Legislature(2005 - 2006)BUTROVICH 205

03/18/2005 03:30 PM RESOURCES

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03:35:43 PM Start
03:38:08 PM SB50
04:59:52 PM Adjourn
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
Heard & Held
-- Testimony <Invitation Only> --
                    SB  50-OIL SEVERANCE TAX                                                                                
CHAIR  WAGONER announced  SB 50  to be  up for  consideration and                                                               
said he did not intend to move the bill today.                                                                                  
3:38:08 PM                                                                                                                    
SENATOR FRENCH, sponsor,  reviewed an outline of  oil taxation in                                                               
Alaska  by narrating  a slideshow  for the  committee. There  are                                                               
four main  taxes the  oil industry  pays -  the royalty  at 12.25                                                               
percent (which varies  a little from lease to  lease), a property                                                               
tax of 20 mils per dollar  (2 percent), a corporate income tax of                                                               
about 9.4  percent and the  production tax of about  12.5 percent                                                               
for the first five years of a lease and 15 percent afterwards.                                                                  
In general,  the production tax  is 15 percent when  the Economic                                                               
Limit Factor  (ELF) comes  into play.  The 15  percent production                                                               
tax varies because of the ELF.                                                                                                  
     At its  simplest, the  ELF is  simply a  number between                                                                    
     zero  and one.  You multiply  the production  tax of  a                                                                    
     field  by the  field's  ELF and  that  always works  to                                                                    
     lower the field's tax burden.                                                                                              
3:39:10 PM                                                                                                                    
SENATOR SEEKINS arrived.                                                                                                        
SENATOR  FRENCH calculated  some  examples on  a  slide. ELF  was                                                               
designed  to  encourage small  field  development,  but what  was                                                               
small in 1989  is different from what most people  mean when they                                                               
say small.  Back in  1989, Prudhoe and  Kuparuk were  the largest                                                               
and  second   largest  fields  in  North   America.  Small  meant                                                               
something less than giant.                                                                                                      
Now people take  a much different view of what  small means. This                                                               
is one  of the fundamental  assumptions that allowed for  the ELF                                                               
to be constructed  the way it was. In 16  years of hindsight that                                                               
was not a perfect assumption.                                                                                                   
There  are twenty  separate fields  on the  North Slope  and even                                                               
after the Governor put the satellite  fields in with the same tax                                                               
structure as  Prudhoe, there are  still nine operating  fields on                                                               
the North Slope that pay no production tax.                                                                                     
In  2003, the  state took  in  about $599  million in  production                                                               
taxes.  The average  price  that  year was  $28  per barrel;  the                                                               
average  ELF was  about  $.50  - meaning  the  production was  .5                                                               
He presented  a slide showing  the Kuparuk, West Sak  and Tabasco                                                               
fields. This bill would exempt  West Sak and Tabasco because they                                                               
are both  heavy oil (less  than 28  p.i. gravity). There  are two                                                               
satellite fields  near Kuparuk  - Tarn  and Meltwater.  Tarn made                                                               
about 22,450 barrels  of oil per day or about  65 million barrels                                                               
total of oil to date, making it  one of the 30 largest oil fields                                                               
in the United  States. It has a  tiny .013 ELF -  meaning it will                                                               
pay .2  percent production tax in  2005. Its ELF will  go to zero                                                               
in 2007.                                                                                                                        
SENATOR FRENCH said another thing  that wasn't considered in 1989                                                               
is  what  kind  of  production facilities  would  be  needed  for                                                               
satellite fields.  Those fields  are piggybacking on  to existing                                                               
infrastructure. Tarn is produced using Kuparuk's facilities.                                                                    
3:44:33 PM                                                                                                                    
SENATOR GUESS arrived.                                                                                                          
3:45:00 PM                                                                                                                    
     Tarn  is  produced basically  by  two  drill sites  and                                                                    
     three 10-mile  pipelines. That's what it  took to bring                                                                    
     the  Tarn  field on  line  -  a fairly  modest  capital                                                                    
     outlay  by the  oil  industry -  compared  to the  huge                                                                    
     expenditures  that a  new field  startup requires.  The                                                                    
     Meltwater   field,  which   was  also   one  of   these                                                                    
     satellites, is  produced through  Kuparuk's facilities.                                                                    
     It  required  one  drill  site  only  and  in  2003  it                                                                    
     produced about  5,800 barrels of  oil per day  and paid                                                                    
     no production  tax. This rather modest  field will make                                                                    
     the producers  two million barrels  of oil this  year -                                                                    
     at $50 a barrel, that's $100 million.                                                                                      
A  drilling  supervisor  for  Schlumberger,  a  leading  oilfield                                                               
services  provider, said  he charges  between $2  million and  $8                                                               
million for drilling a well on the North Slope.                                                                                 
SENATOR  FRENCH said  that the  Meltwater field  had four  to six                                                               
wells. Using the high figure of  $8 million to drill one well, it                                                               
would cost  $48 million for all  the drilling for a  field that's                                                               
making $100  million a year.  "Chances are the wells  costs less.                                                               
It's hard to find out."                                                                                                         
3:46:13 PM                                                                                                                    
SENATOR  SEEKINS  asked  what  the state's  share  of  that  $100                                                               
million per year.                                                                                                               
SENATOR  FRENCH replied  that  the state  gets  the 12.5  percent                                                               
royalty and  9.4 percent  in corporate income  tax and  the North                                                               
Slope Borough would get its 2 percent property tax.                                                                             
3:46:45 PM                                                                                                                    
He said  that SB  50 sets  out two  principal reforms.  The first                                                               
establishes a  minimum 5 percent  production tax for  all fields.                                                               
In  January  2004  the  Department   of  Revenue  estimated  this                                                               
provision alone would raise $75 million at $22 per barrel.                                                                      
The second  major reform bases the  ELF on the price  of a barrel                                                               
of oil. As the price of oil rises  or falls, so does the ELF. The                                                               
bill sets a  $16 - $20 range  of oil as the norm  and allows this                                                               
range to  increase with inflation  to recognize that  prices rise                                                               
over  time. At  lower  oil  prices, the  production  tax will  be                                                               
reduced. He  felt that it  is only fair  to lower taxes  at lower                                                               
prices  so  the  state  doesn't  tax  the  oil  industry  out  of                                                               
existence during economically hard times.                                                                                       
3:48:57 PM                                                                                                                    
SENATOR SEEKINS asked how he established the norm.                                                                              
3:49:29 PM                                                                                                                    
SENATOR FRENCH said it's impossible to predict oil prices.                                                                      
     The real  key is not what  the prices are going  to be;                                                                    
     the real  key is  preserving the economic  viability of                                                                    
     the companies  and the fields  that are in  place. It's                                                                    
     our belief that the $16 - $20 range establishes that.                                                                      
3:50:21 PM                                                                                                                    
SENATOR SEEKINS remarked  that it was a fair  assumption that oil                                                               
wouldn't get that low for the long term.                                                                                        
SENATOR ELTON said  he thought they would want  to establish that                                                               
"tipping  point" on,  not  the price  of oil,  but  the price  of                                                               
producing it.                                                                                                                   
3:50:45 PM                                                                                                                    
SENATOR FRENCH  said if  oil prices  fall below  $10 a  barrel as                                                               
they did  in 1984, the bill  would waive half the  production tax                                                               
and defer  the other half until  prices rise above $16  a barrel.                                                               
The  bill doesn't  allow the  production  tax to  ever exceed  25                                                               
percent. The bill also exempts heavy oil.                                                                                       
3:51:37 PM                                                                                                                    
CHAIR WAGONER why he capped it at 25 percent.                                                                                   
SENATOR FRENCH  explained that he was  trying to be fair.  If oil                                                               
prices go  to $100, the  formula would produce an  unusually hard                                                               
bite. "[The  calculation] produces roughly equal  share of profit                                                               
between the industry and the state."                                                                                            
3:52:12 PM                                                                                                                    
CHAIR  WAGONER said  it seemed  excessive to  require 25  percent                                                               
when  the  state has  no  risk  and  no upfront  investment  with                                                               
venture  capital. "I  could understand  increasing  taxes if  the                                                               
state had some risk here...."                                                                                                   
3:53:06 PM                                                                                                                    
SENATOR SEEKINS asked what the maximum production tax is now.                                                                   
SENATOR FRENCH replied 15 percent, although no field pays that.                                                                 
SENATOR SEEKINS  said it looks  like the maximum is  being raised                                                               
by 65%.                                                                                                                         
SENATOR FRENCH replied yes.                                                                                                     
3:54:24 PM                                                                                                                    
He continued explaining  that SB 50 allows  tax payers production                                                               
tax  relief, much  like  the  royalty tax  relief  that passed  a                                                               
couple of years ago.                                                                                                            
     If the tax  payer can demonstrate that  the field would                                                                    
     economical, but  for the production tax...by  clear and                                                                    
     convincing evidence to the  Department of Revenue, then                                                                    
     the department has the power  to waive the tax for that                                                                    
     field - to make certain  that the truly marginal fields                                                                    
     -  the fields  that are  truly on  the cutting  edge of                                                                    
     development  and exploration  - don't  get lost,  don't                                                                    
     fall off the table because of this bill.                                                                                   
SENATOR  FRENCH sought  to answer  why  a change  is needed.  Dan                                                               
Dickinson,  Director, Division  of Tax,  said a  year ago  in the                                                               
Petroleum News that:                                                                                                            
     Despite its  name, Economic Limit Factor  - the current                                                                    
     ELF  ignores the  biggest single  economic determinant,                                                                    
     which is price. That's the  missing link in the current                                                                    
     ELF formula.                                                                                                               
He said  we may  be at the  end of cheap  oil. Current  oil usage                                                               
each day  is about 80  million barrels and he  sited publications                                                               
on the  issue. Conoco-Phillips made  $15.2 billion in  profits in                                                               
90  days  -  after  deducting  all the  costs  one  can  imagine,                                                               
including bonuses and lobbying fees.                                                                                            
3:56:43 PM                                                                                                                    
SENATOR STEDMAN asked if he knew their rate of return on equity.                                                                
SENATOR  FRENCH he  couldn't quote  a number,  but said  his data                                                               
came from the Charles Schwab Website.                                                                                           
3:57:26 PM                                                                                                                    
SENATOR ELTON said it was 24 percent for Exxon.                                                                                 
3:57:47 PM                                                                                                                    
SENATOR FRENCH  reminded the  committee about  a book  written by                                                               
Governor Hickel  called "The  Crisis In  The Commons:  the Alaska                                                               
Solution" in which  about how the oceans are owned  in common. He                                                               
wrote that few world leaders  were thinking about how the commons                                                               
should be used  for the benefit of the total.  He also wrote that                                                               
the  Mineral Leasing  Act  of 1920  recognized  that the  commons                                                               
belong  to  the  public  and   required  the  income  from  their                                                               
development to  be paid to  the public's government. He  said our                                                               
statehood act  was modeled  on that  act. "The  subsurface energy                                                               
resources  were  specifically  designated  to the  new  State  of                                                               
4:00:28 PM                                                                                                                    
SENATOR FRENCH said  that recently, portions of  a Wood Mackenzie                                                               
Study  were released  and the  thrust is  that Alaska  is a  more                                                               
profitable place to do business than  the average of 60 other oil                                                               
and  gas  producing  regions  worldwide.  "We  have  higher  than                                                               
average costs with  lower than average government  take at prices                                                               
above $16 a barrel."                                                                                                            
4:02:44 PM                                                                                                                    
SENATOR SEEKINS  asked if  the study was  just talking  about the                                                               
take for government.                                                                                                            
SENATOR  FRENCH  replied that  it  talks  about everything  after                                                               
expenses  including   government  expenses  -  in   other  words,                                                               
profitability.  Other  countries,  like the  UK,  are  increasing                                                               
their take according to Petroleum News.                                                                                         
4:05:21 PM                                                                                                                    
SENATOR STEDMAN asked if SB 50  would tie tax into something like                                                               
inflation proofing.                                                                                                             
SENATOR FRENCH explained the normal  range is set between $16 and                                                               
$20. A higher taxation scheme would kick in at a higher price.                                                                  
SENATOR STEDMAN said he didn't  think historically that inflation                                                               
and oil prices are correlated.                                                                                                  
SENATOR  FRENCH  responded  that  costs  of  doing  business  are                                                               
basically the  same for both  government and industry.  "It costs                                                               
just  as much  to  insure an  oil field  worker  as a  government                                                               
worker.... All their costs over time just tend to go up."                                                                       
CHAIR WAGONER stated  that Conoco Phillips just  announced it was                                                               
putting Orion on hold.                                                                                                          
     That's a  direct affect of when  the Governor announced                                                                    
     his changed  to ELF. So,  how many more Orions  are out                                                                    
     there and  how many  more times  are the  oil companies                                                                    
     going to take their money  that they had programmed for                                                                    
     Orion, for  instance, and  taking it  elsewhere? That's                                                                    
     the hit I see Alaska  taking. Right now these companies                                                                    
     are  investing  billions of  dollars  a  year and  it's                                                                    
     going to take a lot of  money just to stay level on the                                                                    
     amount oil we got  coming down the TransAlaska Pipeline                                                                    
     If you  change the tax  structure now and we  lose that                                                                    
     production  to keep  that level  on the  flow down  the                                                                    
     pipeline, even if you increase  the taxes, what's going                                                                    
     to  be the  difference in  those  two lines  as far  as                                                                    
     income to the state of Alaska?                                                                                             
SENATOR FRENCH agreed and said the  state must find a sweet spot.                                                               
"The idea  is to let industry  and the state have  equal portions                                                               
of the oil  revenue...." - as Hugh Malone said  when the original                                                               
ELF was crafted.                                                                                                                
4:12:02 PM                                                                                                                    
DEBORAH VOGT, Haines resident, said  she served the state between                                                               
1978  and  1999  as  an assistant  attorney  general  and  senior                                                               
hearing  officer and  deputy commissioner  for the  Department of                                                               
Revenue. She  dealt with oil  taxes for  most of her  career. She                                                               
supported  raising  taxes and  finding  the  sweet spot  to  keep                                                               
Alaska  competitive  for new  investments.  "But,  I submit  that                                                               
under  today's statutory  scheme we  are  a long  ways from  that                                                               
sweet spot."                                                                                                                    
She said  that last  year Sir John  Brown with  British Petroleum                                                               
announced  that his  company  could  meet all  of  its needs  for                                                               
operations and  investments with  $20 oil. At  that time,  it was                                                               
his intent  that revenue above  that amount would be  returned to                                                               
the  shareholders. She  asked the  committee to  think about  the                                                               
fact that ANDS  crude was going for $52.50 earlier  this week and                                                               
that's a long way from $20.                                                                                                     
MS. VOGT challenged:                                                                                                            
     So, where is  the additional $30 a  barrel going? These                                                                    
     are Alaska's  resources. This is private  industry, but                                                                    
     they are producing  oil that is leased  from the state.                                                                    
     It's our  oil. They have  the right to produce  it, but                                                                    
     it's different from other  private industry like Alaska                                                                    
     Airlines or somebody.                                                                                                      
4:14:40 PM                                                                                                                    
She didn't  know who the  BP shareholders are, but  deducted that                                                               
that its excess  revenue is not staying in Alaska.  She asked the                                                               
committee to  compare using  $7 million  from the  state's annual                                                               
budget to support gasline activities  to making $30 million a day                                                               
like oil companies do.                                                                                                          
MS. VOGT said  that the long-term forecast when she  was in state                                                               
government in 1999 was $16 to $18  oil. In the fall of 2004, that                                                               
number was  $25.50 and every  indication is that the  number will                                                               
go much higher.                                                                                                                 
4:16:21 PM                                                                                                                    
She explained  a little bit  about the state's  overall petroleum                                                               
picture.  Royalties are  the state's  ownership interest  in oil.                                                               
Royalties are not  general fund money; they go  straight into the                                                               
Permanent  Fund. The  second thing  about royalties  is that  the                                                               
state is  not always  the "farmer" in  the equation.  The federal                                                               
government  passed legislation  to  reauthorize  drilling in  the                                                               
Arctic Wildlife Refuge,  but the state would get  only 50 percent                                                               
while the U.S. would get the other half.                                                                                        
She  explained that  aside from  the property  tax, there  is the                                                               
corporate income  tax, which  is 9.4 percent.  It is  very poorly                                                               
designed for taxing natural resource production.                                                                                
     Because  of  this,  the oil  industry  has  never  paid                                                                    
     anywhere  near the  9.4 statutory  effective tax  rate.                                                                    
     Their effective  tax rate has never  come anywhere near                                                                    
     the  9.4  percent  rate....  It  is  not  sensitive  to                                                                    
     economics of  Alaska. Because  we tax  on a  portion of                                                                    
     worldwide  basis, what's  happening  in Alaska  affects                                                                    
     the corporate income tax very,  very indirectly. I just                                                                    
     want to  emphasize [indisc.] severance tax  rates, it's                                                                    
     very, very important.                                                                                                      
     Think about it. None of  these other revenue sources is                                                                    
     a very  good tool for  funding that sweet  spot between                                                                    
     not  discouraging investment,  but getting  the maximum                                                                    
     benefit for Alaskans from their natural resources.                                                                         
MS.  VOGT  said  that  oil   and  gas  corporations,  like  every                                                               
corporation,   have   a   fiduciary   responsibility   to   their                                                               
shareholders to maximize profits. They  are not going to tell you                                                               
about any changes that will cost  them money. "They are not going                                                               
to make it easy for you to find that spot."                                                                                     
She said the  Chairman of the committee and other  members of the                                                               
Legislature have  a fiduciary  and a  constitutional duty  to the                                                               
people  of  the  State  of   Alaska  to  maximize  their  natural                                                               
resources.  She  agreed  with the  Wood  MacKenzie  report  shows                                                               
Alaska  might be  a  little  over the  sweet  spot  with low  oil                                                               
prices, but  at high prices, "We  are giving away way  too much."                                                               
SB 50  addresses both high  and low prices and  draws intelligent                                                               
4:21:29 PM                                                                                                                    
SENATOR SEEKINS asked Ms. Vogt to  repeat what she said about the                                                               
royalty share going to the Permanent Fund.                                                                                      
MS. VOGT related that by  constitution, 25 percent of the state's                                                               
royalties go directly to the  Permanent Fund and statute mandates                                                               
another 25 percent.                                                                                                             
CHAIR WAGONER  said that HB  11 changed the statutory  25 percent                                                               
for  newly  discovered  oil fields.  Ms.  Vogt  acknowledged  the                                                               
4:22:24 PM                                                                                                                    
JUDY BRADY,  Executive Director,  Alaska Oil and  Gas Association                                                               
(AOGA),  introduced Tom  Williams to  make its  presentation. She                                                               
said he  was director of  the Division of Petroleum  Revenue from                                                               
1975-1979 and was commissioner of  the Department of Revenue from                                                               
1979-1982. He was  in private practice and then went  to work for                                                               
British  Petroleum. He  has degrees  from  Harvard, Stanford  and                                                               
Princeton and knows a lot about oil and gas tax.                                                                                
4:23:59 PM                                                                                                                    
TOM WILLIAMS,  Chairman, AOGA Tax  Committee, speaking  on behalf                                                               
of AOGA,  said he is employed  by BP Exploration. He  presented a                                                               
slide show of  Alaska's oil revenue picture.  This current fiscal                                                               
year, 88 percent  of the unrestricted general  fund revenue would                                                               
come from  petroleum and 12  percent from  non-petroleum sources.                                                               
Historically, it's  been closer to  80 percent. According  to the                                                               
Department of  Revenue projections, oil revenue  will continue to                                                               
provide three-quarters  or more of the  unrestricted general fund                                                               
revenues through 2014.                                                                                                          
Two elements  are critical  to that situation;  one is  price and                                                               
the  other is  volume.  There isn't  a lot  anyone  can do  about                                                               
price, but volume is a result  of investment, which the state has                                                               
some influence over.                                                                                                            
He  reviewed the  four elements  of the  state's fiscal  system -                                                               
royalty from land  ownership, which was $1 billion  last year and                                                               
almost $500  million to  the Permanent  Fund; production  tax was                                                               
$652 million.  Production tax is  where the ELF comes  into play.                                                               
The property tax, with the state  as assessor, is at 2 percent or                                                               
20 mils. The  same property tax is also paid  to the municipality                                                               
where the field is located. A  credit is granted to the municipal                                                               
tax for  the state tax. This  system was created by  the state in                                                               
1973 in a special session.                                                                                                      
The oil and gas corporate income  tax was just under $300 million                                                               
last year.  He pointed out  that taxes that go  to municipalities                                                               
don't show  up in  calculations of  the revenues  that go  to the                                                               
state, but  it still  is part  of the cost  of doing  business in                                                               
Alaska for gas and oil companies.                                                                                               
MR. WILLIAMS stressed  that the ELF is  only affecting production                                                               
     Even if the  ELF makes the severance  or production tax                                                                    
     zero, a field still pays  for royalty to the state, for                                                                    
     property taxes on its  facilities, contributes fully to                                                                    
     the owner's income taxes....                                                                                               
4:28:38 PM                                                                                                                    
He said  that the fields  are creating  Alaska jobs even  if they                                                               
are not paying production tax.                                                                                                  
4:30:51 PM                                                                                                                    
MR. WILLIAMS explained  that the netback is  gross resource value                                                               
to the  point where the oil  is leaving the field  and going into                                                               
the pipeline. The costs of running  the field are not counted for                                                               
the purposes of  this tax, but transportation costs  are. The ELF                                                               
depends on  two parameters  - how  many barrels  per day  a field                                                               
produces and the average rate per well.                                                                                         
     The larger a  field is, the more  productive its wells,                                                                    
     the higher  its ELF  and the higher  its tax  rate. The                                                                    
     thought is it's  more profitable and can  afford to pay                                                                    
He pointed out  that this methodology applies  regardless of what                                                               
the price is.                                                                                                                   
     If you started  with the West Coast price,  say, of $10                                                                    
     and  you  subtracted...$5 for  transportation....  That                                                                    
     leaves  me a  netback of  $5. If  the West  Coast price                                                                    
     triples to $40, my  transportation cost remains $5. Now                                                                    
     I have  a netback of  $25. It's quintupled.  That's how                                                                    
     Alaska is  leveraged by  price. The  ELF does  not have                                                                    
     price as  a specific parameter  in it, but ELF,  a tax,                                                                    
     has price in it in its overall composition.                                                                                
     Now, why do we have an  ELF? I have to confess that the                                                                    
     ELF  is an  idea  that  I thought  of  when  I was  the                                                                    
     director  of Petroleum  Revenue for  the state  back in                                                                    
     1976. In December,  I wrote a memo  suggesting the idea                                                                    
     behind  the  ELF.... We  wanted  to  have a  high  rate                                                                    
     production   tax.   We   didn't  want   to   have   the                                                                    
     consequences  that a  high  rate  production tax  would                                                                    
     have  later in  a  field's  life -  which  is what  the                                                                    
     department said  in 1977....  As operating  costs rise,                                                                    
     the profit margin  shrinks during the life  of a field.                                                                    
     Production  tax  contributes  to the  total  costs  and                                                                    
     tends to  hasten the time  to avoid the  consequence of                                                                    
     high  production  tax in  the  later  stage of  field's                                                                    
He presented the  committee with a graph showing  the four stages                                                               
of a field's life. The first  stage is when the field first comes                                                               
on to production and  costs are as low as they  are ever going to                                                               
be. Stage 4 finally shows a loss.                                                                                               
4:33:09 PM                                                                                                                    
SENATOR ELTON asked if the graph  assumes the price of oil is the                                                               
same in stage 1 as it is in stage 4.                                                                                            
MR.  WILLIAMS replied  no.  It will  happen  regardless. It  will                                                               
happen in  every field. "That's  how fields end. They  go through                                                               
this evolution.... The  point is to illustrate  what happens with                                                               
respect within  that value." He  said that's why fields  get shut                                                               
in. "Those  costs keep going  up and up as  more and more  of the                                                               
oil that is extractable gets  produced. It gets harder and harder                                                               
to get the next one out - and more and more expensive."                                                                         
SENATOR ELTON asked if the period  of time between stages 1 and 4                                                               
would be extended.                                                                                                              
MR. WILLIAMS replied, "Absolutely. There  is no time dimension to                                                               
this graph."                                                                                                                    
4:36:56 PM                                                                                                                    
He said  the wildcatters  who come  up to Alaska  need a  stage 1                                                               
picture or they are not going to explore.                                                                                       
     The response to this  evolution over a field's life....                                                                    
     The first one is do nothing.  Stage two - the gray area                                                                    
     - is  starting to get  squeezed between the  red coming                                                                    
     off the top  and the rise in costs at  the bottom. Now,                                                                    
     producers start saying  we're going to have  to be more                                                                    
     efficient.  We're  going  to  have  to  streamline  our                                                                    
     operations. We're going to  have to debottleneck. We're                                                                    
     going  to  have  to   eliminate  unused  facilities  or                                                                    
     consolidate facilities....                                                                                                 
     Another thing  that they  do is,  as these  margins are                                                                    
     getting  squeezed, it  gets harder  and harder  to find                                                                    
     reinvestment  opportunities  in  the field.  There  are                                                                    
     still  going  to   be  competitors  with  opportunities                                                                    
     elsewhere.   So,   we   start  having   some   economic                                                                    
     casualties  - projects  that are  technically possible,                                                                    
     but don't make economic  sense. As this stage advances,                                                                    
     which can take  years, it could even  take decades. You                                                                    
     will  have increasingly  these  things  - more  drastic                                                                    
     measures  to   try  to  save  costs   and  also  higher                                                                    
     casualties in terms of things  that just don't make the                                                                    
     grade in being competitive for investment.                                                                                 
     When you reach  the point that there is  nothing left -                                                                    
     that is  competitive to invest  in for that  field, you                                                                    
     fall into,  what I call,  a harvest stage.  That's what                                                                    
     you  have illustrated  here -  is stage  3 -  where you                                                                    
     have such a narrow band.  It may be possible that you'd                                                                    
     still  find some  capital investments  in a  field like                                                                    
     that would pay out of  that little thin margin, but I'm                                                                    
     saying  for purposes  of discussion  here  - let's  say                                                                    
     there isn't.  So, that  represents the  situation where                                                                    
     you've gone into harvest mode.                                                                                             
     Then  you have  the running  in the  red stage.  That's                                                                    
     phase 4.  Now, why  are you running  in the  red? Well,                                                                    
     you can run in the red  - at Prudhoe Bay in December of                                                                    
     1998,  that's $8.16  - because  you don't  believe it's                                                                    
     going  to  stay  there  forever and  it  didn't,  thank                                                                    
     goodness. The  other thing that  you'd stay in  the red                                                                    
     for  sometimes is  because there's  a cost  to wrap  up                                                                    
     your operations. You can't just  turn the field off and                                                                    
     walk away. You  have to plug in and  abandon the wells;                                                                    
     you  have  to remove  all  the  surface facilities  and                                                                    
     restore the  land. That's in  the contract for  the use                                                                    
     of the land  - whether it's the lease  or the right-of-                                                                    
     way to whatever. There's never  going to be a return on                                                                    
     that cost. That's  just a cost. So, you  may be willing                                                                    
     to operate  in the  red, because that's  less expensive                                                                    
     than incurring the  cost right now. Why go  to death if                                                                    
     you can only have pain and agony for now?                                                                                  
CHAIR WAGONER remarked, "Death's going to come some time."                                                                      
MR.  WILLIAMS conceded  that point.  He  went on  to explain  the                                                               
ELF's inception. The  department wanted to know  how many barrels                                                               
of oil were  needed to cover the costs of  getting the production                                                               
out of the  ground or production at the economic  limit (PEL). He                                                               
showed the committee  how to calculate the  operating margin, the                                                               
ELF. It was scaled so that  if the operating margin was high, the                                                               
ELF would  be high  and the tax  would be closer  to the  full 15                                                               
percent (12.25  percent at  first). As  the margin  gets squeezed                                                               
the  ELF  gets  smaller  and   disappears.  As  the  margins  get                                                               
squeezed,  the severance  tax disappears.  He  inserted that  the                                                               
state had a stair step tax regime before the ELF was enacted.                                                                   
4:41:59 PM                                                                                                                    
MR.  WILLIAMS  said  the  ELF  was his  idea,  David  Knutsen,  a                                                               
petroleum economist for  the department, came up  with the actual                                                               
formula. The reason  industry did not want the ELF  is because it                                                               
raised the  rate at Prudhoe  Bay without the consequences  at the                                                               
end of field life.                                                                                                              
     In 1977, Prudhoe Bay did go  from a 7.8 percent rate to                                                                    
     approximately 11.7  [percent] under the ELF  and that's                                                                    
     a  50 percent  increase  in the  tax  rate. That's  why                                                                    
     industry didn't like it.                                                                                                   
4:46:54 PM                                                                                                                    
He said that legislators were  told that smaller fields would pay                                                               
less tax for the same well  productivity and that was the intent.                                                               
The  reason it  was  okay is  because the  state  would get  more                                                               
money. "The  giveaway to the  small fields was estimated  at $200                                                               
million....  So,  the state  was  a  net  $2.69 billion  or  $2.7                                                               
billion ahead."                                                                                                                 
4:48:28 PM                                                                                                                    
He said the ELF  has worked the way it was  supposed to - Prudhoe                                                               
and Kuparuk still have a higher production tax.                                                                                 
     Kuparuk is  still paying at  a higher rate of  tax with                                                                    
     the 1989  formula than  it would  have under  the prior                                                                    
     formula. That  will change  because Kuparuk  is closing                                                                    
     in on  the 300 barrels  a day per well  threshold where                                                                    
     the tax goes to zero  - and Kuparuk is getting smaller.                                                                    
     The two things  are going to take  Kuparuk smaller, but                                                                    
     it hasn't reached that yet.                                                                                                
4:50:53 PM                                                                                                                    
He reflected that the state is  ahead by $2.7 billion net and has                                                               
met its  target before 2010.  ELF was enacted over  the strenuous                                                               
opposition of the industry for three years. He said further:                                                                    
     No one  said that  investment in  the big  fields would                                                                    
     stop altogether. What  they said is that  that you will                                                                    
     have production that falls off  the edge, because we'll                                                                    
     cease  to compete  successfully  with  the others.  The                                                                    
     black area  of the  curve is  what the  natural decline                                                                    
     rate would  be in  these fields  - the  existing fields                                                                    
     from '89. The yellow area  that gets added on top, that                                                                    
     the  actual production  that  did  result from  ongoing                                                                    
MR. WILLIAMS  said that  new fields  were discovered  like Alpine                                                               
and North  Star. Instead of being  down at 300,000 barrels  a day                                                               
with  the natural  decline, production  is close  to one  million                                                               
barrels. However,  more investment is crucial.  The Department of                                                               
Revenue has  said that it  is going to  have to double  or triple                                                               
from its present level over the next decade.                                                                                    
4:54:15 PM                                                                                                                    
Different kinds  of investment have different  economic profiles.                                                               
Wildcat exploration spends millions of dollars up-front.                                                                        
     You have it exposed at risk  for years before you see a                                                                    
     dime come  back on  it. When it  does come  back, you'd                                                                    
     better get  it as fast as  you can. On the  other hand,                                                                    
     you have  drilling more wells  in Prudhoe Bay  and they                                                                    
     can be turned on right away.                                                                                               
Most of  the expenditure on  heavy oil  has been on  research and                                                               
development.  Hundreds  of millions  of  dollars  - not  for  any                                                               
specific well or field - but  in trying to crack the nut, solving                                                               
the problems of  the viscosity of the oil and  the fact that silt                                                               
comes out with it. Because  the profiles are different, any given                                                               
tax change promises  to have a different impact  on each category                                                               
of investment. He  urged the committee to make sure  there are no                                                               
unintended consequences, which combines  with Murphy's law to put                                                               
you  behind from  where  you thought  you were  going  to be.  He                                                               
cautioned  that  the fiscal  notes  on  this legislation  do  not                                                               
assume that there  is a response in the level  of production over                                                               
the next 10 years if HB 63 or SB 50 becomes law.                                                                                
The Governor's ELF decision lumps  six small fields together with                                                               
Prudhoe making  them one  larger size because  field size  is the                                                               
dominant factor  where the ELF goes  up. Some were paying  no tax                                                               
and now  they are paying 13  percent. Two of the  fields that got                                                               
aggregated, Orion and Polaris, are West Sak viscous oil.                                                                        
4:55:38 PM                                                                                                                    
MR.  THOMPSON  said  AOGA  doesn't  like SB50  for  a  number  of                                                               
reasons.  It is  a  structural tax  increase.  The Department  of                                                               
Revenue's expected  price forecast  is $25.50  in the  long term.                                                               
It's  a 27.5  percent increase  across the  board if  DOR's price                                                               
forecast comes true.                                                                                                            
Second,  the maximum  tax right  now is  15 percent,  although no                                                               
field is  paying that. That would  increase to 25 percent.  The 5                                                               
percent minimum  is a heavy  burden on satellite  development and                                                               
maybe on the viscous oil development,  too. "In fact, it uses the                                                               
wrong standard for judging viscous oil.  West Sak oil is not best                                                               
measured by  API gravity, but  by centipoises, which is  the unit                                                               
to measure how thick it is."                                                                                                    
4:57:43 PM                                                                                                                    
MR. THOMPSON said:                                                                                                              
     An  analysis of  the  consequences  on investments  and                                                                    
     whether in fact you're really  going to get all the oil                                                                    
     in  the coming  years  that the  Department of  Revenue                                                                    
     assumes  - so,  it  makes Alaska  less competitive;  in                                                                    
     fact,  threatens  that  investment, because  the  funny                                                                    
     thing is about  $50 oil. It's $50 in  Russia, too. It's                                                                    
     $50 in  Trinidad; it's $50  in the United  States, Gulf                                                                    
     of  Mexico,  in  Oklahoma,  wherever  it  may  be.  The                                                                    
     competition  doesn't change  because  of  the price  of                                                                    
     oil;  all  the  boats  rise  and  fall  with  the  tide                                                                    
     together.   That's    the   important    thing   that's                                                                    
     overlooked.  That's the  end.  I'd be  glad  to try  to                                                                    
     answer any questions.                                                                                                      
4:58:04 PM                                                                                                                    
SENATOR  GUESS  asked  if  production tax  is  a  function  price                                                               
through the netback.                                                                                                            
MR. THOMPSON replied yes.                                                                                                       
SENATOR GUESS asked if price is a function in the ELF.                                                                          
MR. THOMPSON replied no. Price is a parameter in the netback.                                                                   
SENATOR GUESS asked regardless of price,  if the ELF is zero, the                                                               
production tax is zero.                                                                                                         
MR. THOMPSON replied that is correct.                                                                                           
CHAIR WAGONER thanked him for his testimony and said he would                                                                   
hold the bill.                                                                                                                  

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