Legislature(2005 - 2006)SENATE FINANCE 532

03/06/2006 03:30 PM RESOURCES

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03:36:58 PM Start
03:36:58 PM SB305
06:14:11 PM Adjourn
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
Joint w/(S) Finance
Heard & Held
Presentation by Legislative Consultant
Daniel Johnston
               SB 305-OIL AND GAS PRODUCTION TAX                                                                            
3:36:58 PM                                                                                                                    
CO-CHAIR  THOMAS WAGONER  announced that  the presentation  would                                                               
DANIEL  JOHNSTON,   Owner  of  Daniel  Johnston   &  Company  and                                                               
Legislative Consultant  to the international  petroleum industry,                                                               
introduced himself.                                                                                                             
3:38:42 PM                                                                                                                    
MR.  JOHNSTON  reviewed  his  credentials  and  said  he  advises                                                               
governments on issues  like the petroleum production  tax as well                                                               
as  teaches   classes  on  resource  development   for  different                                                               
universities.   He   also   does   arbitration   work   involving                                                               
litigations and  mediations. He  said it  was his  strong opinion                                                               
that minerals  and resources were  a gift  from God and  that his                                                               
mandate was to help the State of Alaska design a fair system.                                                                   
3:42:27 PM                                                                                                                    
MR. JOHNSTON  continued reviewing  his credentials and  said that                                                               
much  of   the  presentation  would  be   addressing  fundamental                                                               
taxation  theory.   Future  generations  will  ask   whether  the                                                               
Legislature  designed the  system right  and negotiated  the best                                                               
contract with the  information and tools of the  present date, he                                                               
3:44:40 PM                                                                                                                    
Senator Albert Kookesh joined the meeting.                                                                                      
3:45:45 PM                                                                                                                    
MR. JOHNSTON  advised the committees  of his disclaimer  prior to                                                               
the  presentation.  He  highlighted   the  exorbitant  amount  of                                                               
material that  he had to  study and said  he needed more  time in                                                               
order to  provide a more  thorough report. He reserved  the right                                                               
to  correct,  amend,  change,  and  add to  what  he  called  his                                                               
preliminary report.                                                                                                             
Slide 6: Conclusions                                                                                                            
Alaska has every  right to change the system and  is not the only                                                               
region considering or making changes  these days. Alaska may have                                                               
more justification to change than most due to the following:                                                                    
   · Because the ordinary regressive effect of the royalty                                                                      
   · The ordinary regressive effect of a severance tax                                                                          
  · The inefficiencies of ELF's field production rate element                                                                   
   · The inefficiencies of ELF's daily well production rate                                                                     
3:50:29 PM                                                                                                                    
The new  system should increase  revenues to the State  of Alaska                                                               
and  enhance   exploration  activity.  These  are   not  mutually                                                               
exclusive objectives. Increasing taxes  on existing production is                                                               
relatively  inelastic  and the  proposed  credits  work well  for                                                               
The  new  system should  be  a  well-designed modern  system  and                                                               
should be flexible, progressive, simple, and transparent.                                                                       
3:55:02 PM                                                                                                                    
The ELF tax  itself as is structured is a  progressive tax but it                                                               
only  just barely  counterbalances the  regressive effect  of the                                                               
12.5 percent  royalty, in  which case as  a whole  is effectively                                                               
neutral  and that  is not  enough. Alaska  must develop  a system                                                               
that could  handle extreme prices in  case oil goes up  to $200 a                                                               
3:56:58 PM                                                                                                                    
Trying  to  craft  one  system  to  fit  all  situations  may  be                                                               
impossible.  Exploration is  extremely different  than production                                                               
from  existing fields.  With  fields like  Prudhoe  Bay there  is                                                               
little margin for error.                                                                                                        
4:03:12 PM                                                                                                                    
The producers want fiscal certainty  but Alaska must be extremely                                                               
careful.  It is  such a  long-term contract  that no  wonder they                                                               
want  certainty but  companies operate  regularly with  much less                                                               
certainty than is being demanded.                                                                                               
4:05:09 PM                                                                                                                    
Much of the debate revolves  around government take. With the gas                                                               
pipeline  project,  a  government  take statistic  is  much  less                                                               
meaningful because the project is so large.                                                                                     
4:07:57 PM                                                                                                                    
Crafting language to avoid leakage  deserves appropriate terms on                                                               
the  front end  so  it  is important  to  "get  the deal  right."                                                               
Numerous issues  were left  un-addressed due to  lack of  time to                                                               
prepare presentation.                                                                                                           
4:11:15 PM                                                                                                                    
MR.  JOHNSTON  related  what he  called  "The  Indonesian  Story"                                                               
wherein  the country  changed their  tax  structure and  suffered                                                               
through production challenges.                                                                                                  
4:13:56 PM                                                                                                                    
MR.  JOHNSTON related  "The California  Story" wherein  the state                                                               
designed  their royalty  and tax  rates poorly  and lost  a large                                                               
amount of revenues.                                                                                                             
4:17:20 PM                                                                                                                    
Slide 9: What Criteria?                                                                                                         
   · The system must be progressive                                                                                             
   · There must be a fair division of profits                                                                                   
   · There must be no unhealthy dis-incentives                                                                                  
It must be simple and transparent                                                                                               
4:18:24 PM                                                                                                                    
Slide 10: Alaska is Unique                                                                                                      
Boundary  conditions   make  Alaska   unique  due  to   it  being                                                               
landlocked the  Arctic creates  high transportation  costs. There                                                               
are also issues of sovereignty.                                                                                                 
4:20:32 pm                                                                                                                    
One objective is  that Alaska must fix the ELF  and obtain a fair                                                               
share  of the  profits. In  order to  do so  Alaska must  craft a                                                               
modern state-of-the-art system  and magnify exploration activity.                                                               
Alaska must craft a progressive  tax yet reduce risk exposure for                                                               
the oil companies.                                                                                                              
4:23:21 pm                                                                                                                    
Slide 11: Fiscal System Analysis and Design - things to consider                                                                
   · Expected field size distributions                                                                                          
   · Petrophysical characteristics                                                                                              
   · Well deliverability                                                                                                        
   · Estimated success probability                                                                                              
   · Data quality and quantity                                                                                                  
   · Post discovery costs                                                                                                       
   · Climate                                                                                                                    
4:28:38 pm                                                                                                                    
Slide 11: Contract terms                                                                                                        
   · Type of system                                                                                                             
   · Timing                                                                                                                     
   · Royalties                                                                                                                  
   · Cost recovery limit                                                                                                        
   · Government take                                                                                                            
   · Contract stability                                                                                                         
4:34:26 pm                                                                                                                    
Slide 12: Government Take                                                                                                       
The  petroleum industry  hates  government participation  because                                                               
the company takes  all the risk yet the government  takes a piece                                                               
of  the pie.  Some companies  report short  of what  they extract                                                               
from the ground in order to keep more of the oil revenues.                                                                      
4:42:49 pm                                                                                                                    
Slide 13: Do credits work?                                                                                                      
MR. JOHNSTON said  that he believed the credit  system worked and                                                               
that  he  leans   toward  enhancing  credits  but   he  is  still                                                               
researching that effect.  He offered a few  examples of crediting                                                               
and the effects of the intricacies involved.                                                                                    
4:49:12 pm                                                                                                                    
Slide 14: BP Graph of Production vs. Tax Rate                                                                                   
MR. JOHNSTON showed a graph of  how lowering the tax rate in 1993                                                               
encouraged  rapid growth  in production.  He said  something else                                                               
had to  have happened in  order for  such a dramatic  increase in                                                               
4:51:57 pm                                                                                                                    
Slide 15: UK Petroleum Taxation History                                                                                         
MR. JOHNSTON  presented a history  of the effect of  taxation. He                                                               
said  small increases  or  decreases in  taxes  have very  little                                                               
effect on production.                                                                                                           
4:55:01 pm                                                                                                                    
Slide 16: UK Drilling Activity                                                                                                  
MR. JOHNSTON  said the  graph confirms the  fallacy of  the claim                                                               
that the  reduction of government take  enhanced production. This                                                               
demonstrates  that something  is wrong  with BP's  conclusions of                                                               
the 1993 event.                                                                                                                 
4:56:16 pm                                                                                                                    
Slide 17: Risk vs. Reward and the PPT Credit Plan                                                                               
One critical aspect  of the PPT is the fact  that it was designed                                                               
in  part  to  encourage  exploration  by  providing  credits  and                                                               
allowing  companies  to sell  or  trade  them  and any  tax  loss                                                               
carries forward. This  aspect reduces the risk  for explorers and                                                               
the  state  takes on  added  risk.  Mr. Johnston's  slide  listed                                                               
several examples of other countries risk versus reward factors.                                                                 
5:02:34 pm                                                                                                                    
Slide 18: Summary of Key Fiscal Elements of PPT 20/20%                                                                          
MR.  JOHNSTON  recapped the  5  main  components  of the  PPT  as                                                               
presented by Robynn Wilson on February 22, 2006.                                                                                
   · PPT rate/base                                                                                                              
   · Tax credit rate/base                                                                                                       
   · Net operating loss                                                                                                         
   · Base allowance rate/base                                                                                                   
   · Transition provision                                                                                                       
5:05:53 pm                                                                                                                    
Slide 19: Summary continued                                                                                                     
The proposed structure shifts some  risk from the industry to the                                                               
State of Alaska. The shift is multi-dimensional.                                                                                
   · By shifting the tax base from net production to profits                                                                    
   · By providing a liberal definition of profit                                                                                
   · By applying a 20% credit on capital expenditures                                                                           
   · By allowing credits to be traded                                                                                           
   · By allowing TLCFs to be traded                                                                                             
   · By providing the 73MM allowance                                                                                            
5:10:01 pm                                                                                                                    
MR. JOHNSTON  compared the allowance  to designing one  saddle to                                                               
fit every farm animal and said he  did not know if it would work.                                                               
The 73MM is difficult and awkward, he stated.                                                                                   
5:12:00 pm                                                                                                                    
Slide 20: The "Lookback Provision"                                                                                              
MR. JOHNSTON questioned  the fairness of the  provision but noted                                                               
there was  some logic in  it due  to the losses  suffered through                                                               
5:14:28 pm                                                                                                                    
Slide 21: Flow Diagram                                                                                                          
MR. JOHNSTON  presented a  flow diagram that  was based  on Roger                                                               
Marks'  presentation  assuming  20  million barrels  at  $50  per                                                               
5:18:34 pm                                                                                                                    
Slide 22: Regressiveness and Marginal Take                                                                                      
MR. JOHNSTON  presented a spreadsheet comparing  different prices                                                               
per barrel  as an  illustration of  why royalties  are regressive                                                               
and the logic behind government take.                                                                                           
5:21:25 pm                                                                                                                    
Slide 23: Variations on Government Take Calculation                                                                             
MR. JOHNSTON  presented a spreadsheet that  illustrated differing                                                               
levels of government take.                                                                                                      
5:24:21 pm                                                                                                                    
Slide 24: Wood Mackenzie Treatment Of Government Participation:                                                                 
Global oil and gas risks and rewards                                                                                            
Slide 25: Dr. van Meurs treatment of Government Take:                                                                           
A  page taken  from Dr.  van Meurs  presentation "Proposal  for a                                                               
Profit-based Production Tax for Alaska."                                                                                        
Slide  26:   Take  Calculations   With  &   Without  Factoring-in                                                               
Without  factoring in  the government  participation element  the                                                               
universe  of fiscal  terms is  distorted by  around 5  percentage                                                               
points.  Alaska looks  worse than  it should  if this  element is                                                               
excluded. Mr. Johnston showed an accompanying graph.                                                                            
Slide 27: ConocoPhillips Government Take, Cost, and Tax Graph                                                                   
MR.   JOHNSTON  recreated   a  graph   from  the   ConocoPhillips                                                               
presentation of  February 27,  2006. The  graph compares  low and                                                               
high costs with both low and high tax.                                                                                          
5:30:28 pm                                                                                                                    
Slides 28-30: Government Participation                                                                                          
Many systems  provide an option  for the national oil  company to                                                               
participate  in  development   projects.  Under  most  government                                                               
participation  arrangements, the  contractor bears  the cost  and                                                               
risk of  exploration and if  there is a discovery  the government                                                               
backs in for a percentage.                                                                                                      
MR. JOHNSTON  described the government  take in  India, Columbia,                                                               
and China.                                                                                                                      
Slide 31: Efficiency and Flexibility in Fiscal System Design                                                                    
If a system were designed  efficiently and flexibly theoretically                                                               
it would be a more stable contract.                                                                                             
5:34:06 pm                                                                                                                    
Slide 32: Typical Regressive System & the Regressive Signature                                                                  
MR.  JOHNSTON  displayed  a  typical  graph  on  government  take                                                               
5:36:16 pm                                                                                                                    
Slide 33: Regional Distribution of Petroleum Fiscal Systems                                                                     
MR.  JOHNSTON displayed  a  global  graph demonstrating  regional                                                               
distribution   of  petroleum   fiscal   systems.   Most  have   a                                                               
progressive element of some sort.                                                                                               
5:37:39 pm                                                                                                                    
Slides 34-38: Effective Oil Severance Tax Rate - Government Take                                                                
MR.  JOHNSTON provided  a series  of graphs,  some of  which were                                                               
taken from Dr. van Meurs and Mr. Marks presentations.                                                                           
Slide 39: Industry Statistics:                                                                                                  
Slide  contained Mr.  Johnston's disclaimer  regarding the  dated                                                               
5:39:29 pm                                                                                                                    
Slide 40: Weaknesses of Government Take                                                                                         
   · Does not adequately capture signature bonuses                                                                              
   · Does not address how government takes                                                                                      
   · Says nothing of timing                                                                                                     
   · Does not measure contract or system stability                                                                              
   · Does not differentiate between diverse work programs                                                                       
Slides 41-43: More Dated Industry Statistics                                                                                    
   · Database table 8                                                                                                           
   · World averages for oil and gas                                                                                             
   · Average state take for deepwater projects                                                                                  
5:43:27 pm                                                                                                                    
Slides   44-47:    International   Petroleum    Exploration   and                                                               
Development Contracts Graphs                                                                                                    
MR. JOHNSTON overviewed a series  of graphs detailing the royalty                                                               
tax system for many different  countries. The graphs include data                                                               
on  how systems  changed  when oil  prices  fluctuated, the  risk                                                               
components,  world  average   government  take,  and  comparative                                                               
5:49:47 pm                                                                                                                    
Slide 48: Contract Duration                                                                                                     
MR. JOHNSTON  advised that the  accompanying graph  was developed                                                               
in  response to  a  statement  made by  one  of  the oil  company                                                               
representatives claiming  that typical contract duration  was 50-                                                               
60 years. The average contract term is 25 years.                                                                                
Slides 49-50: Libya's Latest License Round                                                                                      
Graph  of  Gross  revenue  split   into  government  revenue  and                                                               
contractor revenue, "Not worth discussing," he stated.                                                                          
5:52:35 pm                                                                                                                    
Slide 51: Expected Value                                                                                                        
MR.  JOHNSTON displayed  a graph  of probability  of success  and                                                               
risk analysis. The  PPT would reduce risk exposure  by 50 percent                                                               
and so companies can justify smaller prospects.                                                                                 
Slide 52: BP Presentation on PPT (28 February 2006)                                                                             
Slides 53-54: Ringfencing                                                                                                       
MR. JOHNSTON defined "ringfencing" with several examples.                                                                       
Slides 55-56:  Alaska PPT 20/20% Approach                                                                                       
MR. JOHNSTON highlighted the comparison to ELF.                                                                                 
This signifies the  end of the presentation and  the beginning of                                                               
the question and answer period.                                                                                                 
6:00:29 pm                                                                                                                    
SENATOR BERT STEDMAN asked Mr.  Johnston whether he could provide                                                               
material  on a  smaller comparative  group rather  than worldwide                                                               
MR.  JOHNSTON replied  yes.  Dr.  van Meurs  and  Mr. Marks  used                                                               
comparative  presentations  of  countries  where  producers  were                                                               
actively involved.                                                                                                              
SENATOR FRED  DYSON asked  Mr. Johnston the  risk and  the likely                                                               
outcome if the tax rate were set  too high for the Legacy part at                                                               
Prudhoe Bay.                                                                                                                    
6:03:54 pm                                                                                                                    
MR. JOHNSTON  replied the  risk was placed  on the  oil companies                                                               
but if  the risk is too  high, it's easy to  change the contract.                                                               
On the  other hand,  if the tax  rate were too  low, it  would be                                                               
hell to change.                                                                                                                 
6:04:30 pm                                                                                                                    
SENATOR DYSON asked  what the likely outcome would be  if the oil                                                               
companies walk away from the gas negotiations.                                                                                  
MR.  JOHNSTON  said it  depends  on  the  tax rate  increase.  In                                                               
today's price environment it would not  have much of an effect on                                                               
production, although there would  certainly be projects that they                                                               
would put on the back burner.                                                                                                   
6:08:33 pm                                                                                                                    
SENATOR STEDMAN asked whether he  had a feeling for the magnitude                                                               
of risk involved.                                                                                                               
MR. JOHNSTON replied the magnitude  is such that "you should only                                                               
pay for the  additional risks that you take."  Some big companies                                                               
feel they are subsidizing someone  else's exploration but that is                                                               
not true.                                                                                                                       
6:11:02 pm                                                                                                                    
SENATOR DYSON asked him to  talk about how the "look-back" should                                                               
be different for Cook Inlet and the Legacy fields.                                                                              
MR.  JOHNSTON replied  that it  would be  fair to  treat the  two                                                               
differently and  they just  need to  make sure  of what  they are                                                               
trying  to   obtain.  For  example,  they   want  to  incentivize                                                               
exploration at Cook Inlet and so that makes sense.                                                                              

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