ALASKA STATE LEGISLATURE  SENATE RESOURCES STANDING COMMITTEE  February 17, 2012 3:35 p.m. MEMBERS PRESENT Senator Joe Paskvan, Co-Chair Senator Thomas Wagoner, Co-Chair Senator Bill Wielechowski, Vice Chair Senator Bert Stedman Senator Lesil McGuire Senator Hollis French MEMBERS ABSENT  Senator Gary Stevens - excused OTHER LEGISLATORS PRESENT  Senator Cathy Giessel COMMITTEE CALENDAR  SENATE BILL NO. 192 "An Act relating to the oil and gas production tax; and providing for an effective date." - HEARD & HELD ANALYSIS OF OIL INDUSTRY INVESTMENT STRATEGIES PRESENTATION BY PFC ENERGY - HEARD SENATE BILL NO. 176 "An Act exempting sand and gravel and marketable earth mining operations from the mining license tax; and providing for an effective date." - HEARD & HELD CS FOR HOUSE BILL NO. 144(RES) "An Act requiring the Department of Natural Resources annually to deliver to the legislature and the governor a report on fishing stream access." - SCHEDULED BUT NOT HEARD CS FOR HOUSE BILL NO. 185(RES) "An Act relating to an exemption from authorizations that may be required by the Department of Environmental Conservation for the firing or other use of munitions on active ranges." - SCHEDULED BUT NOT HEARD PREVIOUS COMMITTEE ACTION  BILL: SB 192 SHORT TITLE: OIL AND GAS PRODUCTION TAX RATES SPONSOR(s): RESOURCES 02/08/12 (S) READ THE FIRST TIME - REFERRALS 02/08/12 (S) RES, FIN 02/10/12 (S) RES AT 3:30 PM BUTROVICH 205 02/10/12 (S) Heard & Held 02/10/12 (S) MINUTE(RES) 02/13/12 (S) RES AT 3:30 PM BUTROVICH 205 02/13/12 (S) Heard & Held 02/13/12 (S) MINUTE(RES) 02/14/12 (S) RES AT 3:30 PM BUTROVICH 205 02/14/12 (S) Heard & Held 02/14/12 (S) MINUTE(RES) 02/15/12 (S) RES AT 3:30 PM BUTROVICH 205 02/15/12 (S) Heard & Held 02/15/12 (S) MINUTE(RES) 02/16/12 (S) RES AT 3:30 PM BUTROVICH 205 02/16/12 (S) Heard & Held 02/16/12 (S) MINUTE(RES) 02/17/12 (S) RES AT 3:30 PM BUTROVICH 205 BILL: SB 176 SHORT TITLE: EXEMPTIONS FROM MINING TAX SPONSOR(s): SENATOR(s) WAGONER 01/27/12 (S) READ THE FIRST TIME - REFERRALS 01/27/12 (S) RES, FIN 02/15/12 (S) RES AT 3:30 PM BUTROVICH 205 02/15/12 (S) 02/17/12 (S) RES AT 3:30 PM BUTROVICH 205 WITNESS REGISTER TONY REINSCH, Senior Director Upstream and Gas Group PFC Energy POSITION STATEMENT: Accompanied Mr. Mayer in the analysis of oil industry investment strategies. JANAK MAYER, Manager Upstream and Gas PFC Energy POSITION STATEMENT: Continued the presentation on oil industry investment strategies. MARGRET DOWLING, Staff Senator Tom Wagoner Alaska State Legislature Juneau, AK POSITION STATEMENT: Explained CSSB 176 for the sponsor. JOHANNA BALES, Deputy Director Tax Division Department of Revenue (DOR) Juneau, AK POSITION STATEMENT: Answered tax questions on CSSB 176. TONY JOHANSEN, Partner Great Northwest, Inc. President, AGC of Alaska Fairbanks, AK POSITION STATEMENT: Supported SB 176. MARK COTTINI, Professional Civil Engineer Vice President, Alaska Rock Products Association, Mat-Su Borough, AK POSITION STATEMENT: Supported SB 176. BEN SIMMONS, Vice President and Controller Anchorage Sand and Gravel (ASG) Anchorage, AK POSITION STATEMENT: Supported SB 176. CHERYL SHAFER, Owner Dibble Creek Rock Kenai, AK POSITION STATEMENT: Supported SB 176. ACTION NARRATIVE 3:35:06 PM CO-CHAIR JOE PASKVAN called the Senate Resources Standing Committee meeting to order at 3:35 p.m. Present at the call to order were Senators French, Stedman, Wielechowski, McGuire, Co- Chair Wagoner And Co-Chair Paskvan. SB 192-OIL AND GAS PRODUCTION TAX RATES  ANALYSIS OF OIL INDUSTRY INVESTMENT STRATEGIES PRESENTATION BY  PFC ENERGY  3:36:51 PM CO-CHAIR PASKVAN said the committee would continue the hearing from yesterday on SB 192 and the analysis of oil industry investment strategies by PFC Energy. ^Analysis of Oil Industry Investment Strategies Presentation by PFC Energy 3:38:00 PM TONY REINSCH, Senior Director, Upstream and Gas Group, PFC Energy, introduced himself. JANAK MAYER, Manager, Upstream and Gas, PFC Energy, and project manager on fiscal terms reform in Alaska for the LB&A committee, said he would pick up where he left off yesterday. He recapped that he talked about thresholds and metrics that determine how and where companies invest, principals for a well-designed fiscal system, what makes for efficient or inefficient taxation in general and arrived at the basic question of what progressivity is and how and why it is used. MR. MAYER said he would continue today talking about progressivity in principal and look at some international comparisons, then look specifically at progressivity under the ACES regime and answer some of the questions on its limitations to the upside with the oil price; he would then look at what overall levels of government take looks like for ACES in several scenarios including what would happen if particular caps were placed on progressivity. 3:39:13 PM Yesterday he started with his favorite quote from Jean Baptiste Colbert about how the art of taxation is plucking the goose so as to get the most feathers with the least hissing. In present day terms that means taxation is about maximizing revenues subject to the important constraints of efficiency and competitiveness - efficiency being a measurement of how intelligently we are applying a tax and whether it distorts investment opportunities or only targets economic rent, and the idea that one could have a very efficient tax and still not have it necessarily be competitive. 3:40:34 PM He said that royalties are simple to administer, their main strength laying in the ease of administration, but they are also inefficient precisely because at certain prices, some costs distort investments so that by and large, certain projects that might otherwise go forward will not go ahead. Royalty is highly regressive in that as costs fall and prices raise, government take decreases rather than staying neutral or increasing. He said in principal, a well-designed fiscal system, one that meets Colbert's test, is one that would ideally come close to targeting economic rent and taxes things that don't affect economic incentives, making sure that all projects that might otherwise be viable without the tax remain viable. 3:41:32 PM MR. MAYER said as a starting point, one of the things that becomes apparent in thinking about things this way is that progressivity (to achieve the aim of targeting economic rent) can be used in many ways. Internationally, it's used primarily not to create necessarily an overall progressive regime but simply to partially or completely counterbalance the regressive elements of one. A regime that may for historical reasons have a long-standing fixed percentage royalty may introduce another progressive element to offset the aggressive effect of that royalty. PPT, the precursor to ACES, as it was first proposed (as opposed to as it was enacted), looked very much like something that was designed to create an overall neutral regime to counteract the regressive impact of the royalty. In other cases, however, progressivity is not used just to counteract the regressive effect of a royalty, but to deliberately create a progressive regime, one that as costs increase, as oil prices increase, as there is more economic rent available, to make sure that the state's share isn't just a neutral or a fixed percent, but takes more for the state. 3:43:55 PM MR. MAYER said that both approaches can yield fiscal taxation regimes that are entirely efficient to the extent that it is possible to distinguish economic rent and not costs from ordinary return on capital. Regimes that combine both high levels of government take and high levels of progressivity, if well designed, may meet that first criteria of efficiency, but may not always meet the second criteria of competitiveness. That is something he would detail more. MR. MAYER said one of his conclusions was that progressivity works very differently in different regimes. In particular, one can design a fiscal regime to use a wide range of metrics against which to be progressive. Using production levels is the simplest and the most wide-spread application of progressivity. This started in some of the earliest production sharing contracts (PSC) that sought to increase levels of government take on the more profitable fields and it remains a key feature of production sharing contracts in many parts of the world; it is also used in creating variable royalty systems. He explained that Vietnam's fiscal terms have two progressivity elements with regard to production amount; one is a royalty and one is the profit oil split. Both vary depending on how much is produced in a given asset. In essence, he inserted, the idea that is common to all production bearing progressivity is that production level is used as a proxy for profitability, but production level is a poor proxy for profitability because it's only one factor that will determine profitability. If all of the assets in a given country have a very similar cost structure, then possibly a regime could be tailored like this to come close to targeting profitability, but that approach has serious limitations. Vietnam has a single regime for pre-2010 fields that increase the government take in the profit split as production goes up, but after 2010 there are three different possibilities. That reflects that the vast majority of the asset base previously was fairly consistent shallow water fields, and the government of Vietnam understood that if you want to go into deep water, those costs are very different. Having a structure that accommodates those means you have to think differently about how production levels are taxed. That led in this case to increasing complexity in different options within the regime. 3:47:20 PM He said that these systems are always bracketed. In this case, 20,000 barrels of production a day is the first bracket and up to 50,000 barrels a day is another, with the royalty on the incremental barrels increasing and the profit split decreasing (but only on the additional barrels). 3:49:07 PM He said that Vietnam is just one example of a production sharing contract, but there are other royalty-based regimes that similarly use a price-based metric for progressivity. British Columbia in Canada is one example of a regime that combines a production-based metric with a price-based metric to try and achieve a slightly better measure of progressivity. MR. MAYER said that a number of other regimes specifically target price and only price with regard to progressivity. This is particularly common in windfall profits taxes around the world, the idea being that all of the given assets in the country will economically break even below a certain price including return on capital to the investor. So above that threshold, the government would like to take some increasing amount of the rents. For instance, Venezuela's windfall profits tax is essentially a zero rate at all prices below $40, and 20 percent for all prices between $40 and $70. This particular aspect of Venezuela's regime is highly progressive, so that 95 percent is taken by the government at oil prices over $100 (for the incremental barrels). SENATOR FRENCH had jumped ahead to slide 16 that showed that Venezuela, despite bracketing, produces a government take of $100 a barrel and remarked that was virtually indistinguishable from Alaska. So, you can get to the same place, just through different rates. MR. MAYER agreed that was entirely correct. The lack of bracketing in ACES does one thing: it makes a significantly more progressive regime than it would otherwise be and the overall effect is that it increases government take. He said he would never suggest that the lack of bracketing in ACES makes, in and of itself, an invalid or an undesirable characteristic. 3:51:51 PM CO-CHAIR PASKVAN referred to slide 8 and asked if the 90 percent threshold for Venezuela's windfall profits tax was dependent upon the price of oil staying at $95 for an entire year. MR. MAYER replied in the case of the $100 threshold, if the oil price is $110, $10 of that is being taxed at the 95 percent rate, another $10 is being taxed at 90 percent and another $20 is being taxed at 80 percent and so on. That is the way bracketing works in that system. SENATOR WIELECHOWSKI said the argument they hear all the time is that Alaska's system takes away the upside, but a system like this one takes away much more of the upside. Yet this is where the majors have invested historically. Why would they do that in this situation but not in Alaska? MR. MAYER replied that Argentina is an extreme example of the highest marginal tax rate imaginable, because it's 100 percent after the price hits $42, but before that the windfall profits tax component is zero. He explained that the reason a regime like that is implemented in a place like Argentina is not because it's a particularly efficient or sensible form of taxation; it's because the high levels of regulation distort all sorts of aspects of the domestic energy market. 3:54:29 PM MR. REINSCH added that Venezuela was a particularly complex example and because of the impacts of not only the windfall profits tax but other unilateral conditions imposed by the government on the contractors, virtually all of the majors and large companies left Venezuela and they are not going back. Chevron that has stayed deeply vested in Venezuelan heavy oil sands is the exception. This is a different kind of development - more like a manufacturing process - much like integrated mined oil sands in Canada where a company doesn't carry exploration risk. So a company can afford to maintain operations in this kind of confiscatory fiscal environment. SENATOR STEDMAN asked what would be the marginal tax rate in this example if oil was $110. MR. MAYER replied the marginal tax rate in that case would 95 percent. SENATOR STEDMAN said if all of the western oil companies were out of Venezuela except for Chevron, and if Chevron leaseholders were put on the screen, "It would almost be I hate America." 3:56:54 PM MR. REINSCH responded that Repsol, Statoil and a number of other companies are positioned in the same type of asset, Repsol being unique in that it has pursued very large scale gas exploration and commercialization with an eye to LNG, but it is also a Spanish speaking quasi or former national oil company itself and has staked a claim as a linguistic leader in the upstream development in South America generally, and as a result has a different sort of incentive and strategy towards the continent. But there is no question that under a different set of fiscal terms and a different positioning by the national oil company, that Venezuela would attract much more foreign direct investment than is the case today. 3:58:01 PM MR. MAYER moved on to slide 9 showing another more sophisticated metric targeting economic rent a little more directly by looking at the process by which projects recover their capital - instead of focusing on just price, just production or just cost, to assess projects on how far they have recovered their capital and taxing them at a progressively higher rate as they go further above simple undiscounted full recovery. For instance, Malaysia's 1997 and beyond (still in place) production sharing contract was introduced precisely to be more efficient in the sense of increasing rates of taxation once costs had been recovered. It's based on a metric called the "R-Factor." The "R" stands for "ratio" and most commonly refers to comparing cumulative revenues for a project to cumulative costs (both operating and capital). Having an R-Factor of 1 means that one has fully recovered the pure undiscounted accounting costs of the project. As the R-Factor increases, an R-Factor of 2 means the basic costs have been doubled. So the basic idea behind a regime like Malaysia's is that at an R-Factor below 1 (well before cost recovery) there is a relatively high limit on the amount of revenues in any given year that can count towards cost recovery and 80 percent of the split profit oil above that can be kept. As the R-Factor rises above 1 and towards significantly higher numbers, that profit split will go from 80 percent down as low as 30 percent. It's quite a back-loaded regime that allows quick cost recovery for the contractor and improves their economics on metrics like RR and MPV, but allows quite a high level of government take by taking progressively more as costs are recovered. SENATOR FRENCH asked how the Malaysian investment level should be compared to Alaska's. 4:01:44 PM MR. REINSCH answered that the question should be how projects are defined and how capital continues to be attracted to them. Malaysia has a sharper definition of "new project." For instance, a field that has been producing with primary and perhaps secondary water flood techniques and whose production has matured and it's time to introduce enhanced oil recovery would be presented to the government as a new project development falling back, now, to an R-Factor of 1 for the incremental production. SENATOR FRENCH asked if one way to compare the investment levels in Malaysia versus those in Alaska is to compare the number of barrels produced, the decline curve and the relative Capex. MR. REINSCH replied that his expectation was that on a dollar BOE (barrel of oil equivalent) basis he would see the more remote nature and difficult operating environment in Alaska versus Malaysia. SENATOR FRENCH asked if it could overcome any taxation differences. MR. REINSCH replied that it may. SENATOR STEDMAN said he didn't see how such a model could be implemented with Alaska's aging field. MR. MAYER agreed and said he wouldn't suggest using an R-Factor model in Alaska, because it relies on an accurate historical accounting for costs. In that sense, it's something that is much easier going forward than it is for existing mature assets. 4:05:11 PM He said that slide 10 showed another variation of this idea focusing with each of these steps more explicitly on taxing returns above a baseline normal return on capital. One of the new ways some regimes choose to do this is to set progressivity rates specifically based on a particular IRR that may have been achieved. For instance, in the shallow water Angola where significant above ground risks exist the focus is explicitly on an IRR metric meaning that a contractor's share of profit may be quite high in any project that has yet to make a 20 percent IRR, (60 percent in the example). But as IRR rises above those hurdle rates, the contractor's share gets progressively less and less. And in the case of Angola, the deep water has a slightly different regime than for the shallow. SENATOR STEDMAN said when the legislature initially did progressivity in PPT, they contemplated doing it on the IRR basis, but couldn't get that information. He asked how this would this be implemented on an aging field. MR. MAYER answered that it is a system that tends to be seen much more in production sharing contracts than in tax royalty regimes. Part of the reason for that is that production sharing contracts tend more frequently to exist in places that either have a very active national oil company that is, itself, involved in the development of the project or a highly developed oil ministry. Many parts of the world may have very little government capacity, but have a highly functioning petroleum industry. Having one of those things helps you to do this in a way that if you don't have that capacity it's very difficult to do. 4:08:35 PM MR. REINSCH said the actual application of a system like this can be seen in Tanzania and Mozambique, young jurisdictions where organizations like the International Finance Corporation, World Bank and International Monetary Fund (IMF) were very much involved in supporting development of these regimes. To make this operational, the companies were required to give IRR models to third party auditors to verify. MR. MAYER said an extreme example of regimes of this sort would be the shift in certain jurisdictions away from simple production sharing contracts to things like risk service contracts, which fundamentally change the role of the international oil company from being a risk bearing partner to being a system where government takes the risk and the international oil company is guaranteed a particular IRR, but no more. In Malaysia the national oil company has put a number of fields on a risk service contract basis. SENATOR STEDMAN asked if he was aware of any areas in the world where industry felt the tax structure was too heavy and asked the government to look at IRR methodology to bring the government split more in line with what they wanted to see. MR. MAYER replied no. 4:12:10 PM SENATOR MCGUIRE asked for an example of a government bearing a larger share of the risk, then negotiating with oil companies for a guaranteed rate of return and nothing more. And what did he mean by the state bearing the risk in his Malaysia example? MR. MAYER replied that guaranteeing a 15 percent rate of return to work a field on one hand limits the upside, but it also works to guarantee an absolute maximum if it turns out that the fields is "dreadfully marginal." SENATOR MCGUIRE asked if Malaysia had other credits, loan incentives or guarantees. MR. MAYER replied that he was not aware of those sorts of things. He moved on to slide 11, an example of Australia that is an OECD jurisdiction. It is one that in some ways follows a method of taxation that is most similar to ACES in that it's a profit based taxation regime, but it's one that is particularly thoughtful and clever. It's the only system that explicitly targets just economic rent rather than profit, including return on capital. He thought this was the least distorting and most efficient tax regime in the world - whether or not it is competitive. 4:15:39 PM MR. MAYER said it's a very simple regime compared to many. Other than corporate income tax, it essentially has one single tax, the petroleum resource rent tax, that is levied at one single rate of 40 percent. That tax is levied not on profit, but on the cash flow of the asset. The basic idea of the system is to try to come as close as possible, without establishing a national oil company and actually directly participating in a project, to replicate the economics of a direct equity stake in the project. Mr. Mayer explained that instead of directly contributing 40 percent of the capital, those costs get recovered from the government later by being taken out of the revenues that would otherwise go in taxes to it. Those revenues are inflated each year by a rate that is essentially equivalent to the cost of capital for the company; it's set in relation to the government bond rate plus a certain percentage. By doing so, the economics on a net present value basis are identical to saying the government puts in 40 percent of the costs and takes out 40 percent of the benefits. 4:17:18 PM Precisely because it's a simple system, no royalty and no other taxes, it's one of the most transparent and rent targeting regimes he has seen anywhere. MR. MAYER said if government pays 100 percent of the costs and gets 100 percent of profits and if the private sector is actually doing all the work, there is very little incentive for the private sector to minimize the costs involved in an undertaking. This is important in talking about the high marginal tax rate under ACES, because in principal, high marginal rates at times imply the same thing. He elaborated that if a company at any point under ACES faces a 90 percent or higher marginal tax rate, that doesn't particularly affect project economics or the hurdle rate; but if the company is considering installing a new gas processing facility and could spend $1 billion to get a pretty good one or spend $1.5 billion to get a really good one, with a 95 percent marginal tax rate, the actual incremental difference in the spending on those two choices is very small and it may be worth spending the $1.5 billion, because the full cost of it will not be borne by the company. SENATOR STEDMAN said that might be getting into the issue of gold plating. MR. MAYER agreed. SENATOR STEDMAN asked when he thought a system got close to gold plating. MR. MAYER responded that he didn't have a particular marginal rate in mind, but certainly marginal rates above 85 or 90 percent. 4:21:36 PM SENATOR STEDMAN said that previous testimony had shown that with Alaska's system the state might be in a negative position (over 100 percent) at prices over $200. MR. MAYER said he had looked at the impact of ACES under high price environments and only at production tax values north of $200 had he seen rates over 100 percent. He wanted to look into that question further before answering definitively. SENATOR STEDMAN agreed that they could look at it in more detail later. MR. MAYER summarized that one could have an efficient regime without distorting project economics, but that regime might not be competitive on the one hand and on the other, one could have a competitive regime in terms of low government take but a distorted structure meaning that marginal projects would be unviable. So the principal that one would seek to follow is having a regime that is neither inefficient nor distorting and without total government take so high as to be uncompetitive. In his discussion up to now, he said he had focused on the efficiency side of the question (progressivity) looking specifically at ACES, at ACES with some international comparisons, and ACES with certain modifications. However, it's important to understand that ultimately, effective rates, not marginal rates, are the ones that drive project economics at a given price level. They determine if a project meets a hurdle rate for return on capital or not. But the fact that is the case doesn't mean that marginal rates are not a useful piece of information and help in understanding certain key characteristics of a fiscal system. One thing that can be understood from the interaction between average rates and marginal rates is that it provides a useful way of benchmarking progressivity of different regimes. A graph of average and margin rates just for production tax components of the ACES regime shows the high rate of progressivity for PTV up until $2.50 and the lower rate of PTV after that threshold. MR. MAYER explained that as long as the marginal rate line is above the average rate line, it is a progressive regime. When the marginal rate line is below the average, it would pull the average rate down as prices increased, and that is a regressive regime. By subtracting the average from the marginal rate one can create an index that can be used to understand just how progressive a regime is at a given price level. 4:27:44 PM CO-CHAIR PASKVAN asked him to define "gold plating" and the context he is using it in and to explain why he used the term "perverse incentives" when talking about high marginal rates. MR. MAYER replied that the term "gold plating" comes from the heart of his previous comments about high marginal rates and the incentives or lack of lack incentives for companies to exercise cost control in certain circumstances. In this sense it describes the sense of his further description of needing a new facility and spending $1 million for one that would do the job or spending $1.5 billion to get an even better facility but one that doesn't in and of itself justify the extra half billion in expenses. If he faces a 95 percent marginal rate of tax, his incentive might be to go for the $1.5 billion facility, because after accounting for the effects of his changed taxation rate in addressing that investment he would only be paying a small portion of that cost. So if there is a very small additional benefit to him for making that additional investment it might be worth it since he is not the one paying the full cost of it. CO-CHAIR PASKVAN asked what would be the cumulative effect of combining the concept of gold plating and high marginal rates with Alaska's capital credit. MR. MAYER replied it would probably move toward increasing costs, because suddenly it's not a system that strongly incentivizes cost control, but quite the opposite. SENATOR WIELECHOWSKI remarked that he understood that it really taxes the cash flow. If you look at industry's $30 billion in profits, it would appear that they are taking the profits and they are certainly reinvesting. He asked if he had seen any evidence of gold plating in Alaska's system. MR. MAYER replied that "gold plating" is hard to identify. If one is not the individual actually making purchasing decisions and deciding whether one needs the $1 billion or the $1.5 billion facility it's very hard to know whether it is going on or not. The incentives might encourage it, but he hadn't looked at enough data to go further than that. SENATOR WIELECHOWSKI said economists used during ACES talked a lot about the advantages of a high marginal tax rate, and the philosophy at the time was that companies were in harvest mode, taking the money out of Alaska and reinvesting it in other places around the world. So, the rationale for the higher marginal rate was that it would incent reinvestment in Alaska, and since ACES has passed, they have seen all-time highs every single year in both capital and operating investment. Are those positive things you would expect to find about a high marginal tax rate? Would you agree with that philosophy that encourages reinvestment in the basin? 4:31:58 PM MR. MAYER replied that it is a very specific set of carrots and sticks and they are set up to provide significant benefits from reinvesting. Whether those benefits are sufficient to compensate for the overall high level of government take is another question and he didn't have a conclusive answer to that at this point. SENATOR STEDMAN commented that it's more complex than saying having a high marginal rate policy encourages reinvestment. Alaska also has up front credits to encourage capital to stay here and if they both accelerate at the same time all of a sudden there are distortions all over the place and the whole thing loses its ability to function at more moderate levels. There is the issue of the theory and then the issue of the implementation, which could be explored in further detail with advanced modeling. He asked if they could get a reference to the price of oil on the chart of Production Tax Values, slide 13. 4:36:36 PM MR. MAYER responded that slide was showing something specific about a specific small portion of the ACES system; there are many different variables and cost is one of the major ones; cost over time and how cost is phased over time is another. So if they do this analysis on the basis of oil price rather than PTV, it's suddenly no longer a clear-cut simple graph. "It's a much fuzzier picture." SENATOR STEDMAN said maybe they could have a double X axis with current prices underneath so people could reference back and forth. Getting the concept across is kind of a two-edged sword. MR. MAYER said the basic point he was making about subtracting the average rate from the marginal rate to get a basic idea of progressivity was that this is not the way other fiscal system comparisons are made. This is analysis PFC does by identifying assets in their database of assets as typical for a particular regime. In some cases they may be comparing a relatively low cost field to a relatively high cost field, but that's because both of the developments are typical of that area and that regime, and they are trying to get to the question of what government take looks like given the nature of the assets in a given jurisdiction in different places. Here they do an exercise of subtracting the average and marginal take and see that the world is split up into progressive and regressive regimes, at least at the $100 price level, with a few neutral ones in the middle, and of those, Alaska is among the more progressive regimes around. In doing the same exercise at $140 barrel, that becomes even more the case, and suddenly it is the most progressive regime of any in the Organization for Economic Cooperation and Development (OECD) and among the highest they have seen. 4:39:48 PM SENATOR STEDMAN, referring to the chart on slide 14, asked if Texas, North Dakota, the Gulf of Mexico and Louisiana are all regressive. MR. MAYER replied yes and said that is precisely because they are largely royalty-dominated regimes, and royalty-dominated regimes are inherently regressive. SENATOR STEDMAN commented like royalty and property and income taxes. MR. MAYER said of those, royalty and property tax, in particular, are the most regressive components. SENATOR STEDMAN recalled that in doing the initial review of PPT, the system was regressive and that's what created the interest to insert a progressivity measure to at least in theory get them to the middle of the chart (slides 14). MR. MAYER agreed and said in looking at ACES at a range of price levels, one of the first things they will see is an analysis of PPT as it was originally proposed rather than as it was enacted. It's a very neutral regime, because the progressivity is almost exactly enough to counter the regressive nature of the royalty. 4:41:39 PM He said since they were addressing the question of overall competitiveness of a regime, regardless of whether it is efficient or not, it was useful to do the same global benchmarking model exercise, and again Alaska ranks relatively high in the deck of OECD countries; at $100 barrel, Norway is the highest, but it is the second highest OECD country. The regimes above it tend to be by and large production sharing contract regimes with some of the high levels of government take. The analysis at $114 barrels makes that even more the case; in this case, Alaska is about equal with Norway. SENATOR WIELECHOWSKI asked in calculating government take, if he takes the actual amount paid in a given year and then backs out what is actually paid or if he uses the general tax rates and assumes that the full tax is being paid. MR. MAYER replied the basic methodology is first of all to start with the concept of divisible income being all of the revenues that the project creates less its costs (per the supplement slide yesterday). That divisible income can be distributed either to the private company owning and operating the project or to the government. If you take away the after-tax cash flow based on what the model suggests that goes to the contractor, everything else, in some form or another, goes to the government. That's the absolute government take (through royalty, property taxes, profit sharing or other ways). 4:44:08 PM SENATOR WIELECHOWSKI asked if he was assuming in this government take figure the companies are paying the full corporate income tax of 9.4 percent. MR. MAYER replied that the model, in most cases, uses a 9.4 percent tax rate, certainly in the Alaska model. SENATOR WIELECHOWSKI said he didn't think that anyone in Alaska pays 9.4 percent, because for instance companies are allowed to write off their losses in other regions. He thought these numbers were much lower for Alaska. MR. MAYER said that may be the case here and in other regions as well. He would also say in that sense, that state income tax is one if the smallest components of government take and would have a small impact here. 4:45:23 PM Slide 18 had a few graphs of PPT as proposed, that was designed with enough progressivity to counteract the regressive nature of the royalty, but that led, relatively speaking, to an overall neutral regime that is very slightly regressive, but overall almost spot-on neutral using these assumptions. It indicated a flat government take of 60 percent. 4:47:01 PM MR. MAYER explained that slide 19 had graphs of PPT as enacted with significantly greater progressivity where government take rose from the flat 60 percent level across all price levels to a peak of about 74 percent, given the assumptions of the particular asset type they were looking at. As a result, there was a decline in some of the MBV and IRR metrics for this generic representation of assets. The primary difference between ACES as it was proposed versus PPT as enacted is that progressivity kicks in at a lower threshold and that raised government take somewhat. ACES as it was actually enacted had a significant increase in the progressivity and a significant increase in the overall government take. CO-CHAIR PASKVAN asked what parameters as far as costs he was imposing and what increased costs would do to the total government take column. MR. MAYER replied that increased costs would suddenly reduce that figure. This analysis had been prepared on the basis of a lower-cost development on the Alaska North Slope, not inconsistent with the cost numbers he had from the Department of Revenue for assets like Prudhoe Bay, but certainly much lower than he would anticipate for some of the newer developments like Oooguruk. He recalled using slightly over $8 per barrel in Opex, around $5 barrel in pure maintenance Capex and probably a similar amount in development Capex. He said he could produce an analysis like this based on a higher cost asset. 4:49:18 PM SENATOR WIELECHOWSKI said a $100 barrel of oil had a 16 percent royalty and a 39 percent production tax, and he thought more accurate numbers would be 12.5 percent for the royalty and 27.5 to 28 percent for production tax. He realized that the federal tax flexed with that, but wanted to know where he was wrong. 4:53:53 PM MR. MAYER responded that the percentages in his model sum up to a total government take of 60 percent, half from royalty, because royalty is 12.5 percent of the gross revenues of the project, which is more like 30 percent of the divisible income not 12.5 percent of it. SENATOR FRENCH remarked that the Capex and Opex numbers were significantly lower than the ones he recalled from the Revenue Sources Book and asked where they are from. MR. MAYER replied that they come from a number of things. A different modeling exercise would show different cost fields in the context of different portfolios. The costs here are not out of keeping with the data he had from the DOR on costs at the lower end of the spectrum from places like Prudhoe Bay. SENATOR FRENCH asked if the commissioner or one of his deputies gave him these numbers. MR. MAYER answered that these specific numbers, no; but he did have numbers that the department was able to release in the cases where there were more than three working interest partners in an asset on general levels of operating and capital costs. He adjusted his figures to distinguish between maintenance costs and capital going to incremental development. SENATOR FRENCH said he was looking forward to seeing maybe 20 more runs using new fields, heavy oil fields along with Prudhoe Bay fields (for some standard to compare to). SENATOR STEDMAN said it would be interesting to look at cost numbers going forward, because in 2013 the Revenue Source Book (that the legislature has access to) has about $13.60 a barrel for Prudhoe Bay Opex and about $17.50 for Capex depending on if you are using net or gross on royalty barrels. It's quite a difference. MR. MAYER agreed and said from those aggregate numbers one can say what an average fields looks like, but no asset and no company portfolio looks like an average field. This was an exercise to show the lower-cost more mature assets. It's very different than the higher cost ones. CO-CHAIR PASKVAN said that is where some of the problems are surfacing from; they are seeing a homogenized industry. It's well taken that they need to understand more specific fields' operations within this overall fiscal system. MR. MAYER said he hoped the work they are doing on an ongoing basis in terms of coming up with a more detailed and granular model assist in that exercise. 4:54:47 PM To address the question that was asked about how ACES limits the upside of high oil prices for an oil and gas company, he said, some of that was seen on the preceding slides looking at the escalating level of government across prices. They could also maybe graph net present value of a project over a range of different prices for some of the different regimes. They could see how that changes over time under PPT as proposed, as enacted, ACES as proposed and ACES as enacted and see the limitation of upside. But whether capping upside is necessarily a bad thing in all circumstance is another question. In many ways it comes to the heart of what they have been talking about in terms of taxing economic rent. MR. MAYER said one way one could seek to quantify this is to take a probabilistic approach to the oil price rather than simply saying they want to know what the economics of this field or another looks like at $60 or $80 or $100 a barrel. A probability distribution curve on slide 22 graphed what each of those looked under different prices; the legend on the right of the graph showed the expected value falling as the upside potential is curbed by high progressivity. That wasn't the same as saying that by curbing the benefit of high upside, one affects the economics that determine meeting hurdles rates or some of the other key metrics under which capital is allocated, but it is one way of understanding the limitations on price upside that high progressivity creates. 4:57:12 PM MR. MAYER said finally to answer the committee's question on the impacts of changing nothing else about the ACES system other than the level at which progressivity is capped that he did a graph on slide 25 capping progressivity at 50, 60 and 70 percent at any price up to $230. It shows almost no difference; that's because the 75 percent cap itself only binds high prices around the $220-230 mark and a very slight decrease from 83 percent to 82 percent in the $230 case. 4:58:31 PM CO-CHAIR PASKVAN asked what oil price the 75 percent cap translates to. MR. MAYER said to get a precise number he would have to do the math again, but somewhere in the $300s. He further explained that reducing the cap to 60 percent would show more of an impact and capping progressivity somewhere around the $160 mark would result in a neutral structure going forward. Similarly, looking at this in a probabilistic approach (slide 22), both straight lines come up as they reach the cap on production tax and, again, relatively speaking, increased expected values on the higher oil side as a result. 4:59:56 PM MR. MAYER summarized that there are a wide range of forms of progressivity in different parts of the world and a wide range of metrics on which it can be based. Sometimes progressivity can be used to counterbalance the inherently regressive elements of a regime - things like a royalty component - and other times progressivity is applied in a way that is deliberately taking as large a share of economic rent as possible. There may be merits in doing so, but even if that can be done efficiently, it could affect competitiveness. He said that Alaska is one of the more progressive regimes in the world and, based on his assumptions, has a relatively high level of government take. In the OECD, only Norway has a higher level and at $140, oil is about equal to Norway. The higher GT regimes tend to be PSE regimes in some of the high-take parts of the world. PPT as proposed was a progressive component that counterbalanced other regressive elements to create a fairly neutral regime. Progressively, as time has gone on, the regime has become more and more progressive, more focused on capturing higher amounts of economic rent at higher prices and less focus on simply at creating a neutral regime. 5:02:24 PM CO-CHAIR PASKVAN thanked Mr. Mayer and Mr. Reinsch for the presentation over the last two days and held SB 192 in committee. At ease from 5:02 p.m. 5:04 p.m. SB 176-EXEMPTIONS FROM MINING TAX  5:04:44 PM CO-CHAIR WAGONER announced consideration of SB 176 [version 27- LS1201\M was before the committee]. CO-CHAIR PASKVAN moved to bring CSSB 176( ), version \B, before the committee for purposes of discussion. CO-CHAIR WAGONER objected for discussion purposes. MARGRET DOWLING, staff to Senator Wagoner, explained that the CS to SB 176, removes standing gravel operations, quarry rock operations and marketable earth from the mining licensing tax. This is because it is extremely cumbersome to both industry and the state. For example, in the last five years an average of about $268,000 was collected as a result of the mining license tax, and it cost the Department of Revenue about $150,000 to collect it. In addition, in FY2011 when the 182 operations were subject to the tax, that included both sand and gravel operations and quarry rock operations. Of those 182 operations, only 17 were actually required to pay the tax, largely because many of them were small operations serving their local communities that fell within the $40,000 exemption for net taxable income. 5:07:30 PM MS. DOWLING said it's cumbersome to tax these businesses, because they produce many products - different grades of aggregate, sand, concrete, concrete blocks, pit run and the like - and in order to comply with this tax, all of the expenses associated with each product have to be tracked. Sometimes one expense can be attributed to a number of different products and their task, then, is to try to determine which part of the expense is attributable to which product and to allocate it appropriately. It gets fairly complex and involves quite a bit of record keeping. A letter in their packets from Secon said it takes about 200 hours per year to do the recording keeping required to file a tax return and respond to audit requests. If a company owns more than one pit, it has to file a tax return and a schedule for each pit. Even if an operation is so small that it qualifies for the $40,000 net income exemption, it still must file a tax return and keep records. That is why the burden of this tax is pretty extraordinary relative to the actual tax revenue that is generated. 5:09:27 PM MS. DOWLING pointed out that 60 to 80 percent of the material that comes out of the ground in Alaska goes into public works projects that serve state residents in local communities. So, what really happens is that the state ends up paying on both sides of the equation; they pay to collect the tax and then as a consumer it ends up paying for the tax again. In addition, it pays for the overhead portion for the bookkeeping that these companies have to add to the price of their materials. 5:10:28 PM MS. DOWLING explained that the reason marketable earth was included in this measure was to address a Department of Revenue and industry concern that once they took out sand and gravel that someday some regulator or some member of the public would see marketable earth and wonder if it included sand and gravel. She understood that there are no tax returns filed under marketable earth now, so it wouldn't cause any harm. In addition, she said, the reason quarry rock was excluded was because there are just too few of them. In the last five years only four to six companies have filed tax returns under that designation. So keeping quarry rock in would not be achieving the efficiencies they are trying to achieve with this legislation. 5:11:40 PM SENATOR WIELECHOWSKI said they had heard a lot over the last few years about rare earth minerals and he wanted to be absolutely certain that taking out marketable earth was not removing those sorts of things. 5:12:23 PM JOHANNA BALES, Deputy Director, Tax Division, Department of Revenue (DOR), said her understanding is that marketable earth includes things such as peat, top soil and clay. She said the Department of Law looked at the rare earth elements to determine whether or not that would cause a problem, but to be honest, they weren't sure those types of elements were even covered under the mining license tax. Another good point to consider was that rare earth elements, unlike the marketable earth, such as peat and top soil, are locatable minerals, and excluding the marketable earth wouldn't affect them, but this issue should lead to a further conversation and some research in the future if the rare earth elements start being produced. 5:13:33 PM SENATOR WIELECHOWSKI said he thought the conversation needed to happen now if they are contemplating removing it from the state's tax structure. Taxes are hard to change down the line if someone discovered and started to mine rare earth minerals, which are extremely valuable. He said he supported the concept of exempting sand, quarry rock and gravel, but he didn't want to go far beyond that. He strongly preferred clarifying the definition. 5:14:32 PM MS. BALES responded that that was a valid concern. The definition of mining in statue includes "valuable metals, ores, minerals," and that she would immediately consult with the Department of Law on whether or not rare earth elements would fit under that language. 5:15:11 PM CO-CHAIR WAGONER asked her to do that and said they would probably hold this bill until next Tuesday. SENATOR FRENCH concurred with that and asked why the department spends $150,000 each fiscal year examining and auditing sand and gravel tax returns (on page 2 of the fiscal note). MS. BALES explained that that amount has been expended over the last five years. Back in 2006, the Matanuska Susitna Borough contacted them about several sand and gravel operators that could not get permits from the borough because they didn't have the state's mining license. At that point, the department realized that a significant number of sand and gravel operators were actually not in compliance. So, they spent the last five years bringing several hundred sand and gravel operators into compliance. The same page of the fiscal note indicates there were only 11 licensees at the time, and in 2011 there were 189. So, about 170 taxpayers were brought into compliance and the resulting tax was negligible. Until they did that exercise they had no idea that most of the operators were small and because of the $40,000 exemption, didn't pay tax. She said the department had already started moving resources back to other excise tax programs after diverting them to help with this. 5:17:42 PM CO-CHAIR WAGONER opened the public hearing. 5:17:57 PM TONY JOHANSEN, partner, Great Northwest, Inc., Fairbanks, and president, AGC of Alaska, supported SB 176. He said early last year his company received a two-page audit request from the Department of Revenue concerning their sand and gravel sales. The request listed 19 detailed sets of information and data needed to perform an audit of the mining license tax for the years 2008 and 2009, paperwork that would take their office manager weeks to assemble. In frustration, he said, he contacted John MacKinnon, the executive director of the AGC of Alaska, and after researching the issue last summer, the AGC approached the DOR about the problems and with suggestions on how the present requirements could be improved. After researching the revenues generated and the cost of their collection, the administration recommended that the simplest and best solution was to exempt quarry rock and sand and gravel operations from the mining license tax requirements. Everyone recognized it as a "true nuisance tax." 5:20:15 PM MARK COTTINI, Professional Civil Engineer and Vice President, Alaska Rock Products Association, Mat-Su, said he supported SB 176. He said he represented 10 gravel pits in the Mat-Su Borough and that he is also vice president of a gravel screening business and owns a pit that receives gravel royalties from the company that operates it. He had never paid mining taxes to the state of Alaska, he said, and all of the small gravel pit owners and the small gravel pit screening business think the mining tax is broken and concurred with the earlier presenter that they should be exempted from the mining licensing tax. 5:22:06 PM BEN SIMMONS, Vice President and Controller, Anchorage Sand and Gravel (ASG), Anchorage, said he has extensive experience with the mining license tax and supported SB 176. He concurred with prior testimony that the statute is very ambiguous as it pertains to sand and gravel. For the most part the other metals and minerals that are covered by the statute are gold, silver, zinc, lead and so forth, but Anchorage Sand and Gravel currently produces and stocks 20 to 40 products made with sand and gravel. Complying with the current audit requirements of determining fair market value for each product is very cumbersome, time consuming and requires a lot data and a lot of paper. He said the tax is inconsistent as it's applied to sand and gravel producers, because each producer is different. A supplier like Anchorage Sand and Gravel sells approximately 70 percent of its production to third parties and uses 30 percent for its internal operations compared to a general contractor, who, for instance, sells approximately 30 percent of his product to third parties and uses 70 percent internally for large construction jobs. The average sales prices calculation for each of those exact same products is different from one supplier to another and from producers. MR. SIMMONS said it just took him more than 18 months and cost more than $50,000 to complete an audit for tax years 2005 and 2006, and the amount of taxes collected were negligible compared to what the state had to do to get them. 5:25:21 PM CO-CHAIR WAGONER thanked him and went to Cheryl Shafer. 5:25:30 PM CHERYL SHAFER, owner, Dibble Creek Rock, Kenai, said she supported SB 176. She said her family runs a small sand and gravel and ready mix business on the Lower Kenai Peninsula. She reiterated what everyone had been saying that the mining tax is burdensome. Because they own a number of pits, she has to file a double mining tax for each piece of property simply because the property is in their family name and she is currently being audited by the DOR for three years of past mining taxes. She only has a two-person office and has spent weeks supplying information and answering questions. It is difficult to separate out the mining activities from the family's integrated activities. More time is actually spent with trying to comply with filing a correct mining tax return than for her filling out her corporate tax return. 5:27:36 PM CO-CHAIR WAGONER added that this is an opportunity that every politician looks forward to - taking something off the books not putting something on the books. He found no further testimony and closed the public hearing. He said SB 176 would be held in committee awaiting the information on rare earth minerals. 5:28:24 PM CO-CHAIR WAGONER, seeing no further business, adjourned the Senate Resources Standing Committee meeting at 5:28 p.m.