HB 111-OIL & GAS PRODUCTION TAX;PAYMENTS;CREDITS  1:45:38 PM CO-CHAIR TARR announced that the final only order of business would be HOUSE BILL NO. 111, "An Act relating to the oil and gas production tax, tax payments, and credits; relating to interest applicable to delinquent oil and gas production tax; and providing for an effective date." CO-CHAIR TARR made announcements. 1:47:10 PM RICHARD RUGGIERO, Consultant, Legislative Audit and Budget Committee, Alaska State Legislature; Managing Partner, Castle Gap Advisors, provided a PowerPoint presentation entitled, "Petroleum Taxation Design," dated 2/27/17. He summarized from an earlier presentation to the House Resources Standing Committee entitled, "Developing Petroleum Fiscal Policy" provided at the meeting of 2/20/17, restating the following key points: there is constant change in the industry, including government terms; governments often make corrections to a near- term issue which jeopardizes long-term goals; increase in government take is a reduction in value for industry; a historical perspective and transparency create better tax systems; new players should be encouraged; regime to regime comparisons should be questioned; countries have different needs [slide 3]. Slide 4 illustrated petroleum taxation change charts, and he acknowledged many governments change their fiscal systems in response to the volatility in oil prices, as was presented in previous testimony by the Alaska Oil and Gas Association (AOGA). The charts identified the many governments that increased their take during rising oil prices, and that during periods of rapid decline in oil price, governments lowered take and created incentives. 1:53:24 PM REPRESENTATIVE BIRCH pointed out when oil was plummeting in value, Alaska was the only regime that increased government take. His stated the distinction between the two slides [presented by Mr. Ruggiero and AOGA] is his concern that Alaska will not be competitive if it tries "to squeeze more revenue out of, out of an already struggling industry." MR. RUGGIERO agreed. REPRESENTATIVE RAUSCHER questioned whether the information on the aforementioned charts indicated if any of the many changes in fiscal policy were successful, for example, the changes made by Russia. MR. RUGGIERO observed the United Kingdom has made significant changes in response to high and low oil prices; however, other countries react in an incremental way. In Russia, the government has taken over a working ownership interest from multinational companies that had started or developed fields. In further response to Representative Rauscher, he said some changes are working, and countries have gained investment and development. However, sometimes a successful policy is unique, and he gave an example of a Southeast Asia country that needed a source for natural gas. REPRESENTATIVE JOHNSON understood the charts on slide 4 intend to give a sense of the inconsistencies in Alaska's oil tax policy. However, she pointed out that from January 15 all of the changes [to other regimes] are consistently to fiscal incentives, because oil prices are going down, and when oil prices go up, they are consistently increasing taxes. Representative Johnson concluded Alaska is one of the latest - and may be the only - regime to increase government take. 2:00:40 PM MR. RUGGIERO agreed the charts indicate that in periods of very low prices most, if not all, governments change to more favorable terms. Whether a system should be changed at a certain point lies with the legislature, and the information provided is to inform its decision. REPRESENTATIVE TALERICO noted the regime comparisons are usually between Alaska and sovereign nations; however, as a state, Alaska has to also contend with federal take, as other states must, and as do Canada and Alberta. The U.S. tax rate does not change often, and he questioned whether there are comparisons with other states. MR. RUGGIERO pointed out the charts include U.S. Gulf of Mexico, which are federal waters, and where changes in royalty rates and in lease payments in the last decade have occurred. Further, in most of the Lower 48, the acreage involved in oil production garners private royalty, such as in Texas, where new land leases are approximately one-quarter royalty and above, thus the payment for the acreage goes to a private mineral holder. He explained comparing operator take to "government" take is really comparing operator take to "non-operator" take, because some of the take goes to private holders of the mineral rights. Mr. Ruggiero directed attention to slide 5, and summarized "takeaways" as follows: there is no ideal structure and many are unique, however, some aspects are more successful; regimes seek to produce a level playing field; all systems have biases. He then listed long-term strategic petroleum taxation design goals for Alaska as follows [slide 7]: keep oil flowing through the Trans-Alaska Pipeline System (TAPS); encourage the exploration and development of new fields; encourage new operators; understand and capture value from existing fields; create more durability to the taxation system. Further, Alaska has high potential and prospectivity but will always be a higher-cost area for the exploration, discovery, and production of oil [slide 7]. 2:08:03 PM REPRESENTATIVE RAUSCHER opined the state always intends for "long-term strategic goals for Alaska," and always enters into agreements projecting a long period of stability, "and then, couple years later, we're rewriting it." MR. RUGGIERO said his presentation addresses how unintended consequences and results occur, and whether there are ways to include in legislation procedures that "stand the test of time." For example, modeling can be too simplistic, and may not include some of the factors that will change in the future, which skews the results. REPRESENTATIVE BIRCH recalled last year there was a welcome uptick in production that appeared to be the result of the stability provided by Senate Bill 21 [passed in the Twenty- Eighth Alaska State Legislature]; he questioned why the state would make changes to a successful tax structure. MR. RUGGIERO pointed out there are aspects to Alaska's current tax structure that will lead to unintended consequences when circumstances change, for example, the minimum tax. REPRESENTATIVE BIRCH pointed out HB 111 raises an additional $300 million in state revenue, which is a massive tax increase on industry. MR. RUGGIERO said he had not reviewed "the numbers" on HB 111, but at this time is providing to the committee helpful background information based on his extensive experience in this regard. REPRESENTATIVE BIRCH characterized Alaska's Clear and Equitable Share (ACES) [passed in the Twenty-Fifth Alaska State Legislature], with progressivity that raised a lot of money, as "terrible from an investment standpoint," and asked whether it was successful. MR. RUGGIERO stressed there is a long lead time between spending and production, thus data is not available to indicate whether the additional production now generated is because of spending attributed to ACES, or spending attributed to Senate Bill 21. However, "a bit" of the spending and arresting of the decline is as a result of spending after ACES, along with increased employment. He acknowledged the very high progressivity rate in ACES led to difficulty, but there were positive aspects also. 2:15:28 PM REPRESENTATIVE DRUMMOND asked whether insufficient data regarding ACES and Senate Bill 21 is due to a lack of transparency. MR. RUGGIERO explained it is known how much money was spent but it is unknown what the money was spent on, "and so we can't tie the correlation between where the production comes from and then when the money was spent on that production, or on the wells and facilities in order to get there." In further response to Representative Drummond, he said yes, because [the legislature] doesn't have the information and can't make a correlation. MR. RUGGIERO directed attention to slide 8 that listed short- term goals at a time when profits are low; for example, keeping industry activity high and encouraging operators to continue doing business, and offering incentives for new investment without putting the state in a "cash-reimbursement position." REPRESENTATIVE JOHNSON inquired as to how a tax increase in HB 111 will help increase production. MR. RUGGIERO responded: I have had some dialogue in talking with people about it. I am not an advocate of putting a heavy burden onto the oil companies at a time when there's no profit in the system. REPRESENTATIVE JOHNSON expressed her understanding the presentation is "an interpretation of HB 111, that's being offered to address these issues, and I don't know exactly how [it] ... actually address[es] the issues ... put before us." CO-CHAIR TARR said the committee would return to Representative Johnson's question. MR. RUGGIERO continued to a comparison of Alaska's petroleum taxation terms to those in the Lower 48 [slide 10]: · Royalty: The royalty charged in Alaska is in line with that of older leases in the Lower 48, many of which are one-eighth royalty. Alaska is more favorable when compared to new royalty rates, which are at a 20 percent minimum in Texas; new private leases average around 20 percent, depending on the location of the land. In addition to higher royalty, many new leases have a "drill or drop" provision which escalates fees to force activity, thus an oil company faces a deadline and may drill an uneconomic well just to hold on to its lease. · Effective tax rate: Under Senate Bill 21, Alaska has one of the lower tax rates and competes mainly against severance tax rates. · Credits: Alaska's exploration and production credits are very unique and valuable to the industry as they serve to overcome the additional risk associated with the state's environment and long lead time. · Unique aspects: Different taxation for location, substantial and stackable credits, and monthly taxation are unique to Alaska. MR. RUGGIERO, speaking from his experience working in the oil industry, said when projects are considered, fiscal terms have to meet certain criteria, but most attention is centered on relative risk; in fact, a project may advance with a higher non- operator take if risks can be mitigated. 2:25:05 PM REPRESENTATIVE BIRCH referred to information previously provided to the committee indicating HB 111 "shows a $300 million increase in taxes. ... I'm concerned that that is not stable, that that is actually a pretty significant increase." CO-CHAIR TARR clarified Representative Birch was referring to a fiscal note, "and those are the numbers for 2025, so the actual fiscal note for the bill, as it stands in this current fiscal year, is $45 million." MR. RUGGIERO advised an increase can be seen as stable - if it occurs at the right time - or unstable, relative to those who are impacted. He cautioned against looking at situations in isolation. REPRESENTATIVE BIRCH, referring to a statement on slide 11, questioned whether stability of the petroleum tax is a good thing. MR. RUGGIERO responded that "you've got a certain increase in one spot, but you may have also at the same time enacted other incentives, other credits, other things that would actually draw people in." He urged for the committee to look at the totality of the circumstances. Mr. Ruggiero directed attention to slide 13, and in response to an earlier question from Representative Rauscher, said governments do believe in their legislation at the time of enactment; however, the future brings unintended results due to changing prices and unpredictable variables. Further, interdependencies of variables are often ignored for modeling simplicity. Self-correcting systems attempt to avoid unintended consequences; one approach to petroleum taxation theory is that operators recover their cost and a fair return, with the government to receive the remainder. However, in reality, an attempt to approach taxation design from this direction and to determine the operator's fair share, returns all parties to the ongoing to debate on what is fair, which remains an unanswered question. Mr. Ruggiero further explained self-correcting mechanisms have been developed because governments are setting a tax rate prospectively, and the future is unknown. Therefore, self-correcting mechanisms allow governments and operators to make appropriate adjustments such as project profitability, and fixed, bracketed, and S curve metrics [slide 14]. 2:32:06 PM REPRESENTATIVE BIRCH returned attention to slide 14 and asked whether it was the government's role to decide what a fair return is for a business in the United States. MR. RUGGIERO clarified he is presenting theories of costs and of economic rent; the theory of economic rent is that government, as the steward of the resource, should receive economic rent, which is everything that is in excess of the company's return of its cost and a return on its costs. He said, "The whole bit about putting together petroleum taxation systems is governments deciding what their fair share is, oil companies battling and trying to achieve the best return that they can on their resources, and trying to find that point where you can make them both work." REPRESENTATIVE BIRCH opined the risk is made by an investor during exploration and development, and decisions are made in response to their return [on investment]. He said he struggled to accept that the government would be metering out a fair return on investment for any business. MR. RUGGIERO noted that when many countries set a windfall profits tax on a typical project they are setting a cap on what producers will make; in addition, many governments are using risk service contracts which have defined caps and rates of return so that governments set an expected range of profits, and the range of profits is known to the oil company. REPRESENTATIVE JOHNSON asked whether petroleum taxation theory is a field of study. MR. RUGGIERO explained the aforementioned theory applies for all extractive industries in which the government is the owner of an asset and hires a private company to develop its asset. The theory of economic rent is that whoever develops on behalf of the state should recover their costs and a fair return, and the government gets the rest as the owner of the resource. He returned to options for Alaska and suggested adopting a self- correcting system that would remove much of the complexity of the current tax system, and some of the unintended results. Firstly, in order to create durability, the state needs to retain its net based system which is based on margin and not on price; in fact, fixing a system on price is "setting yourself up for some of these unintended consequences or ... if you don't make changes, then people are going to pick up their toys and go home." Also, a system based on margin and profit will demonstrate to producers there will be sharing on the low end, and on the high end, as well [slide 15]. Slide 16 illustrated an example of an unintended consequence: The intent at the time of the legislation was that there was to be no tax when the companies were losing money, however, there has been a $25 shift in cost, and thus companies have an additional burden of a gross tax when they are losing money [slides 16 and 17]. 2:42:40 PM MR. RUGGIERO, referring to changes that can result in an unintended consequence, provided a chart that showed the total average cost of production has increased from $17.34 per barrel in 2007 to $35.64 per barrel in 2016 [slide 18]. Slide 19 illustrated another possible unintended consequence of Alaska's current tax structure, and he explained: If at any point, if your effective tax rate is the same as the tax rate at which your NOLs are converted to a credit, you're in a[n] equal situation whether I get an NOL carry forward or I get the tax credit. ... We'll leave the time value out on it right now. However, if you're ... giving credits at 35 percent and your effective tax rate is only 10, that credit is actually shielding three and [one]-half times the margin than the loss that created that tax credit. And that has to do with the differential between the rate at which the NOLs converted to a credit and then the rate at which their future revenues are taxed at when they use those credits. CO-CHAIR TARR advised the committee will have further discussion related to effective tax rates and NOLs. MR. RUGGIERO said his first option for the committee's consideration is to continue with the net tax system - outside of royalty - and ensure mechanisms of the system are not tied to price but to margins, and to include a low base rate with bracketed progressivity, which be a system that would eliminate features such as gross value reduction (GVR) and per barrel credits. He stressed that a net system requires the state to become an indirect investor in every project, because it allows income to be offset by costs. The second option is for the use of carry forward losses instead of cashable credits, so that the state invests indirectly and after the project is online through taxes not paid. Also as an indirect investor, the state must insure costs are reasonable, and that there is no duplication of facilities. Further, the state must continue to offer top quartile, or decile, exploration and investment incentives to ensure further activity, and allow certain conditional cashable credits. Mr. Ruggiero further suggested an uplift factor to compensate for the time value of money, and that credits or uplift should be tied to a minimum level of data transparency [slide 21]. 2:50:16 PM CO-CHAIR TARR asked for an example of "uplift to account for the time value of money." MR. RUGGIERO explained some countries offer an annual uplift on any unused losses or NOLs; for example, in a year NOLs or losses are not used, they are increased by 10 percent, so when the operator eventually uses the credit or loss, it has a value similar to if it had been cashed or used immediately against current income. This type of uplift can be open-ended or extend for a set length of time. Other regimes use a mechanism that provides a one-time, lump-sum, 100 percent uplift, which creates an incentive to expedite a development by a certain date. Mr. Ruggiero returned attention to a gross versus a net system and restated his next option, which is to retain the net system. However, he advised keeping royalty along with the net system because worldwide, all regimes where petroleum revenues represent a large portion of the treasury include royalty in their fiscal systems, even though royalty may have been eliminated in regimes where petroleum revenues are a small part of total revenue. Because Alaska is predominately funded by petroleum, the state should retain royalty [slide 22]. Net systems have options for rates, and he suggested the best option for Alaska would be a net system with bracketed steps, based on increased profitability per barrel: at high profits per barrel, "you can step up your tax, when the profit per barrel is very low, that's when you start from a low tax" [slide 23]. Mr. Ruggiero reviewed a net system with stepped or bracketed progressivity that is based on margin or profit and not on oil price, and which will adjust as costs and inflation "[go] up and down with respect to the oil patch." For a successful system, the state must determine the starting tax rate, the number of steps, and how broad the change in state take is between steps. He reminded the committee that every dollar of profit not taken as state take remains subject to state and federal corporate income tax [slide 24]. Although not a recommendation, slide 25 illustrated how a bracketed net tax functions - without accommodations for GVR or per barrel credits - and he provided an explanation. Slide 26 illustrated an example of the self- correcting nature of the aforementioned tax system, and he provided an explanation. He said working models of a net based bracketed system, relative credits, and effective tax rates will be presented at the meeting of [2/27/17 at 7:00 p.m.] [slide 27]. Mr. Ruggiero concluded his options for the committee to consider are as follows [slide 28]: · retain a net tax system that has self-correcting mechanisms and is based on taxing on profitability · simplify as much as possible · utilize a system that ensures operators can recover all of their costs · allow NOLs to carry forward and be recovered from production-based income · provide uplift for the time value of money. [HB 111 was held over.]