Legislature(2011 - 2012)SENATE FINANCE 532

04/02/2012 01:00 PM FINANCE

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01:05:18 PM Start
01:07:22 PM SB192
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
Heard & Held
+ Bills Previously Heard/Scheduled TELECONFERENCED
                  SENATE FINANCE COMMITTEE                                                                                      
                        April 2, 2012                                                                                           
                          1:05 p.m.                                                                                             
1:05:18 PM                                                                                                                    
CALL TO ORDER                                                                                                                 
Co-Chair Stedman called the Senate  Finance Committee meeting                                                                   
to order at 1:05 p.m.                                                                                                           
MEMBERS PRESENT                                                                                                               
Senator Lyman Hoffman, Co-Chair                                                                                                 
Senator Bert Stedman, Co-Chair                                                                                                  
Senator Lesil McGuire, Vice-Chair                                                                                               
Senator Johnny Ellis                                                                                                            
Senator Dennis Egan                                                                                                             
Senator Donny Olson                                                                                                             
Senator Joe Thomas                                                                                                              
MEMBERS ABSENT                                                                                                                
ALSO PRESENT                                                                                                                  
Tony Reinsch, Senior Director,  Upstream and Gas, PFC Energy,                                                                   
Contract,  Legislative  Budget  and  Audit  Committee;  Janak                                                                   
Mayer,  Manager,  Upstream  and Gas,  PFC  Energy,  Contract,                                                                   
Legislative Budget and Audit Committee;                                                                                         
PRESENT VIA TELECONFERENCE                                                                                                    
SB 192    OIL AND GAS PRODUCTION TAX RATES                                                                                      
          SB 192 was HEARD and HELD in committee for further                                                                    
1:07:22 PM                                                                                                                    
SENATE BILL NO. 192                                                                                                             
"An  Act relating  to the  oil  and gas  production tax;  and                                                                   
providing for an effective date."                                                                                               
TONY REINSCH, SENIOR DIRECTOR,  UPSTREAM AND GAS, PFC ENERGY,                                                                   
CONTRACT,  LEGISLATIVE BUDGET  AND  AUDIT COMMITTEE,  related                                                                   
that PFC  Energy were  consultants for  large global  oil and                                                                   
gas producers,  major independents,  national oil  companies,                                                                   
governments, and  regulatory agencies. PFC Energy  focused on                                                                   
above ground challenges to the  oil and gas industry advising                                                                   
on strategy, policy, regulation, and legislation.                                                                               
JANAK  MAYER,   MANAGER,  UPSTREAM   AND  GAS,  PFC   ENERGY,                                                                   
CONTRACT,  LEGISLATIVE BUDGET  AND AUDIT COMMITTEE,  provided                                                                   
members  with  a  presentation,  "Discussion  Slides:  Senate                                                                   
Finance  Committee,"  April  2,   2012  (copy  on  file).  He                                                                   
communicated that  the presentation examined the  tax credits                                                                   
available  to producers  under Alaska's  Clear and  Equitable                                                                   
Share (ACES).                                                                                                                   
1:10:15 PM                                                                                                                    
He outlined the tax credits available under ACES, Slide 2:                                                                      
 Tax Credits Under ACES                                                                                                         
    · Qualified Capital Expenditures Credit of 20 percent for                                                                   
      qualified capital expenditures, including exploration                                                                     
    · Carried-Forward Annual Loss  Credit of  25 percent  for                                                                   
      excess lease expenditures (where Production Tax                                                                           
      liability is insufficient to deduct costs)                                                                                
    · Well Lease Expenditure  Credit of  40 percent  for Well                                                                   
      Lease Expenditures (Intangible Drilling Costs) below                                                                      
      North Slope                                                                                                               
    · Alternative Credit for  Exploration of  30 percent  for                                                                   
      Exploration expenditures for wells more than 3 miles                                                                      
      outside an existing area (if outside Cook Inlet)                                                                          
    · Alternative Credit for  Exploration of  40 percent  for                                                                   
      Exploration expenditures for wells more than 25 miles                                                                     
     outside an existing area (10 miles in Cook Inlet)                                                                          
    · Cook Inlet Jack Up  Rig of  up to  100 percent  for the                                                                   
      First 3 unaffiliated wells drilled by same jack-up rig                                                                    
      in Cook Inlet (now unavailable)                                                                                           
    · Education Credit;  a maximum  of  $5 million  for  cash                                                                   
      donations to educational institutions.                                                                                    
    · Transitional Investment   Credit  of  20   percent  for                                                                   
      Expenses before March 31 2006 (pre-PPT)                                                                                   
    · Middle Earth Credit of $6 million for  production below                                                                   
     North Slope and outside Cook Inlet (Expires 2016)                                                                          
    · Small Producer Credit of $12 million for producers with                                                                   
      less than 50 mb/d average production (expires 2016)                                                                       
Mr.   Mayer  observed   that  small   producers  engaged   in                                                                   
challenging  projects  yielding   marginal  economic  returns                                                                   
benefitted  most from  the small  producer  credit. He  noted                                                                   
that  the first  five  credits were  relevant  to PFC's  ACES                                                                   
He   related   that   the  discussion   would   explore   the                                                                   
difficulties   of    incentivizing   exploration    and   the                                                                   
interaction  between  the exploration  credits  coupled  with                                                                   
progressivity  under  the  current fiscal  system.  He  would                                                                   
further  examine   the  interaction  of   progressivity  with                                                                   
exploration  credits  by  removing   progressivity  from  the                                                                   
production  tax and  imposing  instead,  a progressive  gross                                                                   
severance  tax. He would  conclude with  analysis of  capital                                                                   
credits and the return on investments by the state.                                                                             
1:15:07 PM                                                                                                                    
Mr. Mayer offered a brief summary  of the credits analyzed in                                                                   
his  presentation;   capital  credits  and   the  alternative                                                                   
credits  for exploration.  He explained  that there were  two                                                                   
key components  to ACES credits: credits claimed  against tax                                                                   
liability by current producers  that accounted as a reduction                                                                   
in state  revenue and credits  refunded to producers  with no                                                                   
tax liability that accounted as  expenditure by the state. He                                                                   
referred  to  Slide  3,  "Total  Impact  of  Credits,"  which                                                                   
depicted a graph  displaying the total impacts  of both types                                                                   
of  credits  to  the  state:   credits  claimed  against  tax                                                                   
liability  and  credits  refunded.  The  impacts  of  credits                                                                   
claimed  against tax liability  varied  from $400 million  in                                                                   
2009 to  $475 million in  2013. The total  cost to  the state                                                                   
combining both  tax credits as lost revenue  and expenditures                                                                   
was approximately $800 million per year from 2009 to 2013.                                                                      
Mr.  Mayer  noted  that  the  qualified  capital  expenditure                                                                   
credit accounted for  $585 million in FY 2010  rising to $640                                                                   
million  in FY  2011.  In  contrast, the  exploration  credit                                                                   
amounted  to  $41 million  in  FY  2010  and $13  million  in                                                                   
FY2011. He remarked that the exploration  credits represented                                                                   
a relatively small portion of the pie.                                                                                          
Mr. Reinsch turned to Slide 5:                                                                                                  
   •Recent Trends in Exploration Activity and Basin Focus                                                                       
     •Credits and Incentives: Lessons from the Past                                                                             
      -National Energy Program (Canada)                                                                                         
      -Norwegian Continental Shelf (Norway)                                                                                     
     •Development Cycle Time: Incenting the Required                                                                            
Mr. Reinsch  announced that  he would  address the  issues of                                                                   
exploration  credits and incentivizing  exploration  in other                                                                   
countries, report  on recent  trends in explorations,  review                                                                   
credits and  incentives in light  of government  positions on                                                                   
exploration risks and discuss development cycles.                                                                               
Mr. Reinsch  remarked that the  1990's "set the stage"  for a                                                                   
period  of   development  capital  expenditure   through  oil                                                                   
exploration  and   resource  development.  During   the  late                                                                   
nineties  through  approximately  2008,  capital  expenditure                                                                   
funds  were  channeled  into   production  growth  and  major                                                                   
resource  development  projects  such as  the  Canadian  oils                                                                   
sands  and large  scale  liquefied  natural gas  projects  in                                                                   
Qatar.  He  noted  a recent  rebound  in  global  exploration                                                                   
Mr.  Reinsch  turned  to Slide  6,  "Rebound  in  Exploration                                                                   
Spending" that  graphed total worldwide exploration  spending                                                                   
by global  oil companies from  1989 through 2011.  He relayed                                                                   
that capital expenditure  levels were flat in  the first half                                                                   
of  the 2000's.  In  2007, a  sharp increase  in  exploration                                                                   
expenditures occurred.  Companies such as Statoil,  Shell and                                                                   
British  Petroleum   (BP)  significantly  increased   capital                                                                   
expenditures to capture new resource development.                                                                               
1:22:54 PM                                                                                                                    
Mr. Reinsch cited Slide 7:                                                                                                      
 Trend in Worldwide Exploration: Global Players                                                                                 
     •Exploration spending by many of the Global Players                                                                        
     accelerated sharply in 2005-2006 as focus shifted to                                                                       
     restocking the portfolio of development projects                                                                           
     •Statoil (North Sea) and Shell (Asia, North America)                                                                       
     were early movers, quadrupling exploration spending                                                                        
     since 2004                                                                                                                 
     •The    growth   represents    real   activity    gains,                                                                   
     substantially outpacing the Exploration & Appraisal                                                                        
     (E&A) Index                                                                                                                
The slide also charted the net  undeveloped properties of the                                                                   
global oil companies.  He observed that Shell  was the leader                                                                   
among global  oil companies in  securing any available  lands                                                                   
for  development.   He  explained  that  the   oil  companies                                                                   
predicted very  limited access  to new land for  exploration.                                                                   
National oil  companies were  strengthening control  over its                                                                   
resource base and severely restricting  the global companies'                                                                   
exploration activity.  The majority of the  available acreage                                                                   
was  located  in  Asia  and  Africa,  including  onshore  and                                                                   
offshore sites. He commented that  Shell and Exxon Mobil were                                                                   
dominant in North American holdings.                                                                                            
Mr.   Reinsch  declared   that  the   global  oil   companies                                                                   
strategically  accelerated  exploration  spending  in  recent                                                                   
years. He  identified the regions  where the majority  of the                                                                   
global  oil industry  was expending  capital on  exploration,                                                                   
mapped  on Slide  8,  "Selected  Global Players:  Regions  of                                                                   
Exploration Focus."  He described the region  as the Atlantic                                                                   
Margin Basins  extending from the  deep water in the  Gulf of                                                                   
Mexico to  Brazil, West  Africa coastal  deep water,  and the                                                                   
Equatorial margin  comprising of Sierra Leon,  Cote d'Ivoire,                                                                   
and Ghana. He  added that renewed emphasis in  the Arctic had                                                                   
occurred in deep  water offshore of Norway,  the Barents Sea,                                                                   
Northern Russia, and Alaska. He  remarked that due to greater                                                                   
control by national  oil companies, the Middle  East with the                                                                   
exception of Qatar was no longer  a growth driver in industry                                                                   
Mr. Reinsch turned to Slide 9:                                                                                                  
 Trend in International Exploration: Independents                                                                               
     The  International  Independents  are a  more  disparate                                                                   
     group when it comes to exploration activity:                                                                               
          •Some,   like   Anadarko,    have   been   material                                                                   
        exploration players through the last decade;                                                                            
          •Some, like BG and Apache,  have aggressively grown                                                                   
          their  exploration   activities  through  the  past                                                                   
          •Others,  like Occidental  and Noble, have  focused                                                                   
          on development  activity in a small  number of play                                                                   
          •Exploration  spending by Anadarko, BG,  and Apache                                                                   
          has  hovered around the  $1.3-1.5 billion  mark for                                                                   
          the last  few years, high  for the Indies  and ~60%                                                                   
          that of the smaller Global Players                                                                                    
1:28:15 PM                                                                                                                    
Mr. Reinsch  stated that  besides the independent's  interest                                                                   
in the Atlantic margin they are  uniquely involved in opening                                                                   
new frontier areas. He pointed to Slide 10:                                                                                     
 Selected International Players: Regions of Exploration                                                                         
     The  Independents   are  similarly  positioned   in  the                                                                   
     US/Canada onshore resource plays (oil sands, shale                                                                         
     gas.  Shale  oil),  and   the  deepwater  plays  of  the                                                                   
     Atlantic Basin                                                                                                             
    • The Independents are also at the forefront of  new                                                                        
     basin development, such as  the     Equatorial   Margin,                                                                   
     East Africa Deep water,   South  America  "North   Tier"                                                                   
     deep water play,    Argentina   shale   gas,  and   Lake                                                                   
     Albert basin (Uganda)                                                                                                      
  • The Independents are not as prominent in the     high                                                                       
     cost, high risk exploration    opportunities   in    the                                                                   
     Arctic offshore                                                                                                            
Mr.  Reinsch directed  attention  to  Slide  11, "IOC  Growth                                                                   
Centered   on  Successful   "New   Frontiers"…."  The   graph                                                                   
displayed  the  projected growth  in  new frontier  areas  of                                                                   
development   through  2010  and   indicated  a   decline  in                                                                   
conventional areas of development.                                                                                              
Mr. Reinsch  discussed  the "Redirection  of Free Cash  Flow"                                                                   
depicted  on Slide  12. He  reported  that the  focus on  new                                                                   
frontiers in  nonconventional development  was financed  by a                                                                   
redirection of  free cash flow.  He described  a reallocation                                                                   
of capital from  maturing areas in Africa, Asia  Pacific, and                                                                   
Europe to the United States and Canada.                                                                                         
Mr. Reinsch moved to Slide 14:                                                                                                  
 Exploration and Government Risk Taking                                                                                         
     •By and large, Governments  have refrained from engaging                                                                   
     in the business of upstream risk                                                                                           
     -In  emerging  basins, nascent  National  Oil  Companies                                                                   
     (NOCs)  will usually  have  "back-in provisions"  within                                                                   
     production  sharing   contracts,  allowing   entry  into                                                                   
     development  projects as  an equity  participant at  the                                                                   
     point  of  sanction.  Are prohibited  from  engaging  in                                                                   
     exploration activity                                                                                                       
     -In more  mature basins, the  NOC may engage  fully from                                                                   
     license award  to production (Petora in  Norway, ONGC in                                                                   
     India, PDVSA in Venezuela)  assuming it has internalized                                                                   
     the  necessary degree  of  technical sophistication  and                                                                   
     dry-hole tolerance                                                                                                         
     •Exploration credits/rebates  are, in essence,  a direct                                                                   
     engagement  by the  government in  exploration risk.  As                                                                   
     such,  they  have been  used  sparingly  outside of  the                                                                   
     context of the tax and royalty regime.                                                                                     
Mr.  Reinch  offered  that  large  amounts  of  capital  were                                                                   
invested by  oil companies  without any returns.  Governments                                                                   
are generally  stewards of the  resource and not  comfortable                                                                   
with risk. He  added that governments engaged  in exploration                                                                   
risk through  exploration credits or incentives  by reduction                                                                   
in  tax  liability.  Governments  rarely  extend  exploration                                                                   
credits to  non-taxable entities.  Governments tend  to adopt                                                                   
incentives and credits to broaden  resource development where                                                                   
production was in decline.                                                                                                      
1:35:42 PM                                                                                                                    
Senator  Thomas  questioned  whether  a  direct  relationship                                                                   
existed  between exploration  credits  and up  front risk  in                                                                   
investments in high cost areas  such as Arctic and off-shore.                                                                   
Mr.  Reinsch  responded  that   the  opposite  was  true.  He                                                                   
elucidated that  the exploration  credit represented  a small                                                                   
portion  of   incentives  offered  by  governments.   Capital                                                                   
credits  represented   80  percent  of  government   credits.                                                                   
Exploration  credits were  found  in areas  where well  costs                                                                   
were low.  The credits  had a  persuasive impact with  little                                                                   
risk  by the  government. Deep  water  investments with  high                                                                   
well costs carried significant risk for governments.                                                                            
Mr. Reinsch cited Slide 15:                                                                                                     
 Canada's National Energy Program: An Experiment in                                                                             
  Intervention Gone Awry                                                                                                        
     •The  NEP  was  introduced   to  both  enhance  Canadian                                                                   
     ownership  in   Upstream  activities   [exploration  and                                                                   
     recovery of oil and natural  gas], and to accelerate the                                                                   
     discovery  and  development  of  domestic  resources  to                                                                   
     enhance security of supply  and support energy subsidies                                                                   
     to domestic consumers.                                                                                                     
The  slide  included a  chart  that  indicated the  types  of                                                                   
incentives,  credits,  and risk  sharing  activities  offered                                                                   
through the National Energy Program (NEP).                                                                                      
Mr.  Reinsch related  that  the  program failed  because  the                                                                   
market turned against the National  Energy Program (NEP). The                                                                   
program was not  considered favorable to the  business cycle.                                                                   
He opined  that the best  government incentives  were "robust                                                                   
to  the  business   cycle."  The  program  was   intended  to                                                                   
"Canadianize"  ownership in  the upstream  activities and  to                                                                   
address  decline.  Oil  production  was in  decline  and  oil                                                                   
prices  were   rising.  He   highlighted  the  program.   The                                                                   
structure allowed  greater incentives to  Canadian companies.                                                                   
"Exotic"  activity  received   greater  incentives.  Drilling                                                                   
deeper wells or farther from existing  wells was awarded with                                                                   
more  incentives.  The  result   was  to  drive  a  typically                                                                   
efficient industry to place more  effort into marginal areas.                                                                   
1:42:37 PM                                                                                                                    
Mr. Reinsch discussed Slide 16:                                                                                                 
 National Energy Program (Canada) and Exploration                                                                               
     •NEP  introduced substantial  distortions  into the  E&P                                                                   
     decision   making  process.   In  particular,   incented                                                                   
     Upstream  activity towards  less prospective and  higher                                                                   
     cost  areas,  and  introduced  "artificial"  demand  for                                                                   
     Upstream services                                                                                                          
     •Drilling  costs   (seismic,  rigs,  etc.)   accelerated                                                                   
     rapidly  as   demand  soared  in  new   and  unsupported                                                                   
     exploration environments                                                                                                   
     •Many  companies  were  effectively  "drilling  for  PIP                                                                   
     grants"  with  commercial discoveries  representing  the                                                                   
     Failure case                                                                                                               
                          Canadian Arctic      Atlantic Offshore                                                                
     1966-1970            $4.3 mm              $1.2 mm                                                                          
     1971-1975            $3.6 mm              $3.8 mm                                                                          
     1976-1980            $24.4 mm             $22.4 mm                                                                         
     1981-1985            $63.2 mm             $45.8 mm                                                                         
     1986-1990            $44.2 mm             $20.5 mm                                                                         
Mr. Reinsch  noted the  chart on slide  16 and observed  that                                                                   
the  program  ended in  1985  in  response to  declining  oil                                                                   
prices. He pointed out that the  program "incented" companies                                                                   
to  drill  away  from  the  established  infrastructure  into                                                                   
frontier  areas.  The  Petroleum   Incentive  Payments  (PIP)                                                                   
grants  incentivized "drilling  for  nothing" or  speculative                                                                   
Mr. Reinsch reviewed Slide 17:                                                                                                  
 Canada's National Energy Program                                                                                               
   · The decline in crude prices in the mid-1980s forced the                                                                    
     withdrawal of virtually all aspects of the NEP                                                                             
   · Alberta:                                                                                                                   
     -PIP grants replaced by Royalty Tax Credits (75% rising                                                                    
     to 90% with maximum credit per well)                                                                                       
     -Exploration Incentives restructured as either:                                                                            
          12 month Royalty holiday on eligible wells to a                                                                       
          maximum per well;                                                                                                     
          Royalty exemption on cumulative production, linked                                                                    
          to well depth and location                                                                                            
          Exploration Drilling Incentive Program: 50% credit                                                                    
          set off against subsequent royalties                                                                                  
     -Moved away from credits/rebates outside of the royalty                                                                    
     and tax environment => reward success, not simply                                                                          
     · Federal:                                                                                                                 
        -PetroCanada back-in eliminated;                                                                                        
        -Royalty linked to "payout" of development                                                                              
             1% royalty rising to 5% at rate of 1% per 18                                                                       
             Royalty jumps to 30% net CF after Payout                                                                           
        -Exploration Tax Credit of 25% for well costs above                                                                     
        $5 mm, used to reduce Federal Income Tax. If not                                                                        
        taxable => direct refund of up to 40% of non-                                                                           
        utilized credit                                                                                                         
1:48:11 PM                                                                                                                    
Mr. Reinsch referred to Norway's  oil and gas industry, which                                                                   
was similar in nature to Alaska, Slide 18:                                                                                      
     Norwegian Continental Shelf: Incentives in a Modern                                                                        
          •Oil  production in Norway  peaked in 2001  and has                                                                   
          fallen   by  ~45%   since  then.   Growth  in   gas                                                                   
          production  allowed BOE volumes to rise  till 2004,                                                                   
          and have been in decline ever since                                                                                   
          •Fiscal system provides  incentives for exploration                                                                   
     Base Production Tax - 25%                                                                                                  
          •Applied to net income from Petroleum activities                                                                      
     Special Tax - 50%                                                                                                          
          •Applied  to net  income  generated from  petroleum                                                                   
          activities, to capture  resource rent above "normal                                                                   
     Government Investment - Petoro                                                                                             
          •Engages  in exploration  and development  activity                                                                   
          as  full equity  partner; pays  share of costs  and                                                                   
          receives 100% of revenue  from its working interest                                                                   
     Exploration Incentives - 78%                                                                                               
          •Applies  to  companies  in  non-taxable  position.                                                                   
          Since  government  allows  uplift  of  loss  carry-                                                                   
          forward  at  a  risk-free   interest  rate,  it  is                                                                   
          indifferent between refund or offset                                                                                  
          •Introduced  to  expand the  competitor  landscape,                                                                   
          bringing in new Upstream companies                                                                                    
     License access                                                                                                             
          •All companies require  pre-approval for financial,                                                                   
          technical,   and  operating  capability   prior  to                                                                   
          bidding on  a License in the  Norwegian Continental                                                                   
          Shelf (NCS)                                                                                                           
1:50:17 PM                                                                                                                    
Mr. Reinsch predicted continued  decline in Norwegian oil and                                                                   
gas production. He explained that  the special tax was levied                                                                   
on  income   over  and  above   normal  profit   margins.  He                                                                   
identified Petoro  as the Norwegian government's  equity firm                                                                   
for oil and  gas development. He detailed that  the Norwegian                                                                   
license requirements were arduous,  which was not the case in                                                                   
Alaska. He observed  that the process was  straightforward in                                                                   
Alaska.  Conversely, Norway's  ability  to rigorously  screen                                                                   
license  applicants was  the foundation  for their  incentive                                                                   
1:54:44 PM                                                                                                                    
Mr. Reinsch referenced Slide 20,  "Cycle Time to Production,"                                                                   
that contained  a graph illustrating  the project  cycle time                                                                   
from  discovery  to  commissioning   based  on  the  type  of                                                                   
development  project. He revealed  that directing  incentives                                                                   
to produce the desired outcome  was challenging, and commonly                                                                   
referred to as "tool and target."                                                                                               
Mr. Reinsch  outlined  the various types  of oil  development                                                                   
projects and its project cycle time.                                                                                            
   · Integrated Mined Oil Sands are long term development                                                                       
     projects expected to take  10 or more years to establish                                                                   
     due to  protracted regulatory  process and the  scope of                                                                   
     the project.                                                                                                               
   · Off Shore Frontier developments are areas offshore that                                                                    
     do  not have  access to  established infrastructure  and                                                                   
     take 6 to 8 years to develop.                                                                                              
   · Onshore Frontier projects are land based areas without                                                                     
     access  to infrastructure  such as  Uganda. Cycle  times                                                                   
     are 4 to 6 years.                                                                                                          
   · Offshore Tieback Wells connect new discoveries to                                                                          
     existing infrastructure  and shorten cycle time  to 3 to                                                                   
     5 years.  The majority of  time to reach  production was                                                                   
     spent on appraising project for financial viability.                                                                       
   · Enhanced Oil Recovery (EOR) Onshore areas are mature                                                                       
     oil fields  with infrastructure  in place;  only testing                                                                   
     was necessary. Project cycle time was very short.                                                                          
Mr. Reinsch  judged that the  immediate challenge  for Alaska                                                                   
lied in the medium three to five  year time frame to increase                                                                   
the volume of oil  flowing into the pipeline to  a level that                                                                   
maintained  government revenues.  He  concluded that  mapping                                                                   
tools  to  targets  was an  important  factor  in  developing                                                                   
exploration incentives for Alaska.                                                                                              
2:01:27 PM                                                                                                                    
Co-Chair  Stedman asked  for clarification  on the  licensing                                                                   
requirements  in  Alaska  compared  to  Norway.  Mr.  Reinsch                                                                   
commented  that Alaska  does not  screen  the applicants  for                                                                   
financial, operational,  or technical capabilities.  Norway's                                                                   
restrictive licensing  disallowed any entity from  bidding on                                                                   
a license  until pre-approved  for financial, technical,  and                                                                   
operating capability.                                                                                                           
Mr.  Mayer   furthered  that   incentives  worked,   but  not                                                                   
necessarily  in  the way  that  the government  intended.  He                                                                   
exemplified   Canada's   failed    attempt   to   incentivize                                                                   
exploration  that  led  to  speculative   and  non-productive                                                                   
predatory   drilling  practices.   He   stated  that   Norway                                                                   
controlled  that  outcome by  ensuring  the  applicant was  a                                                                   
credible  producer  with  the  intent  to  produce.  A  well-                                                                   
structured incentive program encouraged desired outcomes.                                                                       
2:05:10 PM                                                                                                                    
Senator  Thomas  relayed  that  the  Albertan  government  in                                                                   
Canada had  raised taxes  on oil  production around  the same                                                                   
time that  ACES was enacted.  Production in Alberta  began to                                                                   
decline;   subsequently   taxes   were  decreased   and   oil                                                                   
production  increased.  He  wondered  if  that  scenario  was                                                                   
reflected  in  the  previous   slides  and  was  an  accurate                                                                   
assessment.  Mr.  Reinsch  clarified  that  the  presentation                                                                   
focused on Canadian's National  Energy Program in the 1980's.                                                                   
The   Alberta  scenario   happened   in   recent  years   and                                                                   
represented  a   miscalculation  of  tools  and   timing.  He                                                                   
explained  that  the  Alberta government  had  implemented  a                                                                   
"harvest   fiscal   system."   Alberta  believed   that   oil                                                                   
production  was nearing the  end so  the government  acted to                                                                   
increase  its  share  of  the  revenue.  Simultaneously,  the                                                                   
industry  was ready  to launch  new production  opportunities                                                                   
employing new  technologies such  as horizontal drilling  and                                                                   
multiple stage  fracturing of  wells in conventional  fields.                                                                   
He  elaborated   that  the   Alberta  government   failed  to                                                                   
recognize  the  impact the  new  technologies  could have  on                                                                   
reversing the  long-term decline in conventional  production.                                                                   
The industry responded by moving  investments to new horizons                                                                   
in British  Columbia and Saskatchewan  in shale  oil. Alberta                                                                   
soon realized  that the industry needed support  in fostering                                                                   
new  technologies  in  traditional   fields.  The  government                                                                   
redirected  its  tax  structure  to  incentivize  exploration                                                                   
utilizing the emerging technologies.                                                                                            
2:10:20 PM                                                                                                                    
Co-Chair  Stedman announced  that the  Department of  Revenue                                                                   
had  declined   to  participate  in  the   policy  discussion                                                                   
regarding tax credits.                                                                                                          
2:11:04 PM                                                                                                                    
AT EASE                                                                                                                         
2:19:37 PM                                                                                                                    
Mr. Mayer  concluded that  the lesson  from the Canadian  and                                                                   
Norwegian scenarios  showed that  high levels of  exploration                                                                   
credits without  strict evaluation  of the producer  resulted                                                                   
in a boom,  either in speculative exploration  or exploration                                                                   
activity merely to obtain the  credit. He declared that under                                                                   
ACES,   exploration   credits  coupled   with   progressivity                                                                   
provided  a high level  of effective  government support  for                                                                   
exploration activity.                                                                                                           
Mr. Mayer  reviewed the  graph on Slide  21, "High  Levels of                                                                   
Exploration  Support under  ACES." The  graph depicted  crude                                                                   
oil prices in  the bottom axis and the left  axis represented                                                                   
percentages  of after  tax effective  government  exploration                                                                   
contribution based  on a 40  percent credit. He  demonstrated                                                                   
how the exploration  incentive tax structure  worked combined                                                                   
with  progressivity  to  the point  where  it  benefited  the                                                                   
producer to  drill "dry  holes." He began  at $55  per barrel                                                                   
(BBL.)  price  of  oil  (progressivity  was  not  applicable)                                                                   
exemplifying  an existing producer  with existing  production                                                                   
tax  liability.  The  producer   spent  $100  million  on  an                                                                   
exploration  project  that  resulted   in  a  dry  hole.  The                                                                   
applicable  25  percent  production  tax  credit  immediately                                                                   
reduced $25  million from the  tax liability paired  with $40                                                                   
million in  exploration credits,  which resulted in  an after                                                                   
cash flow liability  of $35 million for the  producer, out of                                                                   
the $100 million investment. The  state reduced the producers                                                                   
risk for exploration by 65 percent.                                                                                             
2:24:34 PM                                                                                                                    
Mr. Mayer  furthered that  the effects  were multiplied  with                                                                   
progressivity. He  exemplified that at $110/bbl.  an existing                                                                   
producer that  invested $100 million in  exploration activity                                                                   
receiving  the   same  credits  coupled   with  progressivity                                                                   
incurred a $10 million dollar  cash flow liability. The state                                                                   
bore  90  percent  of the  burden  in  reduced  revenue  from                                                                   
production tax  and expenditure with exploration  credits. He                                                                   
maintained  that  at  $215/bbl.   the  after  tax  cash  flow                                                                   
liability    on   $100   million    spent   on    exploration                                                                   
(progressivity  was  capped  at  75 percent)  was  zero.  The                                                                   
state's contribution  was 100  percent. At the  unprecedented                                                                   
price  of the  mid  $200/bbl., a  producer  would receive  an                                                                   
after  tax  cash flow  benefit.  He  warned that  the  result                                                                   
encouraged  a  producer  "to  drill  as  many  dry  holes  as                                                                   
Co-Chair  Stedman wondered  how  the immediate  write-off  of                                                                   
capital  expenditure influenced  the tax  structure and  what                                                                   
resulted from reducing  the 40 percent credit  to 20 percent.                                                                   
Mr. Mayer  answered that  if the  existing structure  of ACES                                                                   
was maintained with  a 20 percent credit, the  75 percent cap                                                                   
in  progressivity   would  prevent   a  90  to   100  percent                                                                   
contribution  by the  state at  any price for  oil. He  added                                                                   
that the immediate write-off of  capital expenditures against                                                                   
production liability  enabled the high levels  of exploration                                                                   
support when coupled with the  40 percent exploration credit.                                                                   
2:28:36 PM                                                                                                                    
Co-Chair Stedman  observed that  the current structure  could                                                                   
drive the state's production tax  value negative. He recalled                                                                   
that the  same conclusion  was pointed out  by Dr.  Pedro Van                                                                   
Muer in  previous testimony ["Policy  Options for  Alaska Oil                                                                   
and Gas" Senate  Finance Committee presentation,  February 12                                                                   
- 13,  2012 (copy on file).]  Mr. Mayer agreed  that negative                                                                   
value  was  one  of  the  unintended   side  effects  of  the                                                                   
inclusion of  progressivity in  the production tax  structure                                                                   
combined with  high levels of  exploration credits.  He noted                                                                   
that  a  severance  tax  option   eliminated  the  unintended                                                                   
consequences of excessively high  support at high oil prices.                                                                   
As  progressivity increased  it  raised  the production  tax,                                                                   
which qualified for immediate  write-off of capital costs. He                                                                   
exemplified progressivity  levied on gross production  (at 25                                                                   
percent)  instead of  a profit  based  production tax.  Costs                                                                   
were   no  longer   relevant   for  the   gross   progressive                                                                   
calculation.  Costs  against  the  immediate  write  down  of                                                                   
capital were  accrued on  a flat  25 percent production  tax.                                                                   
The tax  remained at  25 percent regardless  of how  high the                                                                   
price  of  oil  was.  The  after  tax  effect  on  government                                                                   
contribution  with   a  40  percent  exploration   credit  at                                                                   
$100/bbl.  of oil  was  60 percent.  The  effect was  further                                                                   
reduced to 45  percent if the exploration tax  was reduced to                                                                   
20 percent. He  added that another unintended  consequence of                                                                   
net  progressivity  within  the   current  structure  was  on                                                                   
potential  large scale  gas development.  The average  prices                                                                   
paid  on  a  BTU  (British  thermal  unit)  equivalent  could                                                                   
further  decrease  revenues  on existing  oil  production  by                                                                   
diluting production tax value  with a lower value product. He                                                                   
noted that SB 192 attempted to  "decouple"; accounting of oil                                                                   
and  gas into  separate streams  of production,  in order  to                                                                   
remedy the inclusion of progressivity  in the production tax.                                                                   
2:32:25 PM                                                                                                                    
Co-Chair  Stedman asked  what the  downside of  progressivity                                                                   
from  net  to gross  was.  Mr.  Mayer  stated that  the  only                                                                   
principle  downside was  the transition  time of the  current                                                                   
fiscal system to convert and administer  a new tax structure.                                                                   
He  opined  that   a  net  severance  tax  system   was  less                                                                   
complicated than  the existing  structure. He furthered  that                                                                   
it  was  far  less  complicated   than  the  existing  system                                                                   
combined with decoupling as a way to remedy progressivity.                                                                      
Mr. Mayer directed attention to  capital credits. He reminded                                                                   
the committee that capital credit  was a 20 percent credit on                                                                   
qualified capital  expenditures as an immediate  write off of                                                                   
capital. He  explained that  the timing  of credits  and cash                                                                   
flow; the  ability to  immediately expense  or claim  capital                                                                   
credits  in the  current year  to  lessen the  impact on  the                                                                   
producers  cash flow was  built into  ACES and preceding  tax                                                                   
structures. The  credit structure  enabled a high  government                                                                   
take but mitigated the cash burden  on producers at the early                                                                   
stages  of a project.  The early  stages impact  the rate  of                                                                   
return on the  project. The credit allowed a  relatively high                                                                   
rate  of  government  take without  penalizing  the  rate  of                                                                   
return  for the  producer who  can  claim the  credit in  the                                                                   
first  years  of  project  development.   He  cautioned  that                                                                   
changes   to  the   capital   credit  should   be   carefully                                                                   
considered.  Changes to  the capital  credit structure  could                                                                   
"deteriorate" the  rate of return for marginal  projects. The                                                                   
ability for a producer to claim  capital credits in the early                                                                   
years of  a project was critical  to the timing of  cash flow                                                                   
especially on  high cost developments with marginal  rates of                                                                   
2:40:42 PM                                                                                                                    
Mr.  Mayer addressed  the  Australian system  that  consisted                                                                   
solely of  state and  federal income tax  and a profit  based                                                                   
tax. He  offered that the  Australians wanted to  structure a                                                                   
fiscal system where  government take was equal  to the equity                                                                   
stake in a project. The tax was  levied at 40 percent of cash                                                                   
flow but contributed 40 percent  of the costs. The costs were                                                                   
fully deductible  each year. The  40 percent deduction  acted                                                                   
as a  40 percent investment  by government  but did  not bear                                                                   
risk.  If   the  project  failed   the  government   was  not                                                                   
responsible for the costs.                                                                                                      
Mr.  Mayer reviewed  Slide  25,  "Capital Credit  -Return  on                                                                   
Investment  Under ACES at  $50 Oil."  which provided  a graph                                                                   
that  depicted the  project  cash flows  and  returns to  the                                                                   
state.  He reminded the  committee that  two capital  credits                                                                   
were available to new producers  without existing production;                                                                   
the qualified capital expense  at 20 percent and the carried-                                                                   
forward annual loss credit at  25 percent. He delineated that                                                                   
the graph  was based on cash  flow economics after  state and                                                                   
federal  income  taxes.  A yellow  line  depicted  the  total                                                                   
divisible income  from a project. The total  divisible income                                                                   
was revenue  less expenses.  A red  line depicted  government                                                                   
take. Government  take dropped as capital credits  were taken                                                                   
in  the  beginning   of  a  project  then  rose   with  fixed                                                                   
royalties,  production,  and  property  taxes.  A  blue  line                                                                   
depicted a 35  percent equity stake. The line  was similar to                                                                   
the government take. The 35 percent  equity stake represented                                                                   
the combined capital  credits minus federal and  state income                                                                   
2:45:17 PM                                                                                                                    
Mr. Mayer concluded that at $50/bbl.  the government take was                                                                   
higher;  8  percent rate  of  return  (IRR) and  negative  36                                                                   
percent  of the  net  present value  (NPV),  than the  equity                                                                   
stake; 5 percent IRR. He turned  to Slide 26, "Capital Credit                                                                   
- Return  on Investment  Under  ACES at $100  Oil." He  noted                                                                   
that the  return on investment  under ACES for  $100/bbl. oil                                                                   
was even  greater for the government  take at 29  percent IRR                                                                   
and three times higher NPV than  the 35 percent equity stake.                                                                   
Mr.  Mayer  remarked  that  the  trend  continued  upward  at                                                                   
$150/bbl.  oil,  depicted  on  Slide 27,  "Capital  Credit  -                                                                   
Return  on Investment  Under  ACES at  $150  Oil." The  trend                                                                   
increased dramatically  at $200/bbl.  displayed on  Slide 28,                                                                   
"Capital Credit  - Return  on Investment  Under ACES  at $200                                                                   
Oil" [57 percent IRR for the government  take and; 33 percent                                                                   
IRR for  the 35 percent equity  stake]. He surmised  that the                                                                   
state of Alaska received a significantly  high cash return on                                                                   
its initial investment of capital credits for a project.                                                                        
Mr. Mayer highlighted Slides 29-32,  "Capital Credit - Return                                                                   
on Investment  Under Severance Option  1 at $50,  $100, $150,                                                                   
and $200  Oil" sequentially.  The slides  portrayed  the same                                                                   
graph using the  severance tax scenario. He  pointed out that                                                                   
at  $50/bbl. the  numbers were  similar to  the ACES  capital                                                                   
credit return on  investment. As the price of  oil climbed to                                                                   
$200/bbl.  the difference  in the net  present value  between                                                                   
the capital credit and severance options narrowed.                                                                              
Co-Chair Stedman compared slide  30 to slide 26 which graphed                                                                   
the rate  of return for both  scenarios at $100/bbl.  oil. He                                                                   
asked if the  net present value represented the  cash flow to                                                                   
the state. Mr.  Mayer confirmed the statement  and added that                                                                   
state and federal income taxes were factored into the net.                                                                      
Co-Chair Stedman  observed that the net present  value to the                                                                   
state  was more  favorable under  ACES.  Mr. Mayer  confirmed                                                                   
that  both  options  had  similar   outcomes  but  were  more                                                                   
favorable under ACES.                                                                                                           
Co-Chair Stedman  asked if the severance tax  option included                                                                   
the seven year tax holiday. Mr.  Mayer replied that the model                                                                   
only examined the 20 percent rate.                                                                                              
2:51:48 PM                                                                                                                    
Senator  Olson referred  to slides  32 and  28. He  requested                                                                   
clarification on why the divisible  income was represented as                                                                   
a notch on the  graph at $200/bbl. oil for  both options. The                                                                   
line  peaked  at  approximately  $750 million  in  2012  then                                                                   
dipped to approximately  $650 million in 2014,  slightly rose                                                                   
in 2016 and leveled out over the subsequent years.                                                                              
Mr. Mayer  responded that  in general  a notch represented  a                                                                   
reaction  to  the impact  of  depreciation  on a  project  or                                                                   
federal income tax kicking in and reducing cash flow.                                                                           
2:55:25 PM                                                                                                                    
The meeting was adjourned at 2:55 PM.                                                                                           

Document Name Date/Time Subjects
SB 192 April 2 Alaska Senate Finance.pdf SFIN 4/2/2012 1:00:00 PM
SB 192
SB 192 DOR Response 040112.pdf SFIN 4/2/2012 1:00:00 PM
SB 192