Legislature(2007 - 2008)BUTROVICH 205
10/31/2007 09:00 AM Senate JUDICIARY
| Audio | Topic |
|---|---|
| Start | |
| SB2001 | |
| Patrick Galvin, Commissioner, Department of Revenue | |
| Rich Ruggiero and Bob George, Gaffney Cline | |
| Steve Porter and Dan Dickinson, Consultants to the Legislative Budget & Audit Committee | |
| Adjourn |
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
| += | SB2001 | TELECONFERENCED | |
SB 2001-OIL & GAS TAX AMENDMENTS
9:09:19 AM
CHAIR FRENCH announced the consideration of SB 2001. Today the
administration would present the evidence that convinced
Governor Palin to use a net-based system in the proposal called
Alaska's Clear and Equitable Share (ACES). Chair French
acknowledged his skepticism to date about using a net approach.
CHAIR FRENCH welcomed Senator Stevens.
9:10:03 AM
^Patrick Galvin, Commissioner, Department of Revenue
PATRICK GALVIN, Commissioner, Department of Revenue (DOR), gave
a PowerPoint slide presentation comparing gross-based and net-
based production tax systems; a hardcopy version was provided.
Showing showed slide 3, the pros and cons, he emphasized that
gross versus net is a spectrum. Many variations had been
considered.
COMMISSIONER GALVIN told members a gross tax has transparency as
its primary advantage. This is the ease of calculating and
understanding the tax paid to the state, whether a straight
percentage or some variation. Avoiding the consideration of
costs minimizes or eliminates the sense of an auditing or
litigation burden, as well as the risk that the state won't
receive what has been expected. Projections under a gross
system are linked to two variables: price and production. When
cost is added in, however, there is an additional possibility of
erroneous forecasts.
9:14:20 AM
CHAIR FRENCH requested confirmation that Alaska's royalty for
oil is the most purely gross-based tax, being 12 percent of the
Alaska North Slope (ANS) oil produced.
COMMISSIONER GALVIN replied it is the grossest Alaska has, but
it isn't a purely gross-based calculation because transportation
costs are deducted. What costs are appropriate to include are
arrived at through extensive negotiation and litigation.
CHAIR FRENCH suggested this carries a warning, since even with
the simplest tax system there can be enormously complex and
long-running arguments and litigation over a single variable,
the transportation costs.
COMMISSIONER GALVIN agreed, noting there would be further
discussion of the auditing responsibility and how it compares
with what is anticipated under a net-based tax.
SENATOR THERRIAULT requested a chart showing what portion is
allocated to each component, including royalty and property tax,
which are more gross-based. Mentioning his e-mails from people,
he surmised most Alaskans don't understand the oil and gas tax
system and its royalty, property tax, and corporate income tax
components; rather, they believe the entire system for
governmental take is being debated here.
9:17:33 AM
COMMISSIONER GALVIN agreed to provide an existing chart after
his staff brought over an electronic version. He emphasized the
importance of limiting the discussion to the production tax when
discussing net versus gross. Other revenue sources coming from
the oil industry are calculated using different methods.
COMMISSIONER GALVIN returned to slide 3. He said for a gross
tax, positive aspects center on certainty and transparency.
Negative aspects relate to flexibility and whether it will match
the intended economic impact. He highlighted the variety of ANS
fields dealt with nowadays, as well as what is anticipated.
Right now, 70 percent of oil revenue comes from the two major
ANS fields, which have an economic framework related to upfront
costs paid years ago. Despite low operating expenses now, new
money must be invested to keep their production levels up. In
addition, longstanding smaller fields surround those and have
different economic drivers, cost structures, and challenges in
maximizing future production. And prospects being evaluated and
explored for new investment and development have different
economic drivers and hurdles as well.
COMMISSIONER GALVIN explained that when setting a tax policy
across such a wide range, one must understand its impact on
different fields and investment decisions. A gross tax requires
setting certain assumptions about expected margins, price versus
cost. The tax is "one size fits all" but anticipates impacts
based upon the assumptions. It won't allow identifying the
economics of a particular field and applying a tailor-made tax,
because there is too much change and there are too many new
fields; the tax would have to be revisited every year or two,
which isn't good for the state or the industry. With a one-
size-fits-all tax, erring on one side may stifle investment, but
erring on the other side may bring in less revenue than
otherwise fairly expected, given the economic opportunity for
the company. It must be decided where to draw the line.
9:22:40 AM
COMMISSIONER GALVIN turned to the net-based tax, noting it has
the flip side of the aforementioned pros and cons. There is
flexibility with respect to economics, and it is easier to set a
number that brings in revenue and yet doesn't negatively impact
the investment climate. However, it has more moving parts and a
greater burden on the state to audit and challenge the claims of
the companies, along with the uncertainty this provides.
COMMISSIONER GALVIN highlighted the balance between these two.
He explained that the biggest challenge in the evaluation
process was to weigh not-easy-to-quantify aspects against
clearly demonstrated economic impacts. Showing slide 4,
"Balancing Act," he noted the remaining slides demonstrate this
variety of balancing.
COMMISSIONER GALVIN said the first balancing is between revenue
and investment climate. The second is between transparency and
flexibility; for the North Slope in particular, this is weighing
the impact on incumbents who have existing fields and economics,
as well as on potential new entrants who must undertake more
risky ventures in more economically challenged fields.
Furthermore, if a single line is drawn across the fields, it
must be ensured that the expected state revenue comes in from
legacy fields, the highly profitable "bread and butter" fields,
while ensuring that the rate doesn't swamp the economics of the
marginal fields.
CHAIR FRENCH asked which fields are defined as legacy fields.
COMMISSIONER GALVIN answered that he puts "legacy" in quotation
marks because the line can be drawn in different ways. For the
purpose of the gross-tax floor, DOR's definition relates to
economic standing, now and historically. This is Prudhoe Bay
and Kuparuk, with 20 to 30 years of clear, longstanding ability
to produce oil and thus money. The sense of mature incumbent
fields can be expanded, though, to include fields like Milne
Point, Duck Island, and various smaller ones such as Northstar
and Alpine. In response to Chair French, he said Duck Island
and Endicott are different names for the same thing.
COMMISSIONER GALVIN pointed out that although Alpine is probably
one of the most profitable fields on the North Slope, it is
predicted to decline fairly rapidly, after recently reaching its
peak production in its seventh year. Considering it a legacy
field in the same context as Prudhoe Bay and Kuparuk - fields
with 20 to 30 years of production far above Alpine's - isn't
comparing apples to apples.
CHAIR FRENCH asked whether it is fair to say there is no
standard definition of legacy field.
COMMISSIONER GALVIN affirmed that.
CHAIR FRENCH asked what guides DOR in making the call.
COMMISSIONER GALVIN answered that DOR must decide the purpose in
making the distinction. If the purpose is to indicate the field
has paid off all of its initial investment, for instance, the
primary consideration likely will be the length of time and the
relationship between production and associated costs; in that
context, a number of fields have seen 10 to 15 years of
production in the legacy field category.
COMMISSIONER GALVIN noted that if looked at in terms of having a
large margin and a tremendous amount of production, however,
that narrows it significantly - as done under ACES - to just
those two larger fields. Those are wholly distinct from other
fields in terms of volume as well as current level of
production. If DOR looks strictly at profitability, a different
view is taken, and some older fields that have paid off but
aren't making much money now would be eliminated.
9:29:56 AM
COMMISSIONER GALVIN, in response to Chair French, said for Cook
Inlet there is a sense of longevity but not margin. With
respect to production profiles and costs, soon a point will be
reached where expectations of profit and costs will cross over
and companies will need to decide at what point to shut these
down. Some fields have shut down in the last few years. It
isn't just the level of production, length of time, or historic
volumes. Rather, current margins need to be looked at in
conjunction with these other factors to determine which fields
can withstand categorizations, for example, with respect to
having higher taxes on certain types of fields.
CHAIR FRENCH welcomed Representative Doll, noting she'd been
present for some time.
9:31:15 AM
COMMISSIONER GALVIN turned to slide 5, which lists three factors
when evaluating gross versus net: "Audit Risk," Revenue to the
State, and Investment Climate. He explained that he'd used
quotation marks for audit risk because it encompasses a wide
range of perceived risk associated with a net tax. This
includes the perception that taxpayers will be motivated to
either 1) incur costs they'd not otherwise incur, simply because
of the tax deduction; 2) shift costs that they'd otherwise incur
but that aren't directly attributable to Alaskan production,
categorizing it as Alaskan production to get a tax write-off; or
3) blatantly misrepresent their costs.
COMMISSIONER GALVIN said audit risk also entails the perceived
cost associated with having to audit, administer, litigate, and
ultimately defend what the state believes is the appropriate
payment under a tax system that could result in differences of
opinion as to whether a deduction is allowed. Also within audit
risk is the sense of public confidence when there is a direct
line between price and production and the tax bill. If inputs
eventually result in something less than what is perceived as
the normal calculation, by contrast, the public is left
wondering how it happened.
COMMISSIONER GALVIN addressed the second factor, revenue to the
state. He highlighted ensuring the revenue matches the state's
expectation and also is a reliable source, not subject to
factors outside its control or expectations. The third factor,
investment climate, relates to how the tax affects companies'
economic decisions as well as the state's recognized goal of
attracting new investment, both within existing fields and in
new fields that there is a desire to see developed.
9:34:00 AM
COMMISSIONER GALVIN turned to slide 6, "Audit Risk," a bar graph
showing relative risk, moving through the spectrum of pure
gross, gross and exploration credits, gross and capital credits,
PPT - net and capital credits, and pure net. He said there is
additional audit risk as one includes items like exploration
credits for new projects. There must be cost accounting,
relying on companies' reporting and checking to ensure accuracy.
But exploration credits are for new projects that lack operating
expenditures and so forth; DOR must isolate components and
approve expenditures if they're associated with the particular
project.
COMMISSIONER GALVIN said a gross-based tax with capital credits
provides additional complexity and perceived audit risk; capital
credits are commingled with operating expenditures and other
costs, and the audit must ensure these are kept apart and
properly characterized. When operating expenditures are added
as a deduction, there is even further risk and complexity.
COMMISSIONER GALVIN pointed out for PPT - the current system
called the petroleum production tax or petroleum profits tax -
there is extra value for capital expenditures. Thus the
distinction of whether something is an operating or capital
expense has value. The complexity is higher than either the
previous category or a pure net system under which all costs are
deductible and treated the same. The purpose of the slide is to
show that once one accepts the economic need to include capital
credit deductions, one also accepts a tremendous amount of
perceived audit risk. They are fairly equivalent. He
emphasized the importance of this in the rest of the balancing.
9:37:41 AM
CHAIR FRENCH gave his understanding that the basic structure of
PPT, enacted a year ago, is kept intact by ACES.
COMMISSIONER GALVIN affirmed that.
CHAIR FRENCH observed that of the tax systems presented, this is
the most complex to audit.
COMMISSIONER GALVIN concurred.
CHAIR FRENCH asked about DOR's auditors, including their
strengths, weaknesses, and numbers.
COMMISSIONER GALVIN indicated the auditors are a subject of this
current legislation. He said DOR has a group of auditors who
are highly qualified and whose primary experience has been with
past state audits.
CHAIR FRENCH surmised that was under the old economic limit
factor (ELF) system.
COMMISSIONER GALVIN affirmed that, noting the ELF system was
based upon the deduction for transportation costs. Thus there
is experience with transportation-cost elements, not just the
pipeline tariffs, but also primarily the shipping costs,
determining the proper costs to deduct with respect to self-
owned tankers as they're repurchased, refurbished, rented, and
so forth. That is primarily the auditing experience of the oil
and gas auditors. Within the last year, there have been new
hires following a nationwide recruitment effort. Targeted were
highly experienced oil and gas auditors, the "lieutenants"
within their companies' accounting departments who knew how the
systems worked, understood reasons and motivations, and had more
than day-to-day experience with what came across their desks.
9:40:51 AM
CHAIR FRENCH asked how many auditors were sought.
COMMISSIONER GALVIN estimated eight to ten new auditors within a
range of experience, from an Auditor III through and Auditor IV
and bringing in some lower-end Auditor Techs. There are perhaps
eight to ten existing auditors.
CHAIR FRENCH noted this doubles the number of auditors.
COMMISSIONER GALVIN affirmed that.
CHAIR FRENCH asked how many applications were received.
COMMISSIONER GALVIN said he didn't have that with him, but could
provide a report on the recruitment experience. In summary,
though, the department didn't get applications from the upper-
echelon auditors it sought who could create the system under the
new tax, train others, and provide leadership to efficiently
direct the audits. Within the auditing world, as elsewhere,
there is the opportunity to get sidetracked and not get the
biggest bang for the buck. Thus he is looking for folks with
the experience and judgment to direct those efforts and achieve
efficiency. The state won't be able to match the companies
auditor for auditor or dollar for dollar. So it must maximize
the return on its auditing investment.
9:42:25 AM
CHAIR FRENCH asked whether the state has finished auditing all
ELF-based tax returns.
COMMISSIONER GALVIN replied there still are a couple of years
left. One was for 2003, and there are a few for 2004 and 2005.
Then it gets into PPT-based returns. The PPT auditing cycle is
in the phase where the companies have reported back to the state
as to what they've worked out between the various partners in
preparation for their federal tax returns for the last calendar
year. With that information, the state can begin to dig into
the returns and reports, and then can formulate its auditing
strategy and communication with the companies.
COMMISSIONER GALVIN added that there have been continual
discussions with the companies in order to acquire information
needed to better understand how the system is working, and to
get a jumpstart on understanding the nature of the deductions
and so forth. That is somewhat a parallel track to the official
audit. The state is just now reaching the point of having all
the information it can get to begin the process, and is looking
at a two-year process, at minimum, to go through the PPT
auditing. Then, if there are continuing disputes, it will go
through the administrative appeal process.
9:45:56 AM
SENATOR McGUIRE recalled that promises were made in 2006 about
the ability to recruit and retain, but the state isn't that much
closer to its goal. She asked whether this is an achievable
goal and whether such professionals will want to leave positions
with private companies to work for the state. If not, she
suggested it is perhaps a question of looking at the possible
and not the perfect for now.
COMMISSIONER GALVIN agreed, but said a year ago, when PPT was
being discussed and the state was looking at moving into this
whole new venture, he believes the context was different. The
previous administration had an overlapping relationship with the
producers through negotiation of the gas line contract. It was
expected that PPT would be part of the contract, there would be
an arbitration process rather than involving the courts, and it
would be more of a partnership. He opined that the previous
administration undersold the expectation with respect to the
department in terms of taking on this responsibility.
COMMISSIONER GALVIN indicated he and Governor Palin initially
were skeptical of this tax system, the state's ability to
implement it, and whether it would ultimately be in the state's
interest. They'd made obtaining the auditors a priority.
They'd tried to identify whether the intangibles of working for
the state in public service would suffice to overcome the
significant gap between what the state could offer and what
could be obtained in the private sector. They'd found the
answer to be no. And so they'd tried to shrink the gap.
COMMISSIONER GALVIN addressed whether a handful of new auditors
can fill this need. Reflecting on his work for the state,
particularly on the oil and gas side, he observed that a handful
of highly capable, creative, dedicated state employees can do a
whole lot. They can use the existing system to accomplish
things that would be much more difficult if there were more
people, and they can overcome many of these hurdles. He opined
that if these lieutenants can be brought in who understand the
picture from both sides, they can meet that responsibility, even
with a small group of auditors. But first he needs to find them
and get the right tools. Citing the value this will create for
the state, he emphasized accepting the burden that comes with a
net-based system. Unless the department can hire these folks,
the system won't work.
9:53:52 AM
SENATOR WIELECHOWSKI noted there has been one deduction, the
tariffs, with costly and time-consuming litigation on that issue
for more than a decade. Now there will be a new system with
perhaps hundreds of deductions. He expressed concern based on
that past experience.
COMMISSIONER GALVIN replied by showing slide 7, "'Audit Risk,'
How Do You Measure It?" He said one way to measure audit risk
is to look at Alaska's experience, primarily royalty-related
auditing and calculations of the appropriate value to place on
oil that is sold, as well as the transportation deductions. The
question becomes whether the decades-long arbitrations and
litigation over royalty disputes will be replicated or
multiplied when dealing with a complex net-based tax. The
administration's analysis has indicated the answer is no.
COMMISSIONER GALVIN explained that a royalty dispute is based
upon contract law and two parties interpreting a contract that
they've mutually agreed to. The stakes increase as it moves
through the process, resulting in endless litigation. By
contrast, tax law is imposed by the sovereign entity,
interpreted by that entity, and ultimately decided by the courts
as to whether the agency has properly exercised its discretion.
9:57:44 AM
CHAIR FRENCH noted Marcia Davis, DOR deputy commissioner, would
speak tomorrow about the differences in the litigation outcomes
for contrast disputes versus more sovereign-oriented tax
disputes. Saying royalty strikes him as the most sovereign and
powerful tax on the oil field, he asked: Why were those long-
running disputes not more like a tax, where the state has the
power and the advantages?
COMMISSIONER GALVIN answered that within the system it was
decided that royalty would be established through a lease
offered in a competitive sale. The parties that accepted those
entered into a contract with the state over development of the
resource. Through that mechanism, the state shared the risk
associated with the initial investment and, ultimately, who
would get the reward if there was success.
CHAIR FRENCH surmised the tax terms aren't set by the lease.
The legislature is currently trying to change those terms.
COMMISSIONER GALVIN concurred. He said royalty income primarily
relates to leases from the initial wave of leases in the late
1960s and early 1970s. There was a line about how the royalty
would be calculated, and that sentence was the seed for all the
litigation that followed. It didn't itemize what would be
deductible, and it didn't talk about what was in or out, or how
to calculate the value. Rather, it stated what percentage of
wellhead value would be paid. The contract dispute arose over
how to calculate that.
10:00:12 AM
COMMISSIONER GALVIN continued, saying taxes are a different
world. Spencer Hosie, a San Francisco attorney that the state
often uses in disputes, had been asked to provide his sense of
the prospect for prolonged tax disputes, particularly given his
experience as a litigator in the royalty disputes. Mr. Hosie
had provided a short memo that the administration distributed to
legislators. It gave his view that tax is not royalty; when
looking at a tax dispute, the agency has authority to set the
timeframe for the administrative appeal and to demand production
of required information. Mr. Hosie had opined that the
timeframe to resolve a dispute would be about two years.
SENATOR HUGGINS observed that some, including Governor Palin,
Commissioner Irwin, and Commissioner Galvin, no longer believe a
gross-based tax is the answer; however, some haven't changed
their minds. Highlighting the proposed extension of auditing
time from three years to six years, he asked: Is hiring more
auditors with the appropriate credentials an alternative, rather
than doubling the current auditing timeframe?
10:03:16 AM
COMMISSIONER GALVIN replied the recommendation to go from three
years to six was as much a product of the way the audit process
revolves around the clarification of information outside the PPT
system. This includes the timeframe for federal income tax
discussions and potential disputes among partners to resolve
themselves. No matter how many PPT auditors there are, those
have their own timelines.
COMMISSIONER GALVIN assured members that the department won't be
deadline-driven in structuring audits. The state and the
industry will want to settle issues and move on. The change
from three years to six clearly is a jump; it recognizes this
area that the state cannot control, and it provides time to get
the work done. While six years isn't mandatory, he highlighted
wanting to avoid the negative implications of having a statute-
of-limitations deadline show up while the state is still working
on an audit. Providing enough time is beneficial. But would
four years be acceptable? He said it is a judgment call.
10:05:52 AM
SENATOR HUGGINS recalled hearing that the agreement to extend
the process was relatively easy to come by and was a common
practice; producers wouldn't want to fight a mutual extension
because the state has the judgment power within its toolbox. He
requested clarification about this.
COMMISSIONER GALVIN noted Jonathan Iversen, director of DOR's
Tax Division, had testified about differences among taxpayers.
Most view it as mutually beneficial to work on an extension so
the issue doesn't have to be brought to a head before the two
parties are in a position to resolve it; usually some extension
will be worked out. However, some taxpayers won't agree, and
then the state must decide how much is at stake and then move to
a formal dispute resolution. The balance here is strictly a
matter of whether that is an appropriate situation to put the
state in or whether time should be allowed to resolve those
issues, recognizing the state will be diligent in its efforts.
10:08:14 AM
SENATOR THERRIAULT remarked that, based on yesterday's
discussion and the impact of the transportation expense, he
believes part of what has been suffered for the past 20 years is
a bad agreement that the state got into with respect to tariffs.
Indicating it isn't over yet, he said it was a bad deal.
SENATOR WIELECHOWSKI asked whether DOR has an assumption about
litigation costs under a net system versus a gross system.
COMMISSIONER GALVIN answered no, primarily because it is so
early in the process. Furthermore, some of the lawyers don't
necessarily see it as adding a significantly greater burden. He
surmised the Department of Law (DOL) would need some experience
with it before determining whether it would result in an
additional burden for that department.
SENATOR WIELECHOWSKI asked how the standard of "ordinary and
necessary" will be determined across the entire range of
possible expenses for all types of companies, fields, and
technologies.
COMMISSIONER GALVIN replied that's a good question. It is one
reason the language that allows the department, through
regulation, to define what is an allowable expense is so
valuable for the state, providing a tool to have a public
process to identify those cuts. When looking at the types of
deductions appropriate for companies to take as an ordinary and
necessary expense of production, DOR believes this should be
done through the regulatory process, rather than on an
individual taxpayer basis through dispute resolution.
10:11:15 AM
SENATOR McGUIRE remarked this is another area about which people
are skeptical. Commissioners change over time. And it isn't
known who the future regulation writers will be; they aren't
held up for reelection or subject to public scrutiny like
legislators are. She requested assurance that the regulation-
writing authority would be subject to checks and balances.
COMMISSIONER GALVIN responded that one choice is that the
statute lays out a fairly broad definition of what is allowable
and has the department make that determination tax return by tax
return. The proposed alternative is that those are determined
through regulations. While it is perceived as a granting of
authority to the department when compared with the first option,
he believes it is the opposite.
COMMISSIONER GALVIN explained that if all the decisions occur in
the context of a confidential determination between the
department and a taxpayer, that grants much greater authority
and discretion to the commissioner than if that same distinction
is made in a public process and then written into regulations,
which the legislature will have every opportunity to review and
force changes about. That ability is taken away from the
legislature if the decisions are made at a tax-return level.
SENATOR McGUIRE agreed the proposal is an improvement, but
clarified that she'd like lease expenditures and operating costs
that can be written off to be put into statute. She expressed
concern about wiggle room, saying she recognizes the difficulty
but wants to be able to tell people, years later, that
legislators were aware of the trade-off and felt it was
important.
COMMISSIONER GALVIN suggested in a perfect world that could
happen. But the department will put in what is allowable as a
sort of proxy for the legislature, going through the public
process and evaluation. The legislature then will have an
opportunity to revisit it within a year or two, as an extension
of this process.
10:16:43 AM
SENATOR THERRIAULT recalled past concern that power given to a
commissioner may someday pass to a madman who would run amok.
He pointed out that legislation passed a couple of years ago
requires that the legislature's legal department receive a copy
of proposed regulations earlier in the process so it can raise a
red flag for policymakers if something seems off-track.
Furthermore, regulations can be enshrined in statute once the
proper balance seems to have been struck. While the department
might believe it would strip flexibility needed to keep the
regulations workable over a long period of time, it is a step
the legislature can take.
AN UNIDENTIFIED SPEAKER said that was a good point.
10:18:08 AM
CHAIR FRENCH referred to earlier remarks about the backlog of
audits under the ELF system. He asked whether one or two audits
remained from 2003.
COMMISSIONER GALVIN replied he believed there was one.
CHAIR FRENCH said that gives some guidance as to how long the
statute of limitations needs to be, given it is nearly five
years later and that was a simpler form of taxation. He
requested an estimate of the time to complete a PPT audit.
COMMISSIONER GALVIN relayed what his staff had told him, saying
there is probably a two-year process from this point forward to
establish the administrative record of the audit. If there
continues to be a dispute, the administrative appeal process
begins. First there is an informal appeal process. One of his
staff reviews the record, analyzes the state's position, works
with the taxpayer to identify areas that can be resolved easily,
and tries to negotiate an informal settlement. If that is
unsuccessful, it moves to a form appeal process. An appeal
officer is assigned. The equivalent of an administrative law
judge holds a proceeding that has the state and the taxpayer
provide their respective testimony. Then a decision is made.
CHAIR FRENCH asked whether that takes place in the state office
of tax appeals.
COMMISSIONER GALVIN answered that it is one component of the
administrative appeals office. If the dispute continues, from
there it moves towards a judicial appeal. The timeframe for
getting through that process is potentially another two years.
10:22:09 AM
CHAIR FRENCH asked whether it can take two years to complete a
full audit of a PPT or ACES tax return, and there can be a two-
year process after that before there is a final conclusion
through the department and the administrative law judge,
followed by court. Or does the two years include the court
time? He recalled that Mr. Hosie had said it takes about two
years for a tax dispute.
COMMISSIONER GALVIN said he believed Mr. Hosie meant from the
beginning of the administrative appeal through the court
process.
CHAIR FRENCH deferred the discussion until tomorrow, when
Ms. Davis would review Mr. Hosie's memo.
SENATOR WIELECHOWSKI asked whether the department had decided
what its hurdles or triggers would be for auditing.
COMMISSIONER GALVIN replied he hadn't been briefed on it and
believed they were still in the process of formulating the audit
strategy and gathering information to analyze. Just now they're
receiving a full record of what the taxpayers are providing
after they've gone through their partnership billing and
auditing process and preparation of their federal tax returns.
SENATOR WIELECHOWSKI surmised there are numerous strategies that
a commissioner or auditors could take.
COMMISSIONER GALVIN concurred. He said that's why he depends on
the expectation of bringing in folks who understand not only the
state's need, but also the intricacies of the companies'
accounting. They'll need to assess where to target for the
biggest bang for the buck in going after the cost structure or
identifying a particular report, for instance, that is the meat
of what the auditors ultimately will pursue.
10:24:52 AM
SENATOR WIELECHOWSKI asked what recourse a company would have if
it wasn't allowed to deduct an expense when another company was
allowed to deduct a similar type of expense.
COMMISSIONER GALVIN answered that given the confidential nature
with respect to the taxpayer, they wouldn't necessarily know.
It is incumbent upon the agency to apply the rules evenly.
SENATOR THERRIAULT suggested this gets more to the court review
of whether the sovereign entity is imposing its powers in a fair
and not arbitrary fashion. If there were disparate treatment
among taxpayers, that would trigger it.
SENATOR WIELECHOWSKI asked how a company that wants to come to
Alaska would find out which are reasonable costs to deduct from
its revenue in the next year or so.
COMMISSIONER GALVIN responded that part of it will be getting
clear regulations out. Also, ACES authorizes the agency to
provide guidance documents that clarify how the department would
interpret certain areas where regulations don't go into adequate
detail. Beyond that, he opined that in the broader range,
companies will understand what is captured and what isn't. The
regulations will address finer points not necessarily considered
by a company in deciding whether to come to Alaska.
The committee took an at-ease from 10:27:23 AM to 10:44:15 AM.
COMMISSIONER GALVIN showed slide 7, the final slide on "Audit
Risk." He emphasized that consultants have said there are no
other gross-based systems around the world. However, the
opposite is true within the United States. In other US states,
the resource is primarily privately owned or, in the Gulf of
Mexico, federally owned. The resource is taxed as just another
commodity produced within those states, and there is a severance
tax - as opposed to a property tax - that reflects the historic
evolution of US tax policy, which generally has been based upon
a gross-value calculation; this is fairly low and generally not
a significant part of the states' revenue streams. Also, they
are dealing with a resource base generally lower than Alaska's.
Thus other states in the US aren't used for comparison purposes.
COMMISSIONER GALVIN referred to testimony in other committees.
He pointed out that in order to make an apples-to-apples
comparison, oil provinces around the world are looked at which
have similar resources and opportunities. They all use a net
system. As for how they are dealing with audit risk - the sense
of exposure to potential manipulation - he'd been informed that
none had gone to a net approach and then ultimately changed to a
gross approach because of such concern. The net systems remain,
although various consultants have said there is a learning curve
for how to implement this properly.
10:48:33 AM
COMMISSIONER GALVIN recalled that legislative consultant Daniel
Johnston, among others, said Alaska could similarly deal with a
net system. It is common, standard, and doable. Noting people
distrust such a system, however, Commissioner Galvin said this
relates to not only the taxes, but also the companies. It is a
big component in the current public preference for having a
gross-based tax.
COMMISSIONER GALVIN said the state must ensure that DOR has the
necessary tools and must make the system as transparent as
possible. What is needed is to get past the current stage,
moving to a new relationship with the companies wherein the
state has information, can say it knows how the system is
working, and can express it to the public. Thus ACES is
intended to provide the tools needed to mitigate some of these
real and perceived risks.
SENATOR HUGGINS asked Commissioner Galvin to review those tools.
COMMISSIONER GALVIN replied they are in three major categories:
people, information, and clear rules. Under people, the change
with respect to the auditors is the primary one. Under
information, tools are: 1) the requirement in ACES that
companies provide current, timely, and useful information and
also forward-looking information about expected expenditures,
which will help the state understand how the system is working
now and what can be expected in the near future; 2) the sharing
between the departments so the state has full use of the
information; and 3) the public disclosure of some information so
there is a sense of transparency and public confidence. Under
clear rules, the state will define what costs are deductible and
clarify what items are excluded, such as improper maintenance or
costs for dismantling, removal and restoration (DR&R).
SENATOR HUGGINS surmised those tools are in the legislation.
COMMISSIONER GALVIN said yes, for the most part.
10:53:01 AM
COMMISSIONER GALVIN turned to slide 8, "Revenue to the State,"
noting this relates to expectations based upon known factors.
Within DOR there is a fairly extensive model of different
building blocks for calculating expected taxes, with assumptions
for production levels, prices, and costs. Accurate depiction
requires breaking it down by field and taxpayer, separating
potential operating expenditures from capital expenditures and
so forth. That is built into the model to enable an apples-to-
apples comparison. This model is a critical tool for analysis.
COMMISSIONER GALVIN indicated variables can be adjusted to
achieve a certain amount of dollars over the next five years,
for any type of tax. The goal is to set these "knobs" so
comparisons are calibrated to each other. The other part of the
revenue picture is how durable and reliable this revenue stream
is if cost assumptions or other assumptions prove inaccurate.
If cost assumptions are off by 5 percent, one amount will rise a
little while the other will rise a whole lot. Thus one
evaluation criterion is the sensitivity that these tax systems
will have to being off in some respect.
10:56:37 AM
CHAIR FRENCH requested discussion of cost, another major concern
with a net-based system. He surmised DOR's August 2007 PPT
implementation report was the first clue to the public that
costs were substantially higher in reality than those envisioned
a year ago.
COMMISSIONER GALVIN replied it was the second clue. The first
was in April, when DOR received the true-up payment, which was
less than expected. Reports came back, and DOR was looking at
operating expenditures in 2006 that were 50 percent more than
anticipated. The effect was dampened, however, because capital
expenditures were below what DOR expected. The spring forecast
and what ultimately came out in the August report reflected
discussions with the companies in terms of what could be
expected for those numbers. In further reply, he indicated
those discussions were in 2007 following the April payments,
before DOR put out its spring forecast, and from the spring
forecast until the August report.
CHAIR FRENCH asked how much of the information used to compile
the original fiscal notes in 2006 came from the producers.
COMMISSIONER GALVIN answered that, in the end, he believed it
was all relying upon information from the producers. The folks
who put those together had indicated they had certain cost
information provided from the 2004 timeframe, actual reports of
costs; those were extrapolated, expanded, and turned into
projected draft numbers that were then brought back to the
companies for input as to their accuracy. That was what was
ultimately used. In further response, he said it was 2004 data
moved forward, reflecting what DOR believed the data for 2006
would be, considering rising costs and so forth.
CHAIR FRENCH asked, then, whether DOR was taking the producers'
2004 numbers, updating them for 2006, and building a fiscal note
on that basis.
COMMISSIONER GALVIN affirmed that.
11:00:19 AM
COMMISSIONER GALVIN, responding to Senator Therriault as to what
went wrong with the predictions, said as far as the fiscal note
it was a combination of two factors: 1) the numbers intended to
reflect actual 2006 costs were significantly wrong, and 2) as
they were used to predict revenue over five or ten years, there
wasn't an appropriate escalation included to reflect the
experience of rising costs. Combined, these had a multiplying
effect, getting worse as the numbers were projected forward.
CHAIR FRENCH remarked that this is why gross versus net is being
debated today. He opined that this is an area where a gross-
based tax could gain a huge advantage, compared with the
100 percent underestimation of costs a year ago. If one
believes a tax should be put in place and then left alone for a
long time, it is a great concern with a net-profit system. He
suggested Alaska would indeed have an unstable tax regime if yet
another set of rules had to be implemented after another year.
He requested further discussion about this today.
11:03:20 AM
COMMISSIONER GALVIN replied the aforementioned is one aspect -
focused on the revenue side - of the effect of being off on the
assumptions. As the first slide showed, being off on the
assumptions affects revenue. A gross tax gives a more
predictable revenue stream. The flip side, however, by being so
far off on the cost assessment, is a much more significant
burden on the investment climate than intended. Mentioning
government take versus what the companies get, he said this is
used as a tool to see how Alaska compares with other places in
the world.
COMMISSIONER GALVIN continued. He said as a reflection of this
tradeoff, if a gross tax is pegged at a certain expectation of
take - say, 68 or 69 percent - and then costs are double those
in the assumption, now the government take is in the mid-70
percent range. But that isn't the intention. In that scenario,
prices could go up 20, 30, or 40 percent and yet the tax would
be higher than intended. This relates also to durability.
Whether one chooses a net or gross system, if costs are poorly
projected the tax won't be what is expected. He mentioned
balancing revenue versus investment.
CHAIR FRENCH asked, then, whether the state gets the tax it
expects under a gross system, but throws the investment climate
off, which may have tax implications down the road.
COMMISSIONER GALVIN affirmed that.
CHAIR FRENCH surmised what follows after a year with respect to
the expected tax may depend on variables.
11:06:13 AM
SENATOR HUGGINS recalled that data provided by Dan Dickinson
indicated the PPT projection for the 2006-2007 timeframe was off
by just under 10 percent; he mentioned a minus-8 percent
variance. However, other taxes for alcohol and so forth were
off by 52 or 53 percent. He suggested the projections are just
guesstimates. It isn't a perfect science. No matter how good
the people are, there will be some variance. In context, the
PPT portion was very accurate. He asked whether Commissioner
Galvin disagreed.
COMMISSIONER GALVIN said it is a reflection of how these numbers
merge and are then used to make different points. Noting DOR
had looked at the perceived difference between what was expected
and what came in, with price and production held constant, he
said the answer was $800 million for FY 2008. It is true,
however, that when the extra variable of cost is added in, it
will affect the outcome if this number proves wrong.
SENATOR HUGGINS, in response to Chair French, clarified that
he'd been talking about the track record for 2006 or 2007 or
perhaps both in aggregate. His point was that it appears to be
a guesstimate.
COMMISSIONER GALVIN responded that Alaska is a resource
development state. When commodity prices are high, the state
expects to receive more. In FY 2007, commodity prices were high
for minerals and for oil and gas. The state got more in mineral
taxes and corporate income taxes, but not petroleum taxes. The
reason was a wrong cost assumption. Normally, given the
dramatic increase in price, the state would expect to receive a
lot more than otherwise. The distinction between 2006-2007 and
2007 forward is this: 2006 wasn't a forecast error. It was an
error in an assumption about reality, what was happening in that
timeframe. With respect to forecasting now, a direct
correlation cannot be drawn between the fact that DOR was off by
100 percent then and the future situation.
11:10:48 AM
COMMISSIONER GALVIN highlighted the learning curve with a new
net tax. The companies will be learning as well, making first
reports and making a call as to whether the state will include
certain costs. Most likely, they'll maximize potential
deductions. Thus DOR will identify where the companies draw the
line for what they believe their starting point should be.
COMMISSIONER GALVIN said as the state bases its tax system on
these assumptions going forward and goes through the auditing
process, most likely DOR will eventually bring in more money
that it otherwise would have expected. In the end, the industry
can expect that this is the direction the system will move, can
respond accordingly in these hearings about where they believe
the actual numbers will end up, and then can base their
expectations on that.
CHAIR FRENCH welcomed Representative Gara, noting he'd been
present for some time. He again acknowledged Senator Stevens.
11:12:13 AM
SENATOR McGUIRE requested assurance that if ACES passes and
regulations are set, at some point the collected data would be
revealed, along with whether the state's assumptions themselves
were inaccurate. One can look at whether the cost of labor or
building materials is increasing statewide, and by what factor.
She said the cost of steel has risen, but not more for the oil
and gas industry than anyone else. She surmised such basic
information went into the cost assumptions in the fiscal note.
SENATOR McGUIRE explained that she didn't want to impugn anyone,
but wanted to know if increased costs factored in to companies'
deductions were based on gold plating, stockpiling, or otherwise
gaming the system. People may think differently in business,
and the goal is to minimize the tax. She wanted to know if the
assumptions themselves were wrong or whether it was how they
were interpreted and applied by the companies and, if so,
whether there could be any assurance that this could be changed.
11:14:33 AM
COMMISSIONER GALVIN agreed the state should know that. He said
through the auditing process what will ultimately be identified,
after the two-year cycle, is how much of the reported costs the
state disputes. That will bring it back to a number the state
believes appropriate for reported costs. That then can be
compared against the state's assumptions. Until then, it won't
be known whether this is a primary factor or a small one.
SENATOR McGUIRE expressed hope that DOR would hire or retain the
best economists possible to look at not only what the costs
generally are in Alaska, but also what they are within the
industry, including in Alberta, Canada, between 2006 and 2007.
COMMISSIONER GALVIN voiced hope that as the administration
evaluates how to deal with the overarching issue of recruitment
and retention, a solution will be found. Hiring top folks in
the field will come down to competitive advantage and so forth.
The state has good economists assisting with this work. While
surmising the state could provide a level of what Senator
McGuire was asking for, given the current capacity, he said the
next level up would require something more.
SENATOR WIELECHOWSKI referred to Senator Huggins' remarks and
recalled a chart showing percentages where the revenues were off
for cigarettes, alcohol, and the Division of Motor Vehicles
(DMV). He suggested the department seriously underestimated how
much Alaskans like to smoke, drink, and drive.
11:17:47 AM
CHAIR FRENCH recalled when the PPT implementation status report
came out in August, he was surprised at its frankness. It was a
fairly strong warning about struggles the state will have in
implementing a profits-based system. At the time he'd debated
Representative Samuels on public radio about a net versus gross
system, drawing most of his points from this report. Those same
difficulties are being discussed today: forecasting,
regulations, and auditing. The report said the department
lacked future information for capital and operating
expenditures. He asked whether DOR now has better information
in this regard.
COMMISSIONER GALVIN indicated DOR has some, but not nearly
enough. There has been a continual effort to get information
from the companies. Without the clear authority to demand
particular information, however, it is an ongoing and time-
consuming exchange.
CHAIR FRENCH observed that ACES has sections that deal with
information and has $1,000-a-day penalties for not complying
with requests. He asked if that will help DOR get the data.
COMMISSIONER GALVIN replied yes, very much so. Those are
essential.
11:20:19 AM
COMMISSIONER GALVIN turned to slide 9, "Revenue vs. Investment."
The first of four "pennant" graphs, it had a small band at the
bottom labeled "Low Gross Tax." He explained that when he looks
at balancing revenue generation and protecting the investment
climate, the hurdle that can't be overcome with a gross-based
tax is this: If there is a certain revenue expectation, how can
the state ensure the income can be collected without negatively
affecting the economics of a particular project? As the
administration gleaned information on a variety of different
fields, these graphs had come to mind. He asked members to
imagine that each field has an economic profile, with a certain
exposure and sensitivity. The longer pennants are for fields
with more sensitivity to having their economic picture impacted.
CHAIR FRENCH surmised this would be either higher cost or less
volume, for instance.
COMMISSIONER GALVIN agreed. He said when one is trying to bring
in revenue, some aspect of the lower band on the chart is filled
up. With a gross tax, it is a very blunt tool; whether it is
cranked up to bring in more money or lowered, that line remains
straight across the horizon.
COMMISSIONER GALVIN showed slide 10, with a thicker lower band
labeled "Medium Gross Tax," noting it depicts pennant "Y" as no
longer being a viable project, since the tax has risen. Showing
slide 11, with an even thicker band labeled "High Gross Tax," he
said this impacts even more projects; they'd no longer look
favorable to a company and thus some projects would be lost.
The administration didn't want to make that trade-off.
11:24:33 AM
SENATOR McGUIRE asked why a system that allows credit deductions
wouldn't help compensate for this problem.
COMMISSIONER GALVIN responded with slide 12, the final slide on
revenue versus investment. Its lower section was labeled "High
Net Tax" and was shown as peaks and valleys correlating to the
contours of the pennants, rather than a solid band.
COMMISSIONER GALVIN explained that with a net tax, the effect
reflects the economics of the projects themselves. When looking
at the economic models, one can set rates to bring in the money,
but do it so it buffers and protects the economics of the
various projects. He said Senator McGuire had brought up a good
point. As shown on a previous slide, a gross tax that includes
capital credits would be similar to this type of approach, but
wouldn't follow the contours of these pennants.
COMMISSIONER GALVIN suggested thinking of a "root" within these
pennants that reflects the capital expenditure portion, separate
from ongoing operating expenditures. Those lines that would
come about because of the gross would reflect that root, not the
actual entire pennant. To the extent that a particular project
had a different relationship between capital expenditures and
operating expenditures, in terms of economic impact the gross
tax would affect it differently than another project with a
different capital component. He said this gives a sense of the
difference in the ability to raise revenue while not clearly and
empirically affecting the economics of particular projects.
11:27:09 AM
COMMISSIONER GALVIN turned to slide 13, "Investment Climate -
Tests," which had two major bullets: "New Fields (7 Field
Models)" and "'Legacy' Fields." He said this reflects the type
of analysis required for the state to better understand that
relationship. When expertise on particular projects is brought
in from the Department of Natural Resources (DNR), Division of
Oil & Gas, a much clearer picture can be obtained of how
different tax options affect those project economics.
COMMISSIONER GALVIN said there are actual project data,
projected capital costs and operating costs, and also production
profiles such as whether oil will be produced quickly or will
slowly rise and then diminish over time. Based upon price
assumptions, those are used to view the economic picture for a
project under one tax system or another.
COMMISSIONER GALVIN elaborated. From that multiple-field model
the state would run the different taxes, looking at revenue and
options for protecting these fields; he mentioned investment
expectations. Economic analyses including net present value
(NPV), internal rates of return, and the probability index would
be run at various prices to see the sensitivity to price
changes. They'd also be run at different discount rates,
reflecting various companies' expectations of their own rates of
return and what would generally be used as an investment metric.
The different tax systems would be compared against those.
COMMISSIONER GALVIN noted the sensitivity of these taxes to
changes in assumptions also would be looked at. Either the
projects themselves would experience different costs and
different cost assumptions would be built in, or else there
would be an analogous project, also on the threshold, that would
have a slightly different cost profile. Indicating the
administration isn't wedded to these seven field models, he
surmised others would come in.
11:30:15 AM
COMMISSIONER GALVIN added this took a lot of time, including
work between the departments to ensure the seven field models
accurately reflected how the tax system would work within a
particular field's cash flow. Also, as the different tax types
were run and various "knobs" were adjusted over and over, they'd
gained insight into which knobs were affecting what and had
winnowed down the options.
SENATOR WIELECHOWSKI asked if the three big producers currently
are reinvesting in the legacy fields.
COMMISSIONER GALVIN replied yes, through their operator. The
operator is making the investments, and they're paying their
share of the costs.
SENATOR WIELECHOWSKI recalled reading in the Anchorage Daily
News that Exxon hadn't done further exploration on the North
Slope since 2000.
COMMISSIONER GALVIN said this relates to two different
standards. As to whether the big three are reinvesting, they
are putting money in. Exxon is doing it through BP and
ConocoPhillips. BP is doing the work at Prudhoe Bay, and
ConocoPhillips is doing the work at Kuparuk. Exxon is paying
the bills for its percentage of that ownership. But Exxon isn't
doing anything outside its ownership of those fields. In
further response, he said Exxon hasn't been doing any
exploration in Alaska since, to his belief, earlier than 2000.
SENATOR WIELECHOWSKI asked if it is accurate to say the fields
Exxon has leased are being explored by ConocoPhillips and BP.
COMMISSIONER GALVIN clarified that he wouldn't characterize the
work within Prudhoe Bay or Kuparuk as exploration. They're
enhancing development of those fields, not looking for new oil.
They know where the oil is. They're just determining how to
produce it. And they're putting money into enhancing production
of existing pockets of oil that are available and also looking
at ways to bring into production other pockets that currently
aren't because of primarily technical or economic hurdles.
CHAIR FRENCH summarized that Exxon isn't an explorer, but is an
investor.
COMMISSIONER GALVIN agreed. He said of the three, he believes
the only explorer is ConocoPhillips right now.
11:33:48 AM
COMMISSIONER GALVIN returned to slide 13, addressing the bullet
on legacy fields that read, "Reinvestment Option analysis 3%,
6%, and 15% decline scenarios." He said in addition to the
seven fields looked at, for which there was solid data, they'd
also sought a way to evaluate reinvestment opportunities in
legacy fields. For those, there isn't data or methodology
similar to the seven field models, which allowed looking at
reinvestment for decision making. But they took a rough cut and
looked at information provided by the companies, both a year ago
and as enhanced this year. This allowed looking at companies'
investment decision making, relative to the level of investment
necessary to stem the decline curve by a certain amount, so it
would give a certain amount of production. The question is how
the different tax types would relate to that.
11:34:39 AM
COMMISSIONER GALVIN turned to slide 14, "New Field Tax Analysis
- NPV Impact." He said this is one representation of the
voluminous data generated during the seven-field analysis. It
shows one level of the net present value analysis, how it
compares against the different types of net and gross tax types,
and the relative impact on the "attractiveness" at these
particular variable choices.
CHAIR FRENCH asked Commissioner Galvin to go through the
assumptions shown under the net production tax scenarios.
COMMISSIONER GALVIN said it starts with NPV impact. It
represents taking the cash flows associated with a certain
investment, bringing them all back to today's dollars, and
asking whether it is a positive or negative, given a certain
expected return. In this particular instance, there is a
10 percent discount rate. If it is assumed one wants to get
10 percent out of one's money, just getting that 10 percent
would be an NPV of zero - breaking even at 10 percent.
CHAIR FRENCH asked whether the only field shown that would break
even is Field D, at a high net tax of 35 percent.
COMMISSIONER GALVIN said yes. It basically results in a cash-
flow return equivalent to a 10 percent rate of return. In
further reply, he said most investors in the oil and gas
industry probably want a rate of return higher than 10 percent.
This is a fairly conservative discount rate for this evaluation.
Most likely, it would be closer to 15 percent. A company looks
at the NPV in terms of whether the investment will actually grow
the business. With an NPV of zero, the answer is "no" unless
other factors will drive them to that. It's treading water.
Based on pure economics, the option won't be acted on.
11:37:41 AM
CHAIR FRENCH referred to Field D, where the chart shows "10" for
the "PPT Status Quo" category. He asked what it represents.
COMMISSIONER GALVIN replied it's a $10 million NPV associated
with this project under the status quo, PPT.
CHAIR FRENCH asked whether all the other numbers there represent
millions.
COMMISSIONER GALVIN affirmed that. He noted options listed on
the left: ACES with a 10 percent floor, ACES without the floor,
PPT status quo, and a high net tax. Columns show the rates for
mature or legacy fields, as well as other fields. Under
progressivity, it shows the trigger and slope. And the capital
credit percentage is shown.
11:38:43 AM
CHAIR FRENCH asked whether any one of the fields, A through G,
represents something close to a legacy field like Kuparuk.
COMMISSIONER GALVIN specified that Field A reflects a heavy oil
project, Field C a traditional oil project, and Field E an
extremely challenged heavy oil project - all within the legacy
fields.
CHAIR FRENCH surmised nobody would do Field E.
COMMISSIONER GALVIN said Fields B, D, and F reflect projects by
new entrants. This is an important distinction. In the
modeling, it affects how much the capital credits are worth to a
company immediately, and whether they'll need to be rolled over
a year before being enjoyed under PPT. In response to Chair
French, he said these are companies without current production -
not so much like Anadarko, but Pioneer and others.
11:40:15 AM
SENATOR WIELECHOWSKI gave his understanding that a higher tax
rate on the lower end could encourage investment for some
fields. He noted the chart shows that for Field A, the high net
tax is $150 million NPV at a 35 percent tax rate with higher
progressivity. Yet under ACES with no floor there is a
25 percent tax rate, lower progressivity, and $120 million NPV.
He requested an explanation.
COMMISSIONER GALVIN replied:
It's counterintuitive, but if you follow along with
the idea that when you make your initial capital
investment the state, through the system, is going to
pick up a percentage of the cost. And that percentage
is going to be a product of primarily two drivers.
It's going to be your tax rate - because you're going
to deduct it first and then you're going to be able to
get basically whatever the tax rate is off of your
taxes - and, secondly, what the credit rate is, what
the rate is you're allowing as your capital credit
amount.
And so with the Field A, it's in an existing unit, by
an existing company. So they can immediately write
off those capital costs. And so, under the high net
tax they're getting a 35 percent deduction and a ...
20 percent credit. They're getting a 55 percent
immediate write-off, as opposed to the ACES, where
they get the 25 percent and the 20. ... There's a
10 percent increase in what they get to write off
right off the bat.
As the production comes in, they're going to pay more
to the state. They're going to pay the higher rate.
But since we're talking about net present value, the
amount that they're going to pay over time has been
diminished, diminishing impact to their net present
value. But the credit they get right off the bat has
immediate and ... whole impact on that.
And so, by allowing them to write that off, right off
the bat at that higher rate, even though they're going
to pay us more over time, it has a positive impact on
the economic profile for them for that project.
11:43:08 AM
CHAIR FRENCH said it's good to raise taxes, then.
COMMISSIONER GALVIN replied that in certain circumstances, in
certain projects, having a higher tax rate is actually
beneficial to the project economics.
CHAIR FRENCH asked about a real-life model for Field G, which
appears to be the most profitable.
COMMISSIONER GALVIN said Field G is a new project with a new
investor in a new area with high prospectivity. Returning to an
earlier point, he said:
I was actually going to follow up on Senator
Wielechowski's point, just to--I don't want to further
confuse it, but just when we talk about the fact that
increasing the tax rate could have a positive impact
on the economic perspective from the investor's
standpoint, because they'll use a potentially
relatively high discount rate. And, in fact, what
you'll see, if we ran this at NPV 15, that effect is
even more dramatic because those future cash flows ...
have even less impact to diminish that value from the
immediate value of the credit.
When you look at it from the state's perspective and
you flip that analysis around, from the state's
perspective, our time value of money ... has a lower
rate. ... Some would say it's in the neighborhood of
5, maybe 8 percent. Others would even say it's zero.
We even had a committee member in another committee
say it was negative. But the idea being that, from
the state's perspective, getting money in the future -
as opposed to getting it now, and the risk that we're
going to spend it on something that we don't need to
spend it on - diminishes ... for our benefit the value
of getting everything now.
And so what that means is, in the cash flow of this
project, for the state to give money to the company
now - with the expectation that we're going to get
more in the future - could actually provide a positive
benefit for us as well, and that we gain value by
doing that and having this project come on at that
higher rate. And ... you can call it the magic of
economic theory, the magic of discount rates, but at
least from the purely economic analysis in these
instances, what we've done is, we've created
additional value to the state and additional value to
the investor.
11:46:28 AM
SENATOR WIELECHOWSKI observed, however, that producers may say
raising oil taxes will hurt investment.
COMMISSIONER GALVIN indicated the consultants would address that
this afternoon. When the oil companies say increasing taxes
will diminish their interest in investing, they're talking in
terms of having their entire cash flow change, since more money
will be taken for the legacy fields as well. They'll weigh this
and say Alaska won't be as attractive. If it is isolated to an
individual project, however, the companies cannot deny it will
potentially make that project look more positive. But they
won't say so, given the outcome is a higher tax rate on
everything else.
SENATOR WIELECHOWSKI recalled this was discussed in the Senate
Resources Standing Committee. He asked: Why not have two
separate taxes, then, one for mature legacy fields and one for
new exploration?
COMMISSIONER GALVIN replied there are different approaches when
looking at options for where the tax will have the greatest
impact. One approach is to set the rate for legacy fields at a
higher starting point than elsewhere. Another entails basing
the progressivity upon the margin of a particular project; those
with larger margins - making the most money, primarily the
legacy fields - pay a higher rate than other fields. So it gets
to the same point, but it's based upon something other than an
arbitrary line depicting some as legacy fields. In response to
Chair French, he said it is self-policing, self-adjusting, and
actually has other impacts as well.
11:49:26 AM
COMMISSIONER GALVIN drew attention to the gross-production tax
scenarios on slide 14. He emphasized that this represents a few
of the tax combinations evaluated under one particular set of
assumptions and criteria; they are in the same ballpark with
respect to revenue. However, the administration had looked at a
tremendous number of tax combinations under a large number of
different criteria. There wasn't any one factor or test that
drove the ultimate outcome. Rather, it was a recognition that
with the gross-based options, any one of these factors can
clearly be identified that will make that gross tax drive a
project into the negative.
COMMISSIONER GALVIN briefly highlighted the gross-tax scenarios:
a 13 percent base rate with no credit, with the progressivity
based upon a gross value, shown as "Low Rate - No Credits"; a
higher rate with a credit, shown as "Medium Rate" at 16 percent;
one labeled "Former Tax no ELF," also at 16 percent, which has
other adjustments made by the modeler that don't show up here;
an even higher rate, 19 percent, labeled "High Rate Flat Tax";
and then one labeled "Sliding Scale," with a tax table.
COMMISSIONER GALVIN elaborated on the sliding-scale concept,
saying for a while it was believed to be the key. It based the
tax rate upon the age of the field, and it slid along the table
for progressivity reasons, based upon the price. Every new
field had a five-year tax holiday. There was a credit up front,
and no taxes would be paid for five years; then they'd pay at
some scale that started to go up. Most of the fields became
positive under this scenario, along the lines seen with a net
system. However, older fields bore all the economic weight, and
the rate for legacy fields was above anything shown as close to
economic on the other chart, the legacy field analysis.
11:53:14 AM
COMMISSIONER GALVIN turned to slide 15, "Legacy Field
Scenarios," a line graph with one axis being barrels per day and
the other being the years 2008-2027. He indicated it shows the
difference between a 15 percent decline in the amount of
investment required in the area depicted as "Harvest Mode" and a
3 percent decline in the area shown as "Reinvestment Mode."
COMMISSIONER GALVIN turned to slide 16, "Legacy Field
Reinvestment Comparison @ $40." He indicated this relates to
what would drive that decision making, just looking at the NPV
of the production associated with the level of investment needed
to equate to 3 percent versus 15 percent. Under the various
net-based approaches, a 3 percent decline would be more
attractive on an NPV basis than allowing it to go into a
15 percent decline; thus the assumption would be that a company
would choose to make more money.
COMMISSIONER GALVIN continued with slide 16. Referring to the
gross-tax scenarios shown previously, he said the credit must be
brought in to get it close. Cranking the credit up to 30 or 40
percent brings these positive, but a credit this high moves the
balance on the other factors associated with audit risks and the
benefits intended by going to a gross tax. Thus the relative
value associated with a gross tax is diminished, and the fact
that it ends up hindering project economics becomes that much
more unacceptable. It wasn't going to work.
11:55:24 AM
COMMISSIONER GALVIN turned to slide 17, "Investment Climate
Summary." He said the industry is more comfortable with a net
tax because companies expect the system to reflect their
economics as the project moves forward, and to have a take that
they consider an appropriate share as the project matures and
changes. The tax self-adjusts to changes in variables such as
costs. For heavy oil integrated within the existing legacy
fields, it is challenging to set a gross tax that balances the
desired revenue and the investment. Furthermore, errors in cost
assumptions under a gross tax can hamper investment, while
overestimating costs will leave money on the table. There is
more value to be gained, but it will be missed because the rate
is based upon earlier assumptions.
CHAIR FRENCH welcomed Senator Ellis.
11:57:39 AM
COMMISSIONER GALVIN concluded with slide 18, "Balancing Act."
Identical to slide 4, it depicted the following pairs: revenue
and investment climate; transparency and economic flexibility;
incumbents and new entrants; revenue from "legacy" fields and
exploration & new field development; and audit risk and
investment challenge. He highlighted the challenges,
recognizing that some pairs balance more easily under either a
gross system or a net system. The administration found if it
wanted to overcome some of those challenges, a gross-based
system would have to be changed to such an extent that all
intended benefits were lost. Thus ultimately it was realized
that a net-based system meets the state's goals better than any
gross-based option looked at.
SENATOR HUGGINS returned attention to slide 16. He asked why
$40 was chosen.
COMMISSIONER GALVIN answered that there was a blend of different
prices, but $40 was the one DOR used as its standard for an
investment evaluation across both the new fields and the legacy
fields. It reflects what its industry consultants and so forth
have indicated is probably the current stress price being used.
SENATOR HUGGINS asked whether there was a tipping point when the
school of thought changed from gross to net.
COMMISSIONER GALVIN recalled it was an e-mail from Antony Scott,
Division of Oil & Gas, DNR, who'd worked closely with DOR on
trying to push the economic options to reflect a balanced
approach to the analysis. In the end, Mr. Scott sent an e-mail
saying it couldn't be twisted enough to make it work, for heavy
oil in particular.
COMMISSIONER GALVIN explained that there was a concerted effort
by the department, and a clear mandate from the governor, that
in the end it must be based on the analysis and not on politics.
If another approach was going to be used, it had to withstand a
critical evaluation. With each gross-based option looked at,
vulnerabilities could be identified that might have impacted
production. Thus it was felt that the administration couldn't
go forward with such a recommendation.
CHAIR FRENCH thanked Commissioner Galvin, noting members would
hear from two international oil consultants next.
The committee took an at-ease from 12:01:57 PM until 1:24:12 PM.
CHAIR FRENCH welcomed Rich Ruggiero and Bob George.
^Rich Ruggiero and Bob George, Gaffney Cline
RICH RUGGIERO, Gaffney, Cline & Associates Inc., began by
explaining the role of Gaffney Cline. When originally engaged,
they were to provide industry and worldwide practices with
respect to data submission and where capital is spent, and a bit
on the pros and cons of net and gross systems; the latter was
summarized well in the slides shown earlier today. Since
arriving in Juneau a couple of weeks ago, however, they've
become much more engaged in the fine-tuning, and last week they
began building models to assist legislators in making the tough
decisions ahead. They would show a series of snapshots that can
be viewed as things change over time, to better understand the
repercussions of choosing one tax over another.
MR. RUGGIERO indicated he and Mr. George would show, reference,
and discuss information provided recently in companies'
presentations to both legislative houses, recognizing a high
likelihood that this $800 million issue wouldn't have led to a
special session if there'd been good data transfer earlier and
thus better projections. For questions about the data, it would
be best to ask the industry representatives who would testify
later, who have experience and can suggest whether the numbers
being used are too high, too low, or just right.
1:27:45 PM
MR. RUGGIERO, in response to Senator Therriault, outlined his
credentials. He'd spent about 20 years with "big oil,"
progressing from engineer to engineering manager to district
engineering manager. He'd then moved to natural gas and the
regulatory arena with respect to Federal Energy Regulatory
Commission (FERC) Orders 451, 500, 436, and so on. Then he'd
gone into the commercial arena and international business
development, working 5 years as a commercial manager with United
Kingdom (UK) operations on North Sea issues, and ending as
project general manager of Atlantic LNG in Trinidad. Then he'd
gone into the "dot.com" world.
MR. RUGGIERO continued with his credentials. For the last
6 years he has been with Gaffney Cline. His assignments
predominantly have been work with Saudi Arabia through its
natural gas initiative, including helping to write its
regulations for midstream and downstream, and working with
Mr. George on some fiscal issues. Over the last 4 years they've
assisted Timor-Leste, the world's newest country in 2002; along
with a couple of other consultants, they've set up and written
that country's legislation and model contracts, for instance.
SENATOR THERRIAULT asked about his interactions with respect to
"go or no-go" decisions made in company boardrooms.
MR. RUGGIERO replied for 2.5 years he worked for one of the
chief executives of the producing arm of Amoco, during which
time he was responsible for consolidating aspects of budgets
coming up from all the operating regions and districts, and then
presenting those budgets to the most senior corporate committee.
He saw the process and often sat through discussions of whether
A versus B versus C could be done.
MR. RUGGIERO, acknowledging that experience is a bit dated, said
he'd also sat on committees that made decisions; for example,
the committee in the UK made decisions about investments or how
to spend budgeted dollars within that operating area. Although
it was 10 years ago, he surmised the overall process hasn't
changed that much, though environmental factors have changed and
may be causing slight tweaks in the decision-making process.
1:31:48 PM
BOB GEORGE, Gaffney, Cline & Associates Inc., offered his
credentials, saying he has about 35 years with the industry,
mostly with Gaffney Cline, but also some years with Getty Oil
and others. He was working in the area of exploration and new
ventures, with responsibility for looking at new projects,
decision making, budgeting, and so on. With Gaffney Cline he
spends about half his time working on government-related
activities, including those noted by Mr. Ruggiero in Saudi
Arabia. He also spent a lot of time in the 1990s and early
2000s advising governments in Venezuela and Brazil; he mentioned
Kuwait and Mexico as well. On the industry side, the other half
of his time is spent in acquisition and strategy work with
companies looking at property or corporate acquisitions,
opportunities to rebalance their portfolios and so forth.
1:33:02 PM
MR. RUGGIERO began Gaffney Cline's PowerPoint presentation by
addressing goals. He explained that from discussions he and
Mr. George had heard in the House, Senate, and elsewhere, they'd
arrived at five goals they believe the legislature is trying to
achieve with SB 2001.
MR. RUGGIERO outlined the first goal: Fields with a larger
margin and greater profitability, though not necessarily larger
profits, should pay higher taxes. The second goal, which he
believes is supported by the industry's presentations, is that
investment should be encouraged today and in the near term in
existing units, which have lots of upside potential to capture;
this includes not only new discoveries, but also reinvestment
and getting more oil out of reservoirs that are already
producing. Part of the challenge for new investment is that
there is everything from accumulations of light oil to
substantial reserves of very expensive, technically challenged
heavy oil.
MR. RUGGIERO told members the third goal is developing the
industry beyond Kuparuk and Prudhoe Bay. The overall policy
should encourage new investment outside those legacy areas and
investment by new entrants. Thus today they'd discuss leveling
the playing field a bit between new entrants and incumbents. In
many countries incumbents have such an advantage, with such a
barrier to entry for new players, that little new gets started.
MR. RUGGIERO said the fourth goal is that the system should be
durable, withstanding the test of time. The legislature doesn't
want to be back in a year or even in 2011 trying to fix things
again. He expressed confidence that there is a way forward that
will provide this durability. And the fifth goal they've heard,
becoming a strong voice, is to build upon the many months of
discussion, compromise, and other work on PPT last year.
1:38:16 PM
MR. RUGGIERO showed a slide that elaborated on the third goal,
encouraging new investment for new players. He reminded members
that in previous testimony Gaffney Cline had said Alaska is one
of the very best in providing incentives for new exploration.
CHAIR FRENCH asked whether that is a worldwide comparison.
MR. RUGGIERO replied if he looks at the structure of what Alaska
is doing, yes.
CHAIR FRENCH asked whether that is currently.
MR. RUGGIERO affirmed that. He explained that there are
investment credits that can be turned into cash, and there is a
net operating loss which, a year after they've had the
investment, companies can turn in for cash, a feature only
Norway has as well, to his knowledge. Thus a new entrant with
no existing tax base to be able to write this off - should that
company come to Alaska and spend the millions of dollars
required to explore for oil and gas, but not find anything - can
get the same type of benefit that an existing player, with an
existing taxable base, has in doing the same type of investment.
MR. RUGGIERO opined that PPT has gone a long ways toward
leveling the playing field between new entrants and incumbents
and also encouraging that investment. He speculated that many
of the costs that increased once PPT came in were investments,
not operating expenses. As for investments encouraged by the
bill, he recalled that one of the "independents" said that due
to these credits they are looking to go from a one-well to a
four-well program. This type of structure helps new and smaller
entrants become players in Alaska, because a lot of companies
don't have the financial wherewithal to suffer a 100 percent
write-down with no chance of any recovery.
1:40:16 PM
MR. RUGGIERO said he believes overall, so long as there is a net
system with some level of progressivity, new developments will
be further away from existing infrastructure. Thus even light
oil will be more expensive to produce on a unit basis. Having a
system with progressivity, so a lower margin results in a lower
tax rate, also helps encourage exploration.
MR. RUGGIERO recalled testimony, from Chevron perhaps, about
going through an expected monetary value (EMV) evaluation in
deciding about investments, looking at the chance of failure and
the cost of failure, but also the chance of success and how much
money can be made if successful. He said people will ask how
the system benefits them if they're successful, looking at what
the fiscal system does and also at the distance and rules
relating to infrastructure access. All this must be considered
when deciding whether Alaska is a good place to invest.
1:42:13 PM
MR. RUGGIERO highlighted whether the base rate is low enough,
given the high cost of doing business in Alaska. He emphasized
that significant new development would extend the life of the
Trans-Alaska Pipeline System (TAPS). Some commentary has
indicated a minimum rate of 300,000 barrels a day, although that
was listed carefully as a mechanical limit, rather than an
economic limit. Although existing fields are on a natural
decline, a larger number of barrels would have a significant
ripple effect into the economics, production, and so forth. He
summarized that Alaska is a good place for accomplishing goal
three, encouraging investment for new entrants.
1:43:37 PM
SENATOR HUGGINS asked why gas was included on the slide.
MR. RUGGIERO answered that the main heading of that section is
"Lower tax rate for fields with a higher cost structure." Due
to the nature of the price received in the marketplace on a
barrel-of-oil-equivalent basis and the cost, the margins for gas
development will be much less than the current margin for
production in units such as Prudhoe Bay or Kuparuk, for
instance. Likewise, heavy oil and distant fields have lower
margins. The market value comes down and the costs come up on a
unit basis. If the system corrects and lowers the tax rate or
increases the credit when that type of thing happens, then the
system is responsive, regardless of what type of development is
brought forward. Gas fits into the thinking of "more expensive
to develop," and it nets a lower margin.
SENATOR HUGGINS encouraged thinking about gas, which is on the
horizon. He opined that deferring it too long would be
counterproductive.
1:45:43 PM
MR. RUGGIERO showed a slide labeled "The Fiscal Design
Challenge." Referring to goals one and two, he said the tug-of-
war in the fiscal design is the same here as everywhere else:
How to get the take right, the take being however the state
receives value for its resources, and also how to get the "give
back" right, meaning how the state encourages investment.
MR. RUGGIERO said within existing units this has been the real
challenge in the dialogue, since the desire is to find a level
of take that either encourages or doesn't discourage further
investment in those units, because there is value there. He
noted the third section of today's presentation would address
the tipping point and so on. He said they'd just put the
aforementioned up as a difficult issue.
MR. RUGGIERO added that probably the biggest part - going to the
heart of the dialogue with Commissioner Galvin this morning
about expected revenues - is that the industry has three moving
parts: price, production, and cost. It's like a three-legged
stool. The minute one changes from what was expected, it starts
to lean quickly. Just as one talks about a net-margin system,
that margin can change if only one variable changes, or it may
change as all three variables change. It isn't easy to try to
predict that.
MR. RUGGIERO emphasized putting together a fiscal system which
recognizes that those move, but without losing sight of those
two goals: 1) ensuring the state gets its fair take and
2) ensuring there is no discouragement of the reinvestment that
needs to occur in those two existing legacy units.
1:48:17 PM
CHAIR FRENCH welcomed Senator Hoffman and also welcomed Senator
Stevens to the afternoon portion of the hearing.
MR. RUGGIERO showed slides emphasizing a key point that is
easily misunderstood: Price doesn't equal margin. He said PPT
is not about price. Rather, PPT and the whole net structure are
about margin. As an example, if there is a $50 price and a $10-
a-barrel cost, the margin is $40. If there is a $20-a-barrel
cost, there is a $30 margin at the same price. For heavy oil or
gas or a development distant from existing infrastructure, the
price could be $50 a barrel and yet there'd be no margin at all.
MR. RUGGIERO highlighted ways to get different margins starting
with a price: 1) the natural decline over time, 2) new or
different development, and 3) oil versus gas. He explained that
if there is a certain fixed cost of operation but the barrels
decline over time, one's unit cost per barrel rises. Just
through being a prudent operator doing the best possible in the
field, someone will have a decreasing margin. Thus over time if
something is fixed at $50, a development that has no margin - no
profit - may be taxed. Or gas might have a very low margin, for
instance. He again emphasized the need to separate price from
margin when talking about taxes.
MR. RUGGIERO showed another slide. He said if he begins with
something that has a $40 margin - meaning the cash flow after
costs is $40 a barrel - and then throws a legacy field onto the
curve that shows margin versus the market price, that margin
will be achieved when the market hits $60, since the legacy
fields generally have about a $20 "all in" cost.
MR. RUGGIERO said for new development, however, which requires
additional capital expenditures for infrastructure and so on,
the $40 margin won't be achieved until the market gets to $70;
for heavy oil, it might require $80; and for gas, under the
current dynamics, it might require the equivalent of a $100 oil
price before seeing a $40 margin on a barrel-of-oil-equivalent
basis. Again, market price doesn't equal margin. Even if it
equals it today, it may not tomorrow or next year. And even if
the price doesn't change, the margin will change.
1:53:33 PM
SENATOR HUGGINS recalled that Dr. Pedro van Meurs had said there
isn't a correlation between gas and oil at this particular
juncture. Instead, oil is taken off and gas is essentially
dormant with respect to price. He asked whether a correlation
can be made when looking at it from the perspective of margin.
MR. RUGGIERO responded that there is no fixed relationship
between the price of gas and the price of oil; it is moving. As
he'd understood it, Dr. van Meurs was talking about Henry Hub
relative to West Texas. What didn't come into that dialogue is
this: Gas from Alaska currently goes to markets different from
the Lower 48. Other markets in the Pacific basin have a very
different price relationship between gas and oil. With respect
to options and potential actions, however, Mr. Ruggiero said he
hadn't looked into details of what it would cost, the options,
or why one course would be chosen over another. He suggested
this relationship should be added as the fourth moving part.
1:55:13 PM
MR. RUGGIERO showed the final slide on price and margin,
addressing how to pull this into a single mechanism. He said
PPT has a base rate, has a degree of progressivity, and then
reaches a maximum rate. If everything except market price could
actually be fixed, it would have to get to $170 to $180 at
today's cost structure before maxing out PPT.
MR. RUGGIERO continued. Given that today' cost structure is
about $20 a barrel, he said that is a margin per barrel of $150
before maxing out PPT. Knowing that costs will move with price,
however, who knows where that maximum level would be reached in
the legislation. It could be $180 to as high as $250 or $260,
depending on the relationship and elasticity between the
movement in oil price and the movement in cost. It would likely
have to be over $200 before ever hitting the maximum rate under
PPT. Thus he suggested if there starts to be a dialogue about a
maximum rate being so high it's penal, people need to look at
where that must get to before it ever kicks in.
`
MR. RUGGIERO continued, noting ACES raises the base rate and has
a slightly lower, sloped progressivity. Not shown on the slide
was that it flattens out at a maximum rate. This relates to a
plus-or-minus $200 West Texas "price world" before getting
anywhere near the maximum rate under ACES. Reminding members of
the five goals and that the first and second goals had just been
discussed, he said it is possible to choose something that has a
base rate but actually make progressivity more of a curve than a
straight line or a single rate, capping out at the maximum rate
a lot sooner than would happen in a $200 price world.
1:58:04 PM
CHAIR FRENCH asked whether each of those three lines on the
slide represents different progressivity rates.
MR. RUGGIERO pointed out this is slightly different from what
was shown to the House. This is just a suggestion, because
they've heard there are different views. He said the
commissioner was clear that the administration's position is
that they'd be talking about the top ACES line, in red, which
starts at a 25 percent base rate. He mentioned goal three.
MR. RUGGIERO further responded that the green lines represent a
net tax system. Conceptually, depending on what is chosen as a
starting point - for instance, 25 percent, which is the
administration's position, 22.5, which is the current
percentage, or something lower - there'd be a rate function that
climbs as the margin climbs. It is an ever-increasing
progressivity factor until a maximum rate is hit.
1:59:39 PM
SENATOR WIELECHOWSKI asked whether the Palin Administration
endorses this new approach.
MR. RUGGIERO replied he couldn't say, but yesterday Commissioner
Galvin testified that the administration endorses a system that
starts at 25 percent; if they're going to give up the gross
minimum floor, a trade-off would be to get more at the top end.
SENATOR HUGGINS remarked, "Balance."
2:00:31 PM
CHAIR FRENCH surmised each green line on the graph shows a
progressivity factor.
MR. RUGGIERO replied it starts out at zero progressivity and
ends up at 100 percent progressivity at that very last increment
before the maximum is hit.
CHAIR FRENCH asked at what level per dollar it rises.
MR. RUGGIERO answered that Gaffney Cline hasn't said where it
should start or end. At this point, it is a general concept.
SENATOR McGUIRE mentioned a price of $200 and asked how the
maximum rate was picked.
MR. RUGGIERO replied they hadn't yet picked the rate. This
section and the next one, which Mr. George would address, are
conceptual. The idea, as Senator Huggins said, is balance. If
some protection will be given up on the low end and the state is
going to be put in the same position as the oil companies, it
will suffer a bit if prices go through the floor, but also
should benefit when the prices go through the ceiling.
SENATOR McGUIRE agreed with that concept, but said she was
trying to understand the idea of having a maximum rate.
MR. RUGGIERO replied this is based off of margin, not price.
When the margin gets huge - whether the price is $80 or $200 -
that's when the state should be taking its maximum fair share.
SENATOR HUGGINS surmised that, theoretically, at the maximum
rate the profit margin would be taken away if the mathematical
equation were run all the way through.
MR. RUGGIERO replied that once the margin is large enough that
it is on the plateau of that curve, Senator Huggins is right.
As the margin moves up or down, there'd be no further percentage
change in the state's share of the incremental dollar.
2:04:35 PM
MR. RUGGIERO continued with the same slide, turning to the
ellipse on the lower left, relating to goal three. With a net
system, the reason there is a low rate at a large margin is to
encourage investment in fields or projects that fall into that
range. Whether the oil price is $10 or $80, there are expensive
projects. For example, a lot of the heavy oil is becoming more
economically viable as prices rise. And there will be more
things that require a bit more expensive development - when the
price is there, there'll be a positive margin or cash flow from
operations. That is when those types of investments should be
encouraged to continue production, continue the livelihood of
existing fields, and continue the state's helping the industry
to develop Alaska's natural resources.
2:05:43 PM
SENATOR WIELECHOWSKI referenced Commissioner Galvin's comments
in the last session, asking whether the higher rate at the low
end here encourages more investment in certain types of fields
like the legacy fields.
MR. RUGGIERO asked him to wait until the second part of the
presentation, when Mr. George would address issues and impacts
associated with varying rates and progressivity. Returning to
the slide, he said the last development on the curve is the
ellipse, the existing field issues. He explained:
What you'll see is, when I'm up at the high end of
progressivity, one, to the extent that cash from
operations is generated, if it exits the state it has
to go through a high-priced state-take filter. To the
extent it stays in the state, that provides an
incentive for them to keep the money here and to
reinvest it, because the state becomes a much larger
participant in each and every one of those new
investments that they make when they're at that point
on the curve.
MR. RUGGIERO gave an analogy of shining a light in a room, with
dark corners remaining. He said one dark corner of the
presentation or philosophy here is that when the maximum rate is
approached, there is a question whether the incentive to invest
needs the credits additionally. Depending on how the
progressivity rate is set and when the maximum is hit, the state
may wish to consider modifying how and when credits are earned.
MR. RUGGIERO cautioned against getting into the following
mathematically possible position: If 20 percent credits are
retained and there is a steep progressivity curve, the point
could be reached where investments could be made and with the
20 percent credit the state could actually be handing a check to
whoever invested. The government share would be above
100 percent. The state doesn't want to get into that position.
MR. RUGGIERO noted that the state doesn't want to get near
100 percent either. It isn't that the oil companies would make
unwise investments, but they might be encouraged to make
investments or gold plate things because the state is paying
nearly 100 percent of it. Depending on what is done with
respect to setting the core aspect of the taxing policy, the
legislature will have to look at the other pieces, test the
reasonableness of those at various points along the curve, and
then make appropriate decisions from that.
2:08:48 PM
SENATOR HUGGINS asked about a progressivity factor that has a
gross component.
MR. RUGGIERO returned to the price-versus-margin slide. He said
if there is progressivity based on gross, the field or
development to the far right has a zero margin at $50 a barrel.
But if some gross progressivity is set up that kicks off at $30
or $40, it will have the taxes going up on a gross basis off of
gross revenue when it is making no profit.
SENATOR HUGGINS asked what happens if it kicks in at $70.
MR. RUGGIERO answered that when talking about net systems and
net progressivity and gross systems, one of the commissioner's
bullet points this morning was perfect. If someone picks an
exact situation, he could pick numerous grosses that work, but
also numerous ones that don't work. That raises the challenge
of goal number four, durability. The question becomes how many
"dials" to put on it, and how often the legislature wants to be
back tweaking the system.
SENATOR THERRIAULT suggested that's part of the debate the
legislature went through before, starting with a gross
progressivity trigger and then, through deliberations, coming
back to having it based on the net. He recalled thinking it
might work for a certain range of prices, but if the desire is
to set up something that will have durability, at least 10 or 15
years, who knows what the prices or costs will be.
MR. RUGGIERO turned the presentation over to Bob George.
2:11:17 PM
MR. GEORGE showed slide 29, "The Net Tax Story." He said this
past weekend they'd started looking at models on this. Having
listened in the first week to what people were saying, he was
bothered a bit by some characterizations of how the tax worked
and thus had looked "under the hood." He highlighted the
perception that this is a tax on net profits with a
progressivity feature that increases the tax rate with
increasing profitability per barrel. He indicated in a few
moments he would try to change that perception slightly with
respect to the term "profitability."
MR. GEORGE also highlighted the perception that this is ring-
fenced so the stated profitability per barrel reflects a
company's portfolio, which is a mix of investments in different
fields and isn't the same for everybody. He would try to break
out some portfolio components to see how that comes together
with the company's decision-making processes, particularly
looking at the implications of the tax structure for
reinvestment.
2:13:12 PM
MR. GEORGE showed slide 31, noting he was starting with the
simple position that is classically portrayed, with an ANS West
Coast oil price of $80 a barrel as an example. It is known that
transportation costs and so forth to the North Slope will be
about $10 a barrel. At the point of production there is a value
on the order of $70 a barrel. These numbers are illustrative,
with $18 a barrel in costs. Thus the profit is $52 a barrel.
He would start and end with that premise, but would break it
apart first.
MR. GEORGE showed slide 32, saying if he has $52 a barrel in
profit, there is a fairly straightforward mechanism within the
definition of PPT such that he'd pay about 25.5 percent. That
is 22.5 percent up until the margin gets to $40 a barrel. In
this case, there is a $52 margin that is the profit per barrel.
Some progressivity kicks in, increasing the rate payable by
3 percentage points, which gives the 25.5 percent.
2:15:03 PM
CHAIR FRENCH asked how the kick-off point is picked for
progressivity.
MR. GEORGE answered that there is a lot of judgment at the end
of the day. In further response as to being able to compute a
number, he indicated he didn't know of any such way. The
perception is that within a company's portfolio under PPT the
net taxes all fields at a single rate. In the way the tax
returns are submitted, it is a backed-out number that would
indeed be the case. However, he offered the perception that the
effective rate can be quite different for different fields in
the portfolio, which goes to the heart of a number of issues
raised here in terms of the goal of allowing more challenged
fields to be taxed at slightly different rates. He would break
things out to show why he believes that is how it works.
MR. GEORGE showed slides 34 and 35, saying he would try to build
up a portfolio of incremental investments to see how the nature
of PPT works to deal with each of these slightly differently.
He'd chosen an existing portfolio of investments of about
200,000 barrels a day, with the assumption of a $65 margin. In
that case, the PPT payable on that portfolio would be 28.4
percent; this is straight from the PPT formula.
2:17:31 PM
MR. GEORGE showed slides 36-39, discussing a company's decision-
making processes when considering new investments under a tax
structure like PPT. It looks at what happens if it does nothing
versus if it makes an investment; running something in isolation
won't provide the right answer. The additional layer about an
investment would be added, and the return would be viewed. In
the example there is similar profitability, $61 a barrel instead
of $65. It will bring in about another 50,000 barrels a day on
top of the 200,000 barrel-a-day portfolio. The average net
margin for the two is $64.20; he mentioned the weighting of the
volumes and the different profitability. The combined rate on
these fields would be 28.2 percent off a $64.20 margin.
MR. GEORGE asked if that means paying 28.2 percent on each
field; he said no. However, if these were two separate
investment decisions, with each field taxed on its own, he'd pay
28.4 percent on the field with a $65 margin, 27.5 percent on the
field with a $61 margin, and for the blended portfolio
28.2 percent. The effect of PPT is such that he'd pay slightly
less on the new field than if it were on a stand-alone basis.
It doesn't show in the first example, but shows in later ones.
MR. GEORGE said this impact within the portfolio has important
consequences when moving into heavier oil or more challenged
fields. The effective rate on new investment is different from
the blended rate. The portfolio together pays 28.2 percent, but
actually the 28.4 percent is paid on the original property if
nothing is done; if the investment is made, 28.2 overall would
be paid, but that is the same as paying 28.4 percent on the
existing investment, but only 27.4 on the new investment. Thus
the new investment - which isn't quite as profitable as the
existing one - gets taxed at a lower rate.
2:21:00 PM
MR. GEORGE moved to a broader portfolio, slide 42. He said this
could be done progressively, adding new investment decisions.
He'd made up a portfolio of an existing 200,000 barrels a day
with a $65-a-barrel margin. Investment X was at $61. A more
challenged one was added, with a $50 margin, as well as one at
$37. Those are examples only. Each of those new investments
adds 50,000 a day to the portfolio, but has decreasing
profitability individually.
MR. GEORGE addressed what happens then. He said each
incremental one that is less profitable pays a lower and lower
marginal or effective rate within that portfolio. If the
portfolio is considered in its entirety, it pays 26.9 percent.
One might think existing reservoirs pay 26.9 and the much more
challenged one pays 26.9. But this isn't so. The existing one
pays the same as if nothing were done, over 28 percent.
However, the most challenged investment out of this particular
set actually pays an effective rate just under 19 percent
because that is its impact within the portfolio. This effect is
what companies look at when making investment decisions.
MR. GEORGE showed slide 44, saying if one simply averages the
rates in the portfolio, it would be about 27.3 percent between
what each property would pay as an investment in its own right.
When blended, however, there is a slight decrease, to
26.9 percent. It is how the progressive structure works. The
net result is that the more challenged fields pay lower rates.
A feature actually provides greater encouragement to the
marginal fields relative to the more profitable fields. It
works to take the cash from the more profitable ones and put it
into less profitable investments in there.
2:23:45 PM
CHAIR FRENCH asked whether it is oversimplying to say this basic
structure allows future investments in the same jurisdiction to
produce a better tax result than if that money were moved to
another jurisdiction.
MR. GEORGE replied it does encourage reinvestment. It
segregates the rate payable within that, such that it isn't
burdening new, less profitable investments on a unit basis, a
dollars-a-barrel basis, with the same rate as existing legacy
production, which is higher-margin production. This relates to
what Mr. Ruggiero showed on the chart with the green bar.
MR. GEORGE explained that within a single system, one can
effectively tax more profitable units at a higher rate without
necessarily hurting the less profitable units; those aren't
burdened by that same rate and are helped by how the
progressivity works for the most part. Not only can they be
taxed at a lower rate, however. In this case, taking
Investment Z on its own within the same portfolio, it would be
taxed at 22.5 percent. But the progressivity gives it an extra
boost to take the rate below 19 percent on that margin. That
movement of the rate, as well as the tax base, gives a
reinvestment boost within the system.
2:26:03 PM
CHAIR FRENCH asked if this is only for an explorer or developer
with an existing portfolio within that tax jurisdiction.
MR. GEORGE affirmed that, saying a completely new entrant in
this case is helped by the investment tax credits and the
ability to monetize the net operating losses (NOLs). But this
sort of effect wouldn't occur until there was production and a
change came out of that.
MR. RUGGIERO suggested looking at the two numbers for Field Z.
Because of its low margin, an independent with no other
production in the state who came in to do this project would be
looking at an effective tax rate at the floor of PPT,
22.5 percent. But because this is an existing producer with a
portfolio, as Mr. George said, there is the "do nothing"
scenario and related cash flow, as well as the "do something"
scenario, which is to invest in Field Z. When ones looks at the
delta, the effective tax rate comes down to 18.9 percent. As
progressivity increases, that number comes down.
CHAIR FRENCH surmised that the steeper the progressivity, the
lower the effective tax rate would be.
MR. GEORGE and MR. RUGGIERO concurred.
SENATOR WIELECHOWSKI asked whether PPT is advantageous for the
producers that are already there, but not as much for new
entrants, which legislators want to try to encourage to come in.
MR. GEORGE replied no, he thinks if they both had the same
opportunity to invest in the same project, the company that had
an existing portfolio at a higher margin than the new investment
would actually get a break over and above that for the producer.
He noted Mr. Ruggiero had introduced something a bit earlier
when talking about the curve with the green line, related to the
issue of investment credits and whether and to what extent
they'd be needed.
MR. GEORGE went on to say, in part, this issue comes into play
here. If there is steeper progressivity and/or payment at
higher rates in the existing portfolio, there is a better
effect. The desirability of keeping the credits in there
requires looking at it because of the effects produced. Someone
with a portfolio that pays 35 or 40 percent, for instance, who
through the investments would actually get a good reduction,
wouldn't need the same credits as the explorer. Some greater
evening out would be provided, though whether it could be made
perfectly even, he didn't know.
2:29:25 PM
MR. GEORGE reminded members that he'd voiced concern about how
costs are being expressed. Although PPT is commonly said to be
based on profit per barrel, it isn't. Rather, it's based on net
cash flow per barrel after capital investment. Those two aren't
quite the same thing, largely because capital investment relates
to future barrels divided by today's barrels.
MR. GEORGE showed slides 46-48, noting the portfolio shown
earlier had a blended rate of 26.9 percent, not the 25.5 percent
he'd been talking about. There is a reason for this. Using the
same portfolio shown before, if he were budgeting for 2008, for
example, he'd be asking how much money he'd spend next year. If
he were considering spending $800 million, it would reduce the
blended rate of the portfolio from 26.9 percent to 25.5 percent.
But the elements within it must be looked at.
MR. GEORGE said if it were producing 350,000 barrels a day, the
$800 million he was considering investing would equate to $6.26
a barrel in the existing portfolio. That isn't $6.26 for the
barrels he'd necessarily get out, which could be a completely
different number. Rather, it is $6.26 for existing production.
If he only had half that portfolio, it would be $12.52 a barrel.
If he had twice the amount of production today, it would be
$3.13 a barrel.
MR. GEORGE showed slide 51, saying the left side depicts before
the capital decision is made. Shown are lifting costs,
operating costs upstream of the point of production. To produce
350,000 barrels a day, there'd be $11 a barrel in costs. For
calculating PPT, he could also deduct capital he spends in the
year. In this case, he'd evaluate spending $800 million. That
would allow him to add another $6.26 a barrel. Slightly
rounded, the example shows $18 for the two numbers added
together, lowering the blended tax rate to 25.5 percent. But
there are other ways still of looking at this.
2:33:11 PM
MR. GEORGE showed slide 52. He highlighted the portfolio and
four separate investments that individually are subject to
marginal PPT rates between about 19 and 28 percent; on a blended
basis, it is 26.9 percent. It he spent that capital and it
brought his overall portfolio PPT rate down to 25.5 percent, the
net effect would be that the state would pick up 38.6 percent -
not 26.9 percent - of his $800 million of capital investment.
MR. GEORGE showed slide 53, discussing the reasons for this. He
suggested looking at the tax system through the amount of tax
payable and how these things change. If he had the four
elements to the portfolio, with $80 a barrel and so forth, he'd
be paying a little over $2 billion in PPT. But that isn't how
the tax system works. It blends everything together. One comes
up with an average cost per barrel, and as a result there is a
small savings of $32 million by taxing them as one unit rather
than four separate items. When he drops the rate to 25.5
percent, the $2 billion drops to just under $1.7 billion.
Mr. GEORGE highlighted total savings of $309 million. The net
effect of deciding to go forward with an $800 million investment
is that the tax rate and tax base are both reduced, since the
whole $800 million can be deducted against the tax base as well.
Thus while $800 is spent, $309 million is saved in taxes - $215
million from reducing the taxable base by $800 million, plus $94
million from reducing the tax rate. This gives a significant
boost to the capital investment. It also goes to the question
of at what point capital credits are still given or not.
MR. GEORGE concluded by saying the flip side of the state's
taking a high sum is giving a high sum back. The question is
how much a boost is needed for already profitable operations.
These effects come at the more profitable end.
2:36:28 PM
MR. RUGGIERO returned to an earlier statement he'd made about
the other impact of progressivity: As one goes higher up the
progressivity curve because of being overall a higher net-margin
operation, the impact seen here grows. The $309 million will
increase. The state's participation in the investment increases
as it gets higher up the progressivity rate curve.
CHAIR FRENCH surmised this creates a greater incentive to spend
capital in the same tax jurisdiction.
MR. RUGGIERO agreed.
MR. GEORGE concurred, noting in the scenario shown there'd be
not only $309 million through the PPT system, but also a further
$160 million available from tax credits. In this particular
example, the $800 million investment would end up costing the
investor a net $330 million, and it would have a huge effect on
the rate of return as well as the investment decisions. At some
point, there would be a need to look at the top end of this and
what effect it has. Gaffney Cline didn't have a numeric answer
today, but it requires some review.
2:38:05 PM
MR. RUGGIERO added that he hoped this tied back to Senator
Wielechowski's question about why, if there is a higher tax, the
rate of return to the oil company can actually be higher than
when there is lower tax. It relates to the impact of being able
to get immediate credits or the impact of progressivity in that
the "delta rate" is larger than the absolute rate at any one
given point.
SENATOR WIELECHOWSKI recalled Gaffney Cline's testimony in the
Senate Resources Standing Committee that about $6-10 billion
leaves the state yearly. He surmised if that delta on
progressivity were increased at the higher levels, from a
financial standpoint the companies would be more likely to
reinvest that money in Alaska, rather than taking it to Bolivia
or Venezuela.
MR. GEORGE said there is a choice for companies at that point.
They either can export their capital back to the corporate
treasury and pay a high rate or can reinvest in Alaska and get a
good co-investment from the state through the tax system.
MR. RUGGIERO, in response to Senator Huggins, specified that the
slides being shown were finished yesterday at 1:30 a.m. and
presented yesterday to the House with an October 30 date. Three
slides were then modified. The version being presented today
carries today's date, October 31.
SENATOR HUGGINS expressed hope that Gaffney Cline would do
further work before this goes to the Senate Finance Committee.
2:40:58 PM
MR. GEORGE showed slides 57 and 58. He said adding the
$160 million in investment tax credits doesn't actually lower
the tax rate to 23 percent, but has the same effect. It is
worth about another 2.5 points against the profitability. The
last slide in this section relates to costs, broken out slightly
differently.
MR. GEORGE explained that, to him, PPT is really a tax on the
net cash flow per barrel that is exported from the state - not a
tax on profits per se. The operating margin in this case is $58
a barrel, and a company has a choice to export that $58 a barrel
and deploy the investment elsewhere, or to deploy some of that
$58 a barrel back in Alaska and then be taxed on the amount it
decides to export after making that capital investment. As it
is lowered, the company pays a progressively lower tax rate, and
it also lowers the tax base. He said it is better to look at it
as a net cash flow per barrel after reinvestment, rather than
just a tax on profitability.
The committee took an at-ease from 2:43:37 PM until 2:57:41 PM.
MR. GEORGE showed slides describing the House Special Committee
on Oil and Gas (HO&G) amendment to the progressivity part of
PPT. He explained that currently under PPT the tax rate
increases by 0.25 percent for every dollar by which the net cash
flow per barrel - profitability, as expressed in there - exceeds
$40. Thus 22.5 percent is paid up to a $40 margin, and
0.25 percent is paid for every dollar above it.
MR. GEORGE said while the HO&G amendment maintains the basic PPT
22.5 percent rate, the progressivity element adds a separate tax
that doesn't affect the base rate. Two calculations are done
and then the total tax is added together. It adds 0.225 percent
for every dollar that the gross value at the point of production
- in simple terms, the same valuation as for royalty purposes -
exceeds $50 a barrel.
MR. RUGGIERO added that the $40 under PPT is margin, whereas the
$50 under the amendment is price.
MR. GEORGE reiterated that price doesn't equal margin. He
referred to an earlier slide relating to the effective rates
applied to the lower-margin fields. He indicated the next slide
used that, adding a red line drawn through the marginal
effective rate paid by each of the investments. It shows that
under the gross amendment proposed by the House, the rate
payable on the existing fields remains the same, but the rate
for less profitable fields starts to go up. Thus the bulk of
the increased burden is actually borne by lower-margin fields,
not those with higher profitability. For this, he'd assumed the
lower margins were caused by a combination of effects: a lower
price per barrel, for heavier oil perhaps, as well as higher
costs. Thus the margin was being squeezed at both ends.
3:01:38 PM
CHAIR FRENCH asked what the blue line above the bar graphs
represents.
MR. GEORGE replied it is a directional line. In further
response, he said the black numbers above the bars are rates
payable by that field if it were a development on its own. That
company would pay 24.9 percent. The red numbers inside the bar
graphs are the effective rate for that particular investment
within the overall portfolio. The 27.8 percent, relating to the
bar to the right labeled "blended," is the averaged-out rate
that would apply to the portfolio as a whole.
SENATOR WIELECHOWSKI asked whether it is the gross progressivity
in the HO&G version that makes it this way.
MR. GEORGE answered it's because the progressivity is applied to
the value at the point of production, without deducting the
actual costs that it takes to produce it. As it works in this
example, moving from left to right the fields are increasingly
less profitable investments, and yet the structure says it
doesn't care how much the production costs. A number had been
come up with, $50 a barrel. Everything above that is the net
cash flow per barrel, which would be taxed at some rate. When
looked at that way, these less profitable fields pay sort of the
same amount, but for a higher proportion of their profits.
MR. GEORGE elaborated on the margin, reiterating that when he'd
put this slide together he'd assumed the lower margin was caused
by a squeeze down from the top from receiving less per barrel,
as well as a squeeze up from the bottom, since it costs more.
The House PPT progressivity amendment does recognize that
because it's the value at the point of production, it starts off
with the value at the ultimate point of sale.
MR. GEORGE explained that if there is heavier oil, it generally
means receiving less per barrel. So that translates back up
through the shipping, the pipeline, and the point of production
as a lower price there. It brings down the average price being
received by the company. The effect is that it's higher than it
would be under the net system; it still recognizes some part of
the reduction in profitability, but not the whole.
3:04:56 PM
SENATOR HUGGINS requested clarification about this slide versus
the previous one.
MR. GEORGE said this is what happens under PPT. Under the House
amendment, the progressivity portion of PPT is replaced by a
separate component that works off the gross. It works off that
amount by which the average cash flow per barrel in the
portfolio exceeds $50. The $50 is a hard number in there. The
effect is that a company's existing, more profitable reservoirs
don't actually pay any more; rather, it's borne by the less
profitable ones because the company pays on the gross value
overall, not on the net margin that those less profitable ones
are subject to.
MR. RUGGIERO added that this is saying the House proposed
amendment isn't taking any more money from high-profitability
fields. Instead, it creates a bigger hurdle or barrier to
development of low-margin projects that are out there such as
the significant reserves for heavy oil development.
3:06:30 PM
MR. GEORGE said if he takes a further step, saying his lower-
margin fields aren't caused by a lower price but just by higher
cost of extraction, his lower-margin fields actually pay a
higher effective tax rate than those with higher profitability.
This is because none of those additional costs are recognized in
the system. Chances are that as one moves into heavy oil
developments and so on, there will be some effect caused by a
lower market price. This slide illustrates the regressive
nature of the gross system in there, not recognizing
profitability. A company would end up paying a similar amount
of tax for less profit, which translates into a higher rate.
MR. GEORGE showed a slide depicting numbers reflecting that. He
said under PPT, the portfolio would pay just over $1.5 billion
on the $80 West Coast price, $2 billion before capital
investment and about $1.5 after capital investment. Noting the
illustration doesn't relate to all numbers, he said under the
House amendment there'd be a slight rise in the amount of take
before capital investment, but after capital investment it would
rise a couple of hundred million. Hence capital investment
wouldn't get as much effect with respect to tax as it would
under the more progressive system. It essentially raises the
cost of investment to companies going forward.
MR. RUGGIERO added that a lot of the snapshots shown depict
fields on the same date, using the same assumptions. These
slides attempt to show why, depending on the fiscal system
chosen, certain investments might not be made. As Mr. George
just showed, the marginal $800 million investment just got a lot
more expensive. Furthermore, Field Z might not have ever been
developed if it would actually raise the average tax paid; it
would be at a much higher rate than the existing production just
because of the nature of the tax.
3:09:43 PM
SENATOR THERRIAULT observed that whereas elsewhere the red arrow
comes down because the tax rate comes down, here the red arrow
comes down but the rates have gone up.
MR. GEORGE replied the red arrow was the top of the effective-
rate bars under the net PPT system; he'd kept it in place to
show where that was. He apologized that it wasn't well labeled.
He said the point was to show that the lower-margin fields can
effectively have a higher tax rate.
MR. GEORGE wrapped up by saying the PPT net-tax system taxes the
cash flow that a company decides to retain; it isn't just a tax
on simple profitability. As structured with a sort of corporate
ring-fence taxation on a companywide basis for investments in
Alaska, it allows the effective rate to vary so more profitable
fields pay a higher effective rate and less profitable fields a
lower one. More aggressive net progressivity provides a greater
differentiation between higher- and lower-profitability fields
than a simple gross progressivity is capable of doing.
MR. GEORGE said the progressivity feature itself, the
progressivity based on net manifested in PPT or ACES - which
basically have the same structure but different rates - is more
responsive to individual field profitability than under any
gross structure Gaffney Cline has seen for this. He also said
that if one is able to put greater progressivity into the
system, such that higher-profitability fields are taxed at lower
margins and perhaps lower-profitability ones are taxed at lower
margins, this can be done by changing the slope and the
progressivity.
3:12:35 PM
MR. RUGGIERO turned attention to slides at the beginning of the
handout, noting the slides had been presented out of order. He
said for slide 2, "Topics," they'd already discussed the bottom
two points: the goals or drivers for putting a system together;
ands how a net progressive structure, from a 50,000-foot view,
adapts and meets those goals, as well as how the House's
recommended structure fits in to meeting those goals as Gaffney
Cline had listed them. The remaining topic on slide 2 was:
"What is the risk of raising state revenue share on the existing
producing reservoirs?"
MR. RUGGIERO noted although they didn't have a great computer to
stuff all the numbers in and provide the correct answer, they'd
address questions asked in the previous Senate and House
committees about where the tipping point is. How far is too
far? How far is not enough?
MR. RUGGIERO explained that he didn't want to leave money on the
table, but also didn't want to wake up tomorrow and notice that
during the night the bags had been packed and the oil companies
had left. This would be discussed. And Gaffney Cline would do
what it was invited to do: Read the lines and read between the
lines, taking the data presented by the industry and providing a
representation of that data.
MR. RUGGIERO addressed the first point, that there is no simple
answer as to how an oil company makes a decision. He noted the
debate was always about the tax rate until Chevron made its
presentation, drawing an analogy to the "rock, paper, scissors"
game; Chevron had indicated scissors - in this case, the fiscal
system, which takes a cut out of their potential profits - is
trumped by rock. Chevron goes places with marginal rates of 78,
82, 85, or 90 percent because those places have the rock:
a high expectation of producing billions of barrels of product.
MR. RUGGIERO suggested looking further, noting scissors would
cut paper if paper were the profit. He said there was also
discussion by one company that there are times when it doesn't
come down to rocks or tax rate. If the company believes it can
buy barrels cheaper than it can drill for barrels, it will buy.
That is acquisitions. It can buy back its own stock, which he
said he believes this company has done on the upside. Thus
there is a game such that, at any point in time, any one of
those items can trump the other item in making a decision. It
isn't a simple A, B, C. It depends on what all the factors are
at the time, going forward.
MR. RUGGIERO noted he would speak about numbers and metrics
specific to Alaska that go into some decision making. As for
testing the tripping point, they would read between the lines,
looking at the data presented to see what they could glean from
it. Looked at would be everything from what the Alaska Oil and
Gas Association (AOGA) put forward to what the oil companies had
put forward.
MR. RUGGIERO said to the extent possible, Gaffney Cline had
looked at annual reports, 10(k) filings, other federal
Securities and Exchange Commission (SEC) filings, analysts'
presentations, and other publicly available information, to
determine whether the data presented passed the "smell test" and
looked reasonable. To that extent, they'd done some
modifications and moved some items around in their analyses.
MR. RUGGIERO offered the overall observation from the industry
presentation that for the near term most of the potential is out
of the existing reservoirs - arresting the decline from its
natural 15 or 16 percent and instead making it a 6 percent or
3 percent decline. Gaffney Cline would present some related
numbers. They'd also show that the economics, seen from the
economics presented, are extremely profitable. This has been
tested against some stress points, and Gaffney Cline would show
legislators this testing. Instead of one stress point, they
would stress it six different ways, showing what it does to
profitability six different ways.
3:18:29 PM
SENATOR THERRIAULT asked whether it is Gaffney Cline's
contention that the investment in staving off the decline is a
very wise and profitable investment.
MR. RUGGIERO said yes; he'd show some numbers relating to this.
He noted everything put up by AOGA had the full consensus of all
the oil companies; they were saying there is a significant
upside in the existing reservoirs. Agreeing with this, he noted
Gaffney Cline was also saying the fiscal system should recognize
that as well. He reminded members that the first goal is to get
a fair share from highly profitable scenarios. The second, at
the same time, is to cause the reinvestment being talked about.
MR. RUGGIERO continued with the slide on AOGA, noting they'd
said the 2006 Prudhoe Bay drilling program generated an
additional 70,000 barrels a day. That equates to the fourth-
largest stand-alone field, behind Alpine, Kuparuk, and Prudhoe
Bay. The upside, the potential additional barrels, is
significant from this program. If the decline can be arrested,
25-plus years can be added to the life of those fields, if they
are encouraged to make the investments and get the additional
oil out of the ground that they believe they can today, based on
developments and technology.
SENATOR THERRIAULT remarked that a standard for both oil and gas
production is ramping up to the peak and then tapering. He
asked whether, with the 2006 investment, it was like putting a
70,000 barrel field on. He asked: If you were to treat that
like a new field, would that production profile look about the
same as the norm? Or does it have a quicker peaking and a more
rapid decline, for instance?
MR. RUGGIERO replied that when he got to the light model
demonstration he would show exactly the impact being asked
about. Showing the next slide, he indicated this data came from
two slides presented by BP to the House and Senate committees
earlier. On the upper left was a statement showing that from
2002 to 2006 BP had a drilling program. The upper left plot
shows the production BP claims results from that field
reinvestment within Prudhoe Bay; the lower right shows the
program from each of those years, plotting total dollars spent
on the drilling program relative to the reserves BP believes it
generated, or the additional production BP can generate as a
result of that drilling program.
3:22:11 PM
MR. RUGGIERO said the next slide relates to a general statement
by all the companies: Reinvestment is not only important, but
is getting a bit more expensive. From the diagram in the lower
right-hand portion of the previous slide, it can be seen that in
2002 they spent about $255 million and generated 120 million
barrels, for a per-barrel finding-and-developing cost of $2.13.
Using that same plot, the numbers can be pulled off for 2003-
2006. With roughly the same amount of capital being spent in
each annual drilling program, the number of barrels found as a
result is declining. Therefore, the cost per barrel to find and
develop is rising. That number rises from $2.13 to $4.90 as a
result of the 2006 drilling program.
MR. RUGGIERO addressed how that compares. He said some other
numbers were put forward. It depends on what numbers are looked
at, but it was stated that from the beginning until today
$19 billion in capital has been spent in Prudhoe Bay. That was
to produce between 9.5 billion and 11.5 billion barrels. Hence
the finding and development to date cost $2.00 a barrel. That's
an average for the period. It is climbing, now being almost
$5.00 a barrel. He indicated the company had put up another
slide estimating it may go as high as $12.00 a barrel.
3:24:36 PM
SENATOR WIELECHOWSKI asked whether it's fair to say costs
haven't gone up as dramatically, when one factors in the time
value of money, since $255 million in 2002 won't be the same
amount of money in 2006. He indicated he'd asked BP, and it was
the actual dollars presented.
MR. RUGGIERO agreed there'd be a time-value impact, which
Gaffney Cline hadn't considered in this analysis. He recalled
that Pioneer had mentioned that the Lower 48 was plus or minus
$14 per barrel for finding and development. He added that today
in the House, BP presented a figure of $10 a barrel average for
the United States, but he didn't know whether that just applied
to oil or was for oil and gas. He noted with a lot of gas there
can be much lower finding-and-development transportation costs
in the Lower 48, where someone with a drilling rig on the back
of a truck can go out and put a well into production for just
tens of thousands of dollars per well.
MR. RUGGIERO concluded that while there are various numbers, it
is getting more expensive with time. The barrels will be more
technically challenged to get out of the ground, and the cost
per barrel to do that will continue to rise. He emphasized that
whether it is at $4.90 for 2006 or $12.00 later, this isn't
being discussed in terms of a $90 market.
3:26:46 PM
MR. RUGGIERO showed the next slide, a snapshot related to the
economics of BP's infill drilling program. A plot shows the
actual capital spent. Between BP's testimony in the House and
then the Senate, he said they'd mentioned - quite fairly so -
that one cannot just look at the cost to drill the wells.
Instead, there is a three-times multiplier because of: the cost
of the producing well, whether it is a vertical or multilateral
well; a cost associated with injection because of the secondary
recovery; and an impact on facilities that would have to be
modified, or else new facilities would be needed.
MR. RUGGIERO continued, indicating BP had said the real capital
associated with each producing well, as shown on the right of
the slide, is a 300 percent capital expenditures (CAPEX) figure.
Hence the plot on the right has the same numbers on the left,
but at 300 percent. As a result, it isn't a drilling program at
plus or minus $250 million a year. Rather, it is a program with
all the capital required to actually get those barrels to market
- $750 million to $800 million a year.
MR. RUGGIERO showed the next slide, explaining that Gaffney
Cline had digitized that plot to determine what sort of
production it yields. Shown is the combination of each year's
program, stacked up. They'd said by the start of 2007 this
drilling program was producing 50 percent of the barrels
produced daily out there. Referring to an earlier question, he
said the House version of this has production in 2002 instead of
starting at zero.
MR. RUGGIERO noted the assumption he'd made was that each year's
drilling program doesn't start production until the next year;
thus he'd had to move something on the spreadsheet, but hadn't
changed any of the underlying financials or the economic answer.
But it's a different picture than shown to the House.
MR. RUGGIERO continued, saying that was stacked up until 2007
was reached. The big rise between 2006 and 2007 is the AOGA
presentation that said the 2006 program generated an extra
70,000 barrels a day, to start in 2007. Shown on the slide is a
decline. To Senator Therriault's earlier question, he said they
talk about the field being on a natural 15 percent decline.
However, he'd show in a few minutes that if this type of
production were run from that point - assuming no further
spending - on a 15 percent decline, it would create more barrels
than they say they developed as part of that drilling program.
3:30:10 PM
CHAIR FRENCH said he thought the discussion was about the extra
70,000 barrels of oil a day from the 2006 drilling program.
MR. RUGGIERO returned attention to the plot, noting they'd said
for each of these years' drilling programs an associated amount
of production results.
CHAIR FRENCH surmised that is per year.
MR. RUGGIERO concurred.
CHAIR FRENCH asked whether that totals up to the incremental
production just shown.
MR. RUGGIERO affirmed that. If he takes 2003, for example, that
flows through. Although declining, it still exists in 2007.
CHAIR FRENCH surmised the 70,000 was just for 2006.
MR. RUGGIERO said the 2006 program, because the year had just
been started, was shown on the slide as a small sliver. There
was no way to pull into the economics the results of the 2006
program. Thus they'd relied on the statement in the AOGA
presentation that the 2006 drilling program in Prudhoe Bay
produced an additional 70,000 barrels a day. If he were to take
each of the colored parts shown and then go forward, he'd just
be adding the colored parts from each of those. When he gets to
the end of 2006, there is a big jump. He'd put in the 70,000
barrels a day that AOGA had said BP, as the operator, was able
to develop with its 2006 drilling program.
MR. RUGGIERO asked: Why might those results be a little better
than previously? He indicated this is where the company started
its multilateral or horizontal-completion drilling program. As
they stated, those wells produce more per overall well than the
traditional vertical well. So it's conceivable that the 2006
results are a little better than they were for a couple of the
previous years.
MR. RUGGIERO further explained that to do the economic analysis,
Gaffney Cline had then made an assumption about what those rates
would be over time, beyond the extent of the actual production;
they'd forecast what each well would do in the drilling program.
He indicated although the company had talked about a 16 percent
decline per year in that rate - which would have been a line
that he depicted on the slide - Gaffney Cline had actually used
a 25 percent decline.
CHAIR FRENCH asked why.
MR. RUGGIERO answered he'd not wanted to be accused that the
economics were inflated because there were more barrels in there
than the barrels the company said it was able to produce as part
of those drilling programs.
3:33:15 PM
MR. RUGGIERO continued, saying the decline rate used here was to
ensure that, in each individual year, Gaffney Cline didn't show
more barrels in the system than those shown by the company
itself. He emphasized wanting to ensure that the economics
shown can be tested, reproduced, stressed, and challenged.
CHAIR FRENCH asked whether the red graph depicts a 25 percent
decline curve, assuming no future investment or production from
that investment.
MR. RUGGIERO affirmed that. He added that Gaffney Cline looked
at this infill or incremental drilling as a stand-alone project,
year by year. With that capital and that production curve, they
looked at the company's after-tax rate of return on that
investment. As this produces through time, Gaffney Cline
estimated - based on this 300 percent CAPEX - that the company
gets more than a 60 percent rate of return on the investment in
those infill drilling programs.
MR. RUGGIERO, in response to Senator Therriault, said the price
assumptions were based on what they actually reported as
realized in 2003-2006. Starting with 2007, he believed $80 was
used; he'd have to look at the model. That would be tested in a
number of areas. He'd make sure he'd matched the right price.
3:35:10 PM
MR. RUGGIERO showed the next slide, "BP Prudhoe Bay: Oil
Company NPV." It plotted the net present value (NPV) discounted
at 15 percent, which he said is more representative of the
hurdle rate used to run economics within a lot of oil companies.
If he takes five years of investment between $750 million and
$800 million a year, this is about $3.7 billion to $3.8 billion
they've invested. This says that through 2011, on a discounted
basis, they'll generate another $3.7 billion above their costs.
MR. RUGGIERO emphasized that this is a fully after-tax number.
Gaffney Cline has run this through PPT, property tax, royalty,
income tax, tax credits, and so forth, but didn't try to run all
the early years under ELF. Rather, everything was run under
PPT. He said he didn't want to get ELF wrong, but since
everyone says PPT generates more tax than ELF did, by running
the prior years under PPT instead of ELF, it says the government
take would have been higher and the economics would have come
down from what they'd have been under ELF. This still says it's
a highly profitable project, he concluded.
SENATOR THERRIAULT asked why the 15 percent discount rate was
used.
MR. RUGGIERO replied it was just a choice, what he believed to
be a more traditional discount rate, looked at on an NPV basis
by the oil companies. In order to come to the conclusion that
this is extremely profitable, this would be stressed in many
directions. He'd put in the 300 percent CAPEX, for instance,
and had doubled the "point forward" operating expenditures
(OPEX). Because Alaska is 99 out of 103 and thus has a higher
hurdle rate, he'd put in a 25 percent discount rate. He'd also
dropped the price to $50.
CHAIR FRENCH surmised this is a gross price, not net.
MR. RUGGIERO agreed, saying it means their net margin comes
down. In going from his starting price down to this price, the
only thing he was taking out was margin. He hadn't taken out
any costs, for example. Still, under this scenario, it remains
highly profitable.
MR. RUGGIERO showed a slide labeled "Overly Stressed Case." He
noted it shows the CAPEX is up to three times and the production
is exactly what they reported it to be, with the 25 percent
decline. Still, overall it ends up being plus or minus a
50 percent rate of return project, although it's on an NPV
basis, remembering this is at 25 percent discounting. But this
is still at a billion-dollar NPV, even with a hurdle rate of a
25 percent discount on those cash flows. He'd stressed it
multiple directions. It is highly economic.
3:38:43 PM
SENATOR WIELECHOWSKI asked: If we implement ACES or something
higher, will the investment leave Alaska? Do some places
commonly have rates of return of 50 to 60 percent?
MR. RUGGIERO replied he believes this infill drilling program
would rank very high in the portfolio of many companies. The
benefit of being able to develop many billions of barrels
ultimately - continuing this program over time - is significant
and people would invest in it.
3:40:05 PM
MR. RUGGIERO noted he'd just provided some printouts from a live
model. He'd taken the important parameters in this drilling
program such as CAPEX, OPEX, production, discount rate, royalty
rate, base rate on the net tax, progressivity factor on the net
tax, and price. Based on questions yesterday, he'd added that
in for the same situation - in this case, an NPV of around
$3 billion for the oil company - the undiscounted take for the
State of Alaska is just shy of $11 billion. Running the state
and company cash flows will give a sense of the split after
costs are recovered.
SENATOR THERRIAULT asked what the progressivity trigger is.
MR. RUGGIERO replied the progressivity trigger is PPT, a $40
margin. The control sheet shows actual production off the
digitized plot provided by BP. For 2007 and beyond, he'd
stressed that to a decline rate of 25 percent to make sure he
wasn't showing more barrels produced than what BP said it
developed. A typical cash-flow model was run to see the
economics of this investment. It starts with CAPEX. The prices
are actual prices in the system realized during those years; the
price going forward could be manipulated as he went back to the
control page. As a surrogate, it uses costs ConocoPhillips
reported in its annual report; this is because ConocoPhillips
reports Alaska separately and thus Gaffney Cline was able to
glean some data from that.
3:43:42 PM
MR. RUGGIERO indicated all the normal steps of calculating
revenues, royalties, costs per barrel, CAPEX, and so forth were
done. He apologized that it says "ACES" instead of "PPT," since
it was run as PPT. It could be run as anything that is a net
system, he noted. He indicated this shows progressivity impacts
and corporate income tax impacts. The NPVs and internal rates
of return (IRRs) are then calculated. He said this is the
technical mumbo-jumbo that goes into an economic model. He
emphasized that all the pieces were put in there.
CHAIR FRENCH asked how the credit aspects of capital investments
are estimated.
MR. RUGGIERO replied Gaffney Cline put it in as 20 percent in
the year spent. For each of these drilling programs, the
investment occurs in year one, but production doesn't start
until year two. In reality, they'll start producing things as
fast as they drill, because drilling program is multiple wells.
Gaffney Cline didn't do that, however, but stressed the model,
putting all the production into year two before it started. He
explained that Gaffney Cline has the ability to change any of
the parameters shown in response to a question from legislators.
MR. RUGGIERO said furthermore, each program shown from 2002-2006
has a checkbox. Removing the checkbox from a particular year
removes that year's drilling program. This allows looking at it
on an aggregated basis and also by individual year. For
instance, in 2003 they hadn't drilled thinking it would be an
$80 or $90 world, but thought the price might be closer to $40.
One can go back and see that even in 2002, with rapidly
declining production, at a 15 percent discount rate it still
generates an NPV of $500 million. That's above their costs. He
asked the committee to stress this drilling program with any
parameters they chose.
SENATOR THERRIAULT suggested isolating a particular year,
running the price down to what the company might have made its
investment decision on, as far as a forward-looking price.
MR. RUGGIERO indicated he was running this scenario. If in 2002
the company thought there'd be $40 oil, that still generates a
plus or minus $300 million NPV at 15 percent discounting. This
is at the prices they actually realized, because Gaffney Cline
had put in actual prices through 2006. It's only the data from
2007 that they'd have changed back down to $40. On a rate-of-
return basis, that's roughly a 28 percent return on the
investment, even at the expected price of $40.
3:47:44 PM
SENATOR WIELECHOWSKI requested a real-life projection with
realistic variables with respect to CAPEX, OPEX, discount rate,
and an oil price of perhaps $50 or $60. He said a CAPEX
multiplier of 300 percent seems high, for example, and asked
what would be a reasonable projection.
MR. RUGGIERO replied he'd stick with the 300 percent, which he
believes is realistic because he thinks the numbers generated
are plus or minus the total capital program spent in that area.
He said this is burdening these individual drilling programs
with all the CAPEX that they're spending out there.
SENATOR WIELECHOWSKI asked whether Mr. Ruggiero believes the
CAPEX, OPEX, discount rate, and multiplier are realistic, as
well as the royalties. He then suggested doing a net tax rate
of 25. He asked how to get the progressivity to where
Mr. Ruggiero was suggesting, but he acknowledged that
Mr. Ruggiero wasn't suggesting specific numbers.
MR. RUGGIERO responded that this program doesn't generate a
progressivity curve that's ever-changing. This generates just a
straight line. What could be done, however, is to increase the
progressivity slope, which would get it to the maximum rate
faster. It still would give an example of the impact of the
progressivity, for example, looking at the entire program, using
a $60 price and a starting base tax rate of 25 percent, even
taking it up and saying costs will be 200 percent of what's
predicted.
MR. RUGGIERO continued, saying he was working off the reported
data from 2006. Not only would he have a 10 percent annual
escalator on costs, but now he'd have doubled the total costs.
If he now raised the progressivity factor to 0.6, they'd still
make a substantial return on their investment. The rate of
return would have come down a little, but not much.
SENATOR WIELECHOWSKI asked where the progressivity starts in
this scenario.
MR. RUGGIERO replied it all kicks off at the same PPT, $40.
SENATOR WIELECHOWSKI asked about lowering it to $30.
MR. RUGGIERO said he had nine things up there that he could
change, but this was asking for a tenth. He wasn't sure he
could do it quickly.
SENATOR WIELECHOWSKI asked whether Mr. Ruggiero believed
lowering it to $30 would have a big impact. He offered his
understanding that ACES lowers it to $30.
AN UNIDENTIFIED SPEAKER said, "The margin."
3:50:41 PM
MR. GEORGE replied on this particular one, probably not. On a
broader range of things, it would have a greater impact.
CHAIR FRENCH asked: Can't you achieve the same result by
lowering the price $10 roughly?
MR. RUGGIERO answered that roughly, yes, because that would
change the margin. Following a brief back-and-forth discussion,
he said this is calculating the net margin per barrel. When
it's below $30 or less, no progressivity comes into play. In
response to Chair French, he said at this price there is no
progressivity.
CHAIR FRENCH noted it was at a net rate of 25 percent, looking
forward five years to 2012.
MR. RUGGIERO concurred.
CHAIR FRENCH surmised the state would get $6 billion and the
industry $2.5 billion.
MR. RUGGIERO indicated the industry would get about $1.7 billion
"NPV 15." Pointing to an unspecified number, he said this is
the state take, also discounted at 15 percent. That means,
considering the time value of money, that $6 billion the state
would take over the entire period, reducing it to the same terms
as the oil companies, is worth $2.5 billion. Roughly, what is
shown is that of the total amount available as profit, the state
would take plus or minus 60 percent.
3:53:36 PM
SENATOR THERRIAULT offered his understanding that the CAPEX
multiplier was at 300 percent not because Gaffney Cline expected
costs to rise that much, but because it captured both the
drilling costs and all of the capital infrastructure.
MR. RUGGIERO clarified that he'd wanted to be fair and to use
BP's testimony that there actually are injectors and other
facilities associated with it, and that it would be improper to
take just the drilling costs. Thus he was using the 300 percent
as his base case on the CAPEX.
SENATOR THERRIAULT acknowledged it isn't an exact enough science
to pin down every dollar, but he wanted to know what the
industry representatives might say about this tomorrow.
MR. RUGGIERO replied he'd been hoping BP would respond in its
presentation to the House today. However, there was no
discussion of BP's infill drilling program in the paperwork
provided today. He said while sitting in the audience he'd done
some quick "back of the envelope" numbers. The reason he'd done
the analysis and built the model is it appeared to be a lot more
productive than it was. He'd had some numbers that indicated
this to be more economic than here, with a two-month payout, and
after some negative feedback about that he'd tweaked it.
MR. RUGGIERO added that if he has it wrong, then the very people
who can provide the right numbers will come before the
committee. Members can ask BP. If the program isn't this
profitable, if Gaffney Cline has missed some base costs that
need to be absorbed, then BP can come forward with real numbers.
He noted this was floated to a few people within the government
to ensure that nothing major or glaring was absent from the
model and that no numbers appeared to be far outside what they
believed to be reasonable for costs, investment, and the like.
3:56:32 PM
SENATOR WIELECHOWSKI asked whether this was shown to the
legislative consultants and whether they had any comments.
^Steve Porter and Dan Dickinson, Consultants to the Legislative
Budget & Audit Committee
STEVE PORTER, Consultant to the Legislative Budget & Audit
Committee, told members that a lot of time had been spent on
this model recently. One question that needs to be asked, to
add context, relates to what this model addresses. Does it
address infill for legacy fields? Does it address heavy oil
differently from legacy fields? Does it address exploration?
He opined that this is an excellent model for understanding what
is going on.
MR. RUGGIERO indicated Gaffney Cline had spent several hours
with the two legislative consultants going over it because they
have a lot more experience in Alaska and have seen the numbers
going back and forth. Gaffney Cline also had used many people
as a sounding board. He reiterated that the infill drilling
program is extremely economical. Even if there is a highly
progressive tax structure put in place, he doesn't believe the
investment in the infill drilling will fall off. If it does,
they've got to have some barn-burner projects around the world.
3:58:37 PM
MR. PORTER noted he was present during the vast majority of
Gaffney Cline's previous testimony, and had talked a lot with
them about the details. He said he wouldn't talk for Dan
Dickinson, but personally agreed with almost everything they'd
said on the net issues. He added that this is an infill
drilling program analysis. It isn't as clean for heavy oil
because the numbers are slightly different, and for exploration
the risk factors are different. However, the "net world" really
does help out the heavy oils, and it helps exploration in terms
of how CAPEX is placed in the overall tax scheme.
CHAIR FRENCH requested a definition of net world analysis.
MR. PORTER responded that taxing on the net helps put the West
Saks of the world in competition with the legacy field
investments of the world. In terms of net versus gross, when
taking the net cash flow relationship, West Sak is being taxed
at $30 cash flow; if its lifting cost is $40, it doesn't pay a
windfall profits tax until it gets to $70. At Prudhoe Bay,
however, if the lifting cost is $20, that point is substantially
less.
4:00:40 PM
CHAIR FRENCH said this raises the issue of whether there can be
two tax systems: a more aggressive tax system on legacy fields
that will be going through an infill drilling program, and a
lighter tax system on West Sak. It strikes him that the biggest
complication is that they're both located in the same place.
They'll likely be produced using the same flow lines and
production facilities, if not through the exact same well bore.
MR. RUGGIERO noted that legislators would hear all sorts of
complexities to be able to separate these and allocate facility
costs and investment. He expressed hope that from Mr. George's
presentation they'd glean the following: With a single, highly
progressive system the state could get such differentiation -
which is desired for investment in something like West Sak -
without needing two separate systems.
CHAIR FRENCH surmised, "Because it nets it all out against
itself."
MR. GEORGE said it takes account of that in the way the margin
works and the way companies will look at incremental further
investments in the future.
MR. PORTER added one more piece, indicating a Gaffney Cline
slide had talked about base tax versus progressivity, how
actually keeping the base tax low and progressivity higher helps
the West Saks of the world and makes more sense than raising the
base tax. He suggested this be addressed when "moving knobs
around."
4:02:27 PM
MR. RUGGIERO noted this is part of what he and Mr. George wanted
to address at the end.
SENATOR THERRIAULT asked: Do you think this system is sensitive
and adjustable enough to not require a differential tax system
with respect to the legacy fields?
MR. RUGGIERO opined that a single system can be designed to
address the goals discussed earlier: getting high marginal tax
rates when there are high-profitability fields; at the same
time, encouraging reinvestment in those same legacy areas; and
encouraging new investments by new entrants in new areas. Every
system will have some shortcomings. But based on the goals that
he believes Alaska is trying to achieve today and in the near
term, and possibly in the long term, he believes a system can be
put together that works well and meets all those goals.
SENATOR THERRIAULT noted the presentation had discussed infill
drilling in legacy fields, which he said is where the real money
is for the state. However, he also wanted to be sensitive to
new entrants and new exploration, away from the infrastructure,
and thus he'd have to think about how it works for them.
MR. GEORGE replied he believes within the general structure
discussed for PPT, even changing the progressivity, that system
does differentiate between investments of different
profitability. Thus the decision may be more about how much to
tax the more highly profitable end or the less profitable end.
As for new entrants, there is the capital credits issue to help
them in the initial period before production. If they're going
into production with their investments, then the taxation levels
will be commensurate with the profitability of that development.
This is all within a single system.
4:06:10 PM
DAN DICKINSON, Consultant to the Legislative Budget & Audit
Committee, followed up on Mr. Porter's comments. He clarified
that although they'd spent several hours with this model and
earlier data presented by Mr. George, they weren't specifically
doing a technical run-through of the model to make sure the nuts
and bolts were working.
SENATOR HUGGINS said he had no reason to doubt the model, but
didn't know the probability of error. He urged caution with
respect to investment strategies.
4:08:38 PM
CHAIR FRENCH concurred, noting this is the first he'd seen the
inner workings of the system. He asked for a run-through
involving a tax rate of 25 percent, with progressivity at 0.5 on
$40 net, going forward at a price of $60.
MR. RUGGIERO replied they were looking at the entirety of the
five-year drilling program, in aggregate, running CAPEX at three
times the reported drilling amount spent; OPEX at 200 percent of
past projections; royalty unchanged; a base rate of 25 percent;
and progressivity at 0.5 percent at a $60 price. What was shown
here, with the oil company NPV at a 15 percent discount rate,
was that the company's return on this investment would be over
$2 billion. The internal rate of return for the whole project
would be 56 percent.
MR. RUGGIERO, in response to Senator Therriault, showed the
higher overall government share, noting the federal income tax
share had then been subtracted, leaving the Alaska share.
SENATOR THERRIAULT offered a general rule of thumb: If there is
an additional take of $100 for the State of Alaska, $33 came out
of the federal treasury, not the corporate treasury.
MR. RUGGIERO agreed.
SENATOR WIELECHOWSKI said there'd been a little bit of concern
from the legislative consultants about the model as far as the
exploration and heavy oil development. He asked whether that
can be adjusted by adjusting the CAPEX and OPEX multipliers.
MR. RUGGIERO replied that he wouldn't even want to start to use
this model to predict heavy oil development, gas development,
and so on. This is specifically a model of the infill drilling
program in the existing fields. He wouldn't even know what cost
structure would be best, for instance, and there are other
parameters including the rate of success and so forth. All
those would change. It would be speculation at this point.
MR. RUGGIERO added that the reason he thinks this model is
important is that AOGA, BP, ConocoPhillips, and Chevron all said
the significant value - over 70 percent of the value to the
state - is infill drilling in the existing units. This model
represents the economics for 70 percent of the potential they
say exists. Thus he believes the model is valid to look at and
is a very helpful tool for legislators in making decisions.
CHAIR FRENCH characterized it as the center of the target.
4:13:29 PM
SENATOR WIELECHOWSKI recalled discussion about 20 billion
barrels of heavy oil and encouraging exploration to try to hit
other big fields outside. He said if the effort is to make one-
size-fits-all legislation, at some point there should be a
narrower scope as to how it impacts those other fields. He
suggested that may be an issue for the Senate Finance Committee.
MR. RUGGIERO replied that's why Mr. George had presented the
portion he had. Although it took a one-year snapshot, it shows
how on a purely net system - using the progressivity that exists
now - the more the progressivity goes up, the more incentivized
existing operators will be to spend dollars back into those
fields, into this type of very economical investment.
CHAIR FRENCH asked Mr. Ruggiero to run a scenario with a
30 percent tax rate.
MR. RUGGIERO did so and then said it was roughly $1.85 billion.
The state, undiscounted, was at $8.1 billion. He suggested
looking at just one number and changing back and forth. At a
25 percent starting rate, looking at the state on an
undiscounted basis, he said its take would be $7.5 billion. If
they start with that $7.5 billion and go up to 30 percent, it
increases to $8.1 billion - about $600 million. He then
returned to the 25 percent starting point, remarked, "There's my
twenty twenty-five," and said at 30 percent it is "eighteen
fifty-five." Thus he said $200 million was lost in NPV, the
state went up $600 million, and the federal government was "plus
or minus the net loser in this."
4:16:17 PM
CHAIR FRENCH suggested it was closer to $170 million. He noted
some would say this is an enormous tax increase. However, it's
a 10 percent change in their total take.
MR. RUGGIERO specified that on a discounted basis, it made less
than a 10 percent change in their net present value.
CHAIR FRENCH, in response to Senator Therriault, asked that
Gaffney Cline bring the model back tomorrow morning so AOGA
representatives could see it and perhaps comment.
4:17:43 PM
SENATOR McGUIRE asked: If we end up with this kind of tax rate
and this amount of money coming into the state coffers, are we
going to have a whole section on how we're going to save that
money and not spend it all in the next five years on our
drilling program, so to speak?
CHAIR FRENCH replied, "Funny you should ask." He inquired
whether Gaffney Cline had further information for the committee.
MR. RUGGIERO said yes. He referred back to the information from
BP's slide and its discussion of the overall North Slope natural
decline of 15 percent, with 1.3 billion barrels that could be
produced for roughly a $5 billion investment. If the decline
were reduced to 6 percent, they could generate an additional
3.9 barrels for $25 billion total spent. A 3 percent decline
would generate an additional 7.5 billion barrels for $70 billion
spent. He surmised this was presented to show that a
significant potential still exists in the existing fields,
urging legislators, whatever system they devise, to incentivize
investment in the existing fields.
MR. RUGGIERO explained that Gaffney Cline had built a generic
North Slope model using these costs and barrels that BP said
could be generated. The assumption used was that BP's barrel
figures would be produced barrels. The effort was to figure out
the economics of BP's investment in this program.
MR. RUGGIERO highlighted one correction in the slides BP
presented to the House today: a footnote disavowing any
knowledge that those are its cost numbers, instead saying those
come from DOR. He said legislators would have an opportunity to
ask BP why it isn't providing what it will really cost. He
mentioned BP's expectation to "develop these significant barrels
from the existing assets that they're operating on your behalf."
MR. RUGGIERO noted it was run at $80 a barrel. The numbers
would be small if it went lower, but this wasn't going to be run
live because the numbers were very high. Presented would be
"NPV 10" because a lot of numbers in the work seen have been
presented on this basis. Thus he'd switched from a discount of
15 in the previous model to 10 here. It was run on an
undiscounted basis, and then the NPV was generated on a per-
barrel basis. This is the after-tax profit, run under PPT, not
ACES; it is for the existing PPT, with a "base rate trigger
point progressivity."
MR. RUGGIERO said for the 15 percent decline case, there is
"15 billion to 20 billion NPV 10." This has a lot of room for
costs to go up and market price to come down, and there is a lot
of margin in the existing fields. There is a $22 billion to
$27 billion take on cash flow after all taxes on an undiscounted
basis. On a per-barrel basis, it's $15-20 a barrel.
MR. RUGGIERO turned to the 6 percent decline case, noting it
jumps from the $15-20 billion to $30-40 billion on a discounted
basis and to $55-75 billion on an undiscounted basis. However,
the range per barrel doesn't change much, staying in the $14-19
range, close to the previous $15-20 range on a per-barrel basis.
MR. RUGGIERO presented the final set of numbers, noting on a
discounted basis it doesn't go up that much, rising from the
$30-40 billion up to roughly $35-45 billion. This is because
the additional barrels produced under the 3 percent decline are
far in the future. Thus the discounting doesn't add much value
to those barrels when looking at 8-10 percent discounting.
However, if it is undiscounted, those barrels do come into play
because the oil company take is between $90 billion and
$125 billion if they actually operate the North Slope fields on
a 3 percent decline.
4:22:50 PM
CHAIR FRENCH asked about the 6 percent decline. He asked
whether that means 3.9 billion barrels will be produced, costing
the industry $25 billion according to their numbers, although
now they're saying they've switched back to DOR numbers.
MR. RUGGIERO specified that they're saying this $25 billion is a
DOR number.
CHAIR FRENCH said, assuming that's right, it discounts back to a
$30 billion to $40 billion take for them at a 10 percent
discount rate. He asked whether Gaffney Cline had run an
internal rate of return on that, and what was arrived at.
MR. GEORGE answered that in the simple model they'd done, it
can't really be calculated because it starts with the fact that
they're already producing 750,000 a day.
The committee took an at-ease from 4:24:31 PM to 4:42:41 PM.
MR. RUGGIERO indicated two slides ago there was a 250,000-
barrel-a-day abandonment shown. Gaffney Cline had tried to fit
all the barrels BP said could be produced with the additional
investment, and had cut it off at 250,000 barrels a day. Thus
the rates over time and how they'd gotten there relate to trying
to match the number of barrels BP presented as being able to be
produced at those different decline rates for that incremental
investment. Gaffney Cline had then asked what happens if there
is additional development out there, additional barrels that
keep the pipeline going to the extent that these fields could
actually be run down to a lower abandonment rate. Instead of
250,000 barrels a day, therefore, they could take it down to
200,000 or 150,000 or 100,000.
MR. RUGGIERO explained that by taking the top-end number, the
3 percent decline rate, and changing the abandonment rate to
200,000 barrels a day, one gets another 1.2 billion barrels. By
changing it from 250,000 to 150,000, one gets 2.3 billion
additional barrels. At the extreme, by changing it from 250,000
to 100,000, almost another 4 billion barrels can be produced
from those fields.
SENATOR THERRIAULT asked what the abandonment rate number across
the bottom of the slide means.
MR. GEORGE answered that plus or minus 750,000 barrels a day are
being produced. If there is a 15 percent, 6 percent, or
3 percent decline, producing out the volumes on the BP slide -
1.3 billion, 3.9 billion, and 7.5 billion - and retaining the
decline rate, those volumes are still producing at plus or minus
250,000 barrels a day.
MR. GEORGE said that isn't out of line with what was advised
with respect to mechanical issues associated with keeping TAPS
running, under current consideration at least. Thus Gaffney
Cline had cut it off at that point. That said, under current
oil price and operating cost conditions, they're doing what in
reality wouldn't occur: abandoning with a cash flow each year
of $1 billion to $2 billion. Thus there is a circularity in the
argument that isn't very clear.
MR. GEORGE added that Gaffney Cline did say, however, that
they'd continue the production profile declining away. If they
were able to keep that lower production profile flowing through
the pipeline, if the abandonment could be gotten down to 200,000
barrels a day or 150,000 or 100,000, there'd be 2-3 billion
barrels more produced out of there. He said there is a
significant prize in the abandonment issue, which is really the
message from it.
4:46:38 PM
CHAIR FRENCH surmised that this doesn't take into account the
capital costs necessary to resize the pipe, insert choke
points, go to a different form of pumping, and so forth.
MR. GEORGE replied no, they hadn't done economics. He'd used
the word "prize" because there'd be a lot of barrels still in
there. Obviously, the true economics would have to be figured,
including what capital would have to be spent or how to get
around it via other means. As Mr. Ruggiero had said, if one
were able to produce enough things outside the conceived
portfolio that gives a 3 percent decline, which would also keep
the rate up, then the portfolio that gives the decline would
continue to produce some extra barrels.
MR. RUGGIERO showed the summary slide on this point, noting
Gaffney Cline agrees there is a significant upside for the State
of Alaska out of the existing North Slope fields. Based on
their analysis, both on the infill drilling program and the
representation of what BP put forth as arresting the decline
rate, they believe considerable positive economics are
associated with that investment. They'd also taken a quick look
at something important to oil companies and their stock price:
the number of barrels they're able to book as proved reserves.
MR. RUGGIERO explained that if the production volumes associated
between the 15 percent natural field decline and either the
6 percent or 3 percent curve have already been booked as proved
reserves, then to not do the investments - to not produce those
barrels - could result in a significant write-down of reserves.
MR. RUGGIERO noted Gaffney Cline had looked at ConocoPhillips's
annual report. There are some 1.5 billion barrels of reserves
listed for Alaska. If the percentage ownership of Kuparuk and
Prudhoe Bay is compared with the 1.5 billion, Gaffney Cline
doesn't know exactly, but it appears the number of barrels
associated with the 6 percent decline rate have been booked as
proved reserves, at least in the case of one of the companies
operating there. He said that is something that can be asked as
to what decline rate is represented by the number of reserves
they've booked and shown in the annual report.
4:49:44 PM
MR. GEORGE added that for reporting reserves to the SEC, the
only category SEC recognizes is "proved." The standard that
must be applied in booking reserves is "reasonable certainty."
Although Gaffney Cline doesn't audit ConocoPhillips's reserves,
it audits a number of companies and is familiar with those
standards. Inherent in the standard of "reasonable certainty"
is having a high degree of confidence that the investments will
continue in order to produce the barrels that are being added up
and put in there as a reserves statement.
MR. GEORGE said the implication is this: With ConocoPhillips
booking about 1.5 billion barrels of oil and natural gas
liquids, it is reasonably certain it will be producing them.
This means the company is reasonably certain it'll be making the
capital investments necessary to produce them.
MR. GEORGE went on to say that's a plus-or-minus 6 percent
decline rate, if Gaffney Cline has interpreted everything
correctly, and will be a minimum level of expectation. The
standard of reasonable certainty is actually below the level
companies typically expect to get. Every year, companies write
down reserves and add new ones, for instance. But the trend is
that proved reserves will, on a portfolio basis, generally rise
over a period of time as one starts producing. Thus the
expectation Gaffney Cline has for this is, in fact, that there's
a reasonable standard of certainty around the 6 percent, and
probably an expectation that is some number higher than that.
CHAIR FRENCH thanked the testifiers, saying the presentation was
illuminating, some of the numbers were eye-popping, and it went
a long way towards debunking many of the myths seen in media
advertisements about the devastating effects of modest tax
increases on the oil industry. He said he would be encouraging
the commissioner to make Gaffney Cline's model available to the
public in order that folks can see for themselves just what's at
stake for the future of at least the legacy fields, Prudhoe Bay
and Kuparuk.
4:52:47 PM
SENATOR THERRIAULT requested discussion about a suggestion that
has been heard, that companies will base part of their
investment decisions on the fiscal stability of the governmental
regime they operate in. He noted he'd told the press today that
he doesn't personally believes it is a make-or-break situation,
but it could be one thing that gets factored in. He said he
wasn't sure how that would be built into a model, but asked for
comments from boardroom experience, for example.
MR. RUGGIERO replied that going back a decade or so, looking at
investments in different places around the world, he'd found a
number of times that risks were translated into higher discount
rates as one means of evaluating an investment in one area
versus another. He recalled that ConocoPhillips, or perhaps
Chevron, had put up a list of seven projects, not revealing the
discount rate but saying there was a hurdle rate that would have
to be overcome in order to make an investment. If it were below
that line, likely the investment wouldn't be made, but serious
consideration would be given to something above that line.
MR. RUGGIERO noted one way a company might choose to do its
evaluation is to just change the discount rate. That's why
Gaffney Cline put into its model the ability to run it up to a
20-25 percent discount rate, this being a severe hurdle for a
place that a company believes has some risk associated with it.
SENATOR THERRIAULT recalled one thing Dr. Pedro van Meurs had
suggested, which he does with other areas. When they change
their system or believe they aren't getting the level of
investment they should, they try to "rebrand" it, getting the
message out to additional players about what advantage one's
system offers to an investor, for example.
SENATOR THERRIAULT asked: If we modify PPT, getting in place
what the legislature believes is workable and a robust system
that can survive the ups and downs of prices, do you think that
is enough of a departure that the State of Alaska needs to
figure out a way to get the word out? He said this should be an
attractive system.
MR. RUGGIERO answered that he believes once legislation is
passed that defines the fiscal policy for Alaska, it will be
important to get out a clear message that shows the benefits,
both for new entrants and new investment as well as for existing
players. Otherwise, there's an opportunity for others to not
fully understand the process, not fully understand the climate
in Alaska, and make observations from afar. The state needs to
get something out that really explains how the Alaska system
works and why companies should be interested in coming to Alaska
to invest.
MR. GEORGE concurred. He said making things easy for people in
the investment-decision process is part and parcel of the
overall resource-management program for any state or country.
This includes making sure people don't have misunderstandings
and making information and examples readily available. When
Gaffney Cline works with countries on new license rounds,
typically they're starting with a country that has a major
change because of opening up the industry, for example. In that
case, Gaffney Cline does "road shows" with them.
MR. GEORGE said while he wasn't suggesting Alaska needs to do
this, part of the process is educating the industry as to what
is really there, how it is seen, how it works, and so forth.
The philosophy is that within the companies, they have a selling
process to do. They must sell management on the fact that
Alaska is a good place to make investments. If that is made
easy for the companies, it is easy for them to sell it to
management. Just doing something with the fiscal system is an
important component, but it's only one component of an overall
resource-management policy.
The committee took an at-ease from 4:58:26 PM to 4:58:47 PM.
CHAIR FRENCH noted tomorrow the committee would hear from
legislative consultants about gross versus net systems, and then
would hear from the industry in response to today's
presentation. Some legal issues as well as an issue related to
information sharing also would be addressed. He expressed hope
that the information-gathering portion of the committee process
would conclude tomorrow.
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