty for a total of 27.5 percent of the wellhead value of the oil. Currently the spot price of oil is at $50 per barrel and the Energy Information Agency, http://www.eia.doe.gov/emeu/steo/pub/4tab.html, projects a price of $50 for the next couple of years, although Goldman Sachs projects that prices will top $100 per barrel. If we assume the more conservative $50 price and take away the $5 tariffs and royalty the price is $39. Assuming that all possible severance taxes are paid, then the current expected value for producers is 15 percent less than $39 per barrel, or about $33 per barrel.

Comparing the difference, it is odd that a February 2004 expected value of $22 was high enough for the producers to go forward with the Orion satellite, but today now that the expected value of Orion oil is $33, the producers have suddenly stopped investment into the Orion satellite. It doesn’t make sense.

It seems tax breaks are not really the issue for limiting the investment at Orion. A likely reason though is DNR’s restrictive regulations on opening the North Slope to ice roads every winter. DNR has been pushing back winter opening dates. (See Wall’s 2005 University of Alaska Fairbanks Masters’ project entitled, The Economic Implications of the Shortened Oil Exploration Season on Alaska’s North Slope, for a complete analysis.) After 1996 the start date for road construction and, therefore, drilling moved well into January; prior to 1996 it was in early December with an average difference in opening of about thirty days. In addition to the 1996 shift the DNR is shortening the opening period on average by one less day a year. This in turn has caused a reduction in new investment and new drilling.

Active layer freeze-up data from Dr. Vladimir Romanovsky, a UAF professor of permafrost geophysics of the Alaska Arctic, indicates that the tundra is ready for overland oil operations when the active top soil layer is frozen to 12 inches at -1° C. Since 1985, Romanovsky has meticulously measured temperatures through some vertical profiles of the arctic top soil. His techniques generate robust data that show that the tundra can be opened earlier than DNR has allowed. DNR, however, has resisted using scientific methods such as Romanovsky’s and has instead used a variety of ad hoc physical measurement techniques — none of which correlate to actual load bearing strength. In fact, Romanovsky’s scientific data provides evidence that DNR has waited up to 40 or 50 days too long to open up the North Slope each year since 1996.

Recently the DNR has conducted new studies and has opened the tundra earlier. (See PN Sept. 26, 2004.) But DNR is still not using a scientific approach such as temperature reading or the Bureau of Land Management’s cone penetrometer method developed by ConocoPhillips and utilized for federal lands in the National Petroleum Reserve-Alaska. Both methods can protect the tundra with more accuracy, while allowing for an earlier opening.

Oil companies rightly complain that the 100 day tundra opening season the DNR has created greatly complicates their mobilization process for oil drilling and that even twenty more days would improve the logistics for exploring the land they’ve leased. Forty or 50 days may sound insignificant, but when the winter season is already as short as 100 days, the extra time could make a huge difference by enabling the drilling of one or two extra wells. Ice roads cost oil companies millions of dollars to construct, but if only one well is drilled, rather than four, then that can increase fixed costs per well by four times.

Getting back to Rep. Kohring’s argument about the ELF tax break, there is no indication that the pre-income tax value of the oil has declined. Indeed Ron Brenneman of Petro-Canada said in April that there is a “lack of opportunities to find new oil, and that any opportunities that do become available are aggressively pursued since most oil companies are struggling (emphasis added) to replace their oil and gas resources.”

That means Orion, which is proven to exist, has to be considered extremely valuable, and under today’s price and tax structure would be rapidly pursued by any other oil company in the world no matter what other prospects existed.

One possible reason for Orion’s lack of economic viability could be regulations not taxation. And the regulation that may be causing the greatest burden of costs could be DNR’s opening date. The state legislature or the governor needs to accelerate the analysis done on DNR’s techniques of determining tundra opening, and it needs to be done soon. Nevertheless Gov. Murkowski’s decision to take away ELF tax brakes on Orion is more than justified, and with DNR’s partial change, there is no reason to wait to develop the field.l

Dr. Doug Reynolds is an associate professor of oil and energy economics at the University of Alaska Fairbanks, and author of Scarcity and Growth Considering Oil and Energy, and Alaska and North Slope Natural Gas. He can be contacted at [email protected].