GENERAL SUBJECT(S): Revenue Projections - Overview of oil revenue And other revenue sources for FY'00 and FY'01 Commissioner Wilson Condon, Department of Revenue Larry Persily, Deputy Commissioner, Department of Revenue Chuck Logsdon, Chief Petroleum Economist, Department of Revenue The following overview was taken in log note format. Tapes and handouts will be on file with the Senate Finance Committee through the 21st Legislative Session, contact 465-4935. After the 21st Legislative session they will be available through the Legislative Library at 465-3808. Time Meeting Convened: Approximately 9:15 am Tape(s): SFC-00 #1 Side A and Side B PRESENT: Senator Adams Senator Parnell Senator P. Kelly Senator Torgerson Senator Green Senator Donley Senator Phillips Senator Leman Senator Wilken ALSO PRESENT: SENATOR DRUE PEARCE SENATOR KIM ELTON REPRESENATIVE JERRY SANDERS WILSON CONDON, COMMISSIONER, DEPARTMENT OF REVENUE LARRY PERSILY, DEPUTY COMMISSIONER, DEPARTMENT OF REVENUE CHUCK LOGSDON, CHIEF PETROLEUM ECONOMIST, DEPARTMENT OF REVENUE LOG SPEAKER DISCUSSION Tape SF00 - #1 Side A 0 CO-CHAIR PARNELL Introduction (small tape delay) "What a difference a year makes." An advisory vote was held Sept. 14, 1999, asking voters if they wanted to use a portion of permanent fund earnings to finance government. "They sent a strong, loud message that that's not going to happen." The Committee will be spending a lot of time on the budget this session. The governor has proposed an operating budget that increases spending by approximately $120 million over the current fiscal year plus increases to labor contracts still in negotiation. The total could be closer to a $200 million increase. "To me that's cause for concern." From what I've been hearing "in the lunch rooms and neighborhoods of Southcentral Alaska," a huge budget increase has generated more public cynicism and even contempt as to whether or not the governor and the legislature has gotten the message. We're going to continue to work toward reducing government spending and we are going to do it in a way that focuses on results for that spending. Our budget subcommittees are going to begin this week on each agency budget. In November I sent a memo to the budget subcommittee chairs asking them to begin working with the departments on writing measures to allow us to determine whether the agencies are accomplishing the missions we are funding. I anticipate a more aggressive schedule this year establish missions and measures so that we get to the budget numbers much sooner. Allocations for each agency will be released sooner than last year. The offices have had more time to work on missions and measures during the interim. 59 Introduction of Senate Finance Committee Secretary staff: Mindy Rowland, Senate Finance Committee Secretary; Jamie Foley, Asst. Senate Finance Committee Secretary; Bree Simpson, Senate Finance Committee Page. 68 In every budget we deal with revenues and spending. Today we'll begin with revenue. 77 SENATOR DONLEY Last year we were presented with approximately $100 million in new spending by the governor and we tried to work toward our target of a $40 million reduction to help close the fiscal gap. We are in a similar situation this year. While the House was successful at reducing the governor's request, but only by eliminating revenue sharing and municipal assistance. The overall operating budget for state agencies was actually increased. That left the Senate Finance Committee in a difficult situation trying to reduce the operating budget. It is unwise to simply eliminate municipal assistance since that is a direct impact upon local property taxes and small communities across the state where this assistance may be their only source of revenue. I was pleased with the budget the Senate Finance Committee produced. It restored some of the revenue sharing and municipal assistance and still made reductions in state spending consistent with the Majority's five-year budget plan. Unfortunately, after the Conference Committee finished, the final version didn't look like that. Co-Chair Torgerson and I had an understanding at the beginning of the capital budget discussions last year that Alaska Industrial Development and Export Authority (AIDEA) monies would be counted as general funds. However, in the budget submitted from the House, the approximately $19 million AIDEA funds were not treated as general funds "which I don't think is true. I don't think that's an honest way to budget because that's real dollars that could be used to reduce the fiscal gap." The House then increased spending by $19 million, which created a bigger problem. Therefore, I think we should reach an agreement now with the other body as to what funds will be treated as general funds and which will not. The discrepancy last year jeopardized our ability to continue the five-year plan, meet out targets and be successful in reducing overall state spending, which is an important component in closing the fiscal gap. We are again faced with another increase from the executive branch at a time where we need to be working toward reductions and closing the fiscal gap. I'm hoping there will be a different sense from the other body. Maybe we should reach out to them early so they don't cut out municipal assistance and increase the state operating budget. 140 SENATOR ADAMS I don't think we should judge the requested increase of $100 million until we have a chance to look at it. We should look at the budget program by program, item by item and the affects on Alaskans. In looking at last year's budget, we see that sometimes in making these drastic cuts, lawsuits arise because programs such as public safety and rural and urban schools are not adequately funded. "We should fund what is rightly so in the constitution." I realize we are faced with an approximate $100 million deficit but we should look at those programs and services that we need to fund and that help jobs and families in the State Of Alaska. In the past, instead of creating new jobs, we have transferred jobs from Juneau and rural Alaska into Anchorage. I think that is wrong. If you want to cut, let's cut those 1000 state jobs that have increased in the last five years before reducing the governor's proposed budget. 170 SENATOR P. KELLY We are in the final year of the five-year plan and I think we should carry out the plan according to the rules laid out five years ago. However, we should not include the capital budget in the spending reduction plan although we do need to be disciplined in the capital budget. The public wants us to cut government, not cut growth in the state. There is a difference between increasing bureaucracy and addressing building needs. For the state to grow, we need to continue to build roads and bridges, fix schools etc. If capital needs aren't met, we end up doing bond debts later, which increases the operating budget. I recommend that we look at the capital and operating budgets separate. We spend almost the entire capital budget matching federal funds. The state is growing only as the federal government wants rather than letting the state decide how the state will grow. 203 CO-CHAIR PARNELL Introduce Senator Drue Pearce, Senator Kim Elton and Representative Jerry Sanders 220 CHUCK LOGSDON, CHIEF PETROLEUM ECONOMIST, DIVISION OF OIL AND GAS AUDIT, DEPARTMENT OF REVENUE Handout: Alaska State Revenue Outlook Department of Revenue Presentation to Senate Finance January 11, 2000 And Fall 1999 Revenue Sources Book, Alaska Department of Revenue, Oil and Gas Audit Division, December 8, 1999 227 Department of Revenue has restructured the revenue sources book to try to refocus and look at the total revenue picture. 234 Handout: The Total Revenue Picture Our revenue picture has dramatically changed with the reduction of oil production on the North Slope. Other sources of revenue have become more important in the total revenue picture in providing the money that the state has to spend. Investment revenues today is the largest source on income followed by federal revenue and then oil revenues. Handout: The Total Revenue Picture FY99 (pie chart) The white-colored wedges are restricted revenue (Investment Earnings Restricted, 41%, $2.267 billion; NoTUFF Restricted, 36%, $2.350 billion and Oil Restricted, 3%, $0.208 billion.) The green-colored wedges are the unrestricted revenue (Oil Unrestricted, 14%, $0.913 billion; NoTUFF Unrestricted, 5%, $0.332 billion and Investment Earnings Unrestricted 1%, $0.047 billion.) In typical presentations on the revenue situation, the focus has been on the unrestricted portions of the revenue because that is what effectively represents the "general purpose money" that is available for appropriation. Note that the restricted revenue is seventy-seven percent of the monies coming in. Of that, the investment earnings is the biggest chunk of restricted revenues. The biggest portion of the restricted investment earnings revenue is the permanent fund. 252 Handout: Total State Revenue, Actual FY1999 and Projected 2000-2001 (table) We've broken the "unrestricted revenue" amounts into "Oil Revenue", "Non-Oil Revenue" and Investment Earnings". The investment earnings in this case are those that are earned on general fund balances that the Department of Revenue manages. We'll get a nice bump up because oil revenues will be up from last year. We're going to get a nice "bump up" on the 1999 general purpose revenues mostly because oil revenues are going to be a lot higher this year. So far in this fiscal year, we've averaged almost $21 per barrel. In FY99 oil prices averaged just over $12 per barrel. 262 Note that year 2000 restricted money has a big drop in investment earnings. This is based on the permanent fund earnings and there was a big drop in the investment market in the third quarter of 1999. I expect that the permanent fund will probably revise those numbers upwards. 271 CO-CHAIR PARNELL Does the "Unrestricted: Non-Oil Revenue" include corporation general income tax? MR. LOGSDON Correct. CO-CHAIR PARNELL The projected corporation general income tax shown on page 17 of the source book predicts reduced revenue of about one million dollars a year. Is that an economic indicator that we should be concerned about? Or is something else going on? 280 MR. LOGSDON I can't give you an indication of whether that's driven by economic activity. LARRY PERSILY, DEPUTY COMMISSIONER, DEPARTMENT OF REVENUE Some is based on economic activity and also the increased use of "S" corporations, which do not pay corporate income tax in Alaska. CO-CHAIR PARNELL I was concerned that was an indicator of a declining economy. MR. PERSILY I believe it is more a matter of "S" corporations rather than taxpaying "C" corporations. CO-CHAIR PARNELL But aren't the largest taxpaying corporations the larger corporations that don't qualify for "S" status. MR. PERSILY They are and that is why there is just a small decrease. CO-CHAIR PARNELL Thank you. MR. LOGSDON The department is going to continue to refine our forecast document and we have been cooperating with the Division of Legislative Finance and Office of Management and Budget and the Division of Finance to make our revenue estimates and projections more understandable and reconcilable. We have a number of agencies that account for state revenues. I won't address the permanent fund since the corporation will be making a separate presentation to the Committee. The Office of Management and Budget can tell you about the federal revenue situation. I'm going to therefore focus on oil revenues, which continues to provide over 70 percent of our general-purpose spendable money. Handout: Alaska Oil Prices I guess the real question on everyone's mind is how high will Alaska's oil prices go and how long will they stay above $20 per barrel. 307 In December 1999 the average was $24.63 per barrel. That is about the highest monthly average since the Persian Gulf War. Oil prices are very healthy right now and there are fundamental reasons for that, mostly because OPEC dropped production and Non-OPEC production has not increases. We also have a healthy economy and it is winter. Watch OPEC because they are key. ANS has averaged nearly $21 per barrel so far this year. Handout: ANS Spot Price (West Coast Delivery) If you look at the track record of oil prices, you'll notice extreme volatility. There are lots of peaks and valleys since January 1986. In fact, we've just come out of one of the deepest valleys since ANS started production. Volatility is what oil prices are all about. Handout: ANS Spot Prices and 60-month Moving Average (West Coast Delivery) If you look at the data in a different way, you'll see there is a tendency for the average to be relatively stable. The bold line shown on the graph is a calculated 60- month moving average of oil prices. Handout: ANS West Coast Price and Futures Market for ANS These are futures market prices for early October and early December. Whenever the price of oil is below the long-run relatively flat curve, the futures contract for a delivery scheduled a few months into the future will approach the long-run average. In the case of October 1999 futures, when cash prices were below the long-term averages, the futures contract prices go up and begin to approach the long-term average. In the case of the December 1999 futures curve, where prices are considerably above the $17 per barrel number, oil could only be sold for about $17 per barrel instead of the current cash price. The point is that the futures market tends to look at the world with a longer perspective than the next month's estimated price. The question is how fast the price will approach the long-run average. Handout: Historical Futures Market Prices for ANS This chart illustrates that the futures market follows the same pattern for several years. The belief of experts is that if oil prices rise above $17 per barrel, the prices will go down again at one point. The only question is, when and how fast. 358 Handout: Futures Based Market Prices for ANS This illustrates the point that even when oil prices in December 1999 were two dollars per barrel above October 1999 prices; the futures market averages the same long-range price of $17 per barrel. Handout: Cumulative Average ANS Oil Price, Moving Average and Confidence Intervals This is the cumulative average of ANS oil price that illustrates several different perspectives. We have already looked at a five-year average, and this chart compares the findings to twelve, twenty-four, thirty-six and forty-eight month averages. Handout: ANS Oil Prices - The Department of Revenue Forecast (Long Term) The department has begun to take a longer- term viewpoint of five and ten years from now. Unless there is major structural change in the world economy, oil prices should average $17 to $18 per barrel. The fundamental reason for this is that over time, market forces will continue to provide production and consumption incentives that tend to guide oil prices to that average. OPEC is currently pulling oil off the market to encourage higher prices and as prices rise, they will begin to put more oil on the market. Non-OPEC producers will explore and develop more oil to add to the market. Consumers react to higher oil prices as well by reducing consumption. Higher fuel prices can be a drag on the community. Higher oil prices mean higher energy prices. 400 SENATOR P. KELLY When you refer to "long-term" do you mean five years? 402 MR. LOGSDON Yes. Although I've actually used ten years to calculate some of the projections. SENATOR P. KELLY Last year the Committee heard information saying that the market forces were conspiring to keep prices down. This handout states that market forces will continue to provide production and consumption incentives to bolster price higher. CO-CHAIR PARNELL The earlier information was provided to us by Cambridge Energy. SENATOR P. KELLY That information seems opposite from what you are saying today. 412 MR. LOGSDON The path to that average is not a smooth one. Oil prices over one or two years can be quite low or quite high, but over time, the highs and lows tend to be offset and prices move toward that average. Because of the possibility of a major structural change in the way the world economy consumes energy, a twenty-year average is not practical. 424 SENATOR P. KELLY Are you saying that your view and Cambridge Energy's is the same. MR. LOGSDON I don't know Cambridge Energy's long-term view. I hope the large multi-national corporations will be in "for the long haul" and invest in projects that are economic with oil prices of $17 to $18 per barrel. 430 SENATOR P. KELLY It seemed that the information given to us last year reflected a long-term view. However, the conclusion was different from your long-term view in that they projected lower prices. 434 CO-CHAIR TORGERSON Cambridge Energy said that the price would go up to $20 per barrel and then drop back down to $15 to $16 due to overproduction. Do any other analysts agree with your assessment of prices of $17 to $18? 439 MR. LOGSDON In looking back at the futures market, our view has been consistent with the market view. The $17 to $18 figure is based strictly on a historical evaluation. However, short of a major structural change, whether it be a policy to address global warming through major fuel taxes to encourage the use of other fuels, the track record demonstrates that if you hang in long enough view oil prices will average $17 to $18. Doesn't mean it won't be painful at certain points because oil prices are volatile. 452 CO-CHAIR TORGERSON I hope you're right. Does the BP/Arco merger have any bearing on your price structures? MR. LOGSDON We do not believe so. CO-CHAIR TORGERSON The merger is not reflected in these projections? MR. LOGSDON Correct. 455 SENATOR LEMAN It appears to be listed as nominal dollars, is that true of your projection? MR. LOGSDON Yes. SENATOR LEMAN 458 MR. LOGSDON Handout: ANS Destination Price, Actual vs. Forecast This shows the actual prices and some of our prior forecasts. In the past we had been guilty of extrapolation in our projections that prices would continue to rise dramatically. This was based on the belief that because there is a limited supply of oil, prices would continue to go up. Our latest forecast shows our belief that over the long term, oil prices will remain relatively flat. 468 Handout: Alaskan Oil Production ANS production in calendar year 1999 averaged 1.077 million barrels per day. This is based on preliminary data from Alyeska. That is about 25 percent or .0358 million barrels per day less than what was produced five years ago. We are currently projecting North Slope projections for FY00 at 1.055 million barrels per day. However, there have been a few production disruptions and we don't yet know the effect that will have on the total production. 477 Handout: FY 2000 ANS Production Year to date we are averaging 1.03 million barrels per day. We are behind our projections. There will be about three more months of cold weather on the North Slope that enhances the performance of the oil fields. We want cold weather, but not too cold. They don't send people out in 50 degrees below zero chill factor for safety reasons. 486 Handout: Alaskan Oil Production Forecast We are expecting Prudoe Bay, the "mother lode," to decline over time by 30-40 thousand barrels per day. Other fields, Kuparuk, Point McIntyre and Endicott, will decline an average of 15-25 thousand barrels per day. Fortunately new fields, Alpine, Prudoe and Kuparuk Satellites and North Star will offset the declines over the next five years. We expect oil production to plateau at just over one million barrels per day through 2006. 496 What are the consequences of these oil price and production estimates in terms of revenue consequences? Handout: State Of Alaska Historical Sources of Revenue CBR fund revenues decline slightly over time and reflects reduced spending. We had high oil prices in 1997 and we didn't have to take from the CBR. The non-oil revenue component is relatively stable. Handout: How Far Have We Come to Closing the Fiscal Gap With Higher Oil Prices? In January of 1999, the Department of Revenue predicted exhaustion of the CBR fund in January 2003, now using the Office of Management and Budget's budget plan we see the CBR fund with a zero balance in August 2003. 511 CO-CHAIR PARNELL So in that case there is not a big difference in the long run? MR. LOGSDON Right, I've got some other scenarios to show the effect. 515 Handout: State Of Alaska, Sources of Revenue This illustrates the exhaustion of the CBR. Handout: Alaska State Revenue Outlook, General Fund FY00 We updated this outlook using the January curves for 2000 and 2001 and the futures market price aiming at $21.78 per barrel FY00 average and a projected North Slope production volume of 1.058 barrels per day. This gives us a projected oil revenue of $1,502.8 million, projected other non-oil revenue of $417.8 million, general fund budget of $2,321.5 million and a projected draw from the CBR fund of $400.9 million. 524 CO-CHAIR PARNELL Is this for the current fiscal year 2000? MR. LOGSDON Correct. Handout: Alaska State Revenue Outlook, General Fund FY01 This uses a projected ANS oil price of $18.86 and a projected North Slope production volume of 1.045 barrels per day. The result is an oil revenue of $1,218.9 million, projected other non-oil revenue of $386.7, a general fund budget of $2,419.4 and a projected draw for the CBR fund of $813.3 million. 530 CO-CHAIR PARNELL Is the general fund budget amount the same that is shown in the Governor's proposed budget for FY01? MR. LOGSDON Yes. CO-CHAIR PARNELL Therefore the projected CBR draw is $813.3 million? MR. LOGSDON Yes. CO-CHAIR PARNELL Is the Governor's budget based upon an oil price of $18.86? MR. LOGSDON I don't know. I only have the spending number. CO-CHAIR PARNELL Ask Mr. Persily. MR. PERSILY The general fund budget expenditure is from the Office of Management and Budget. The projected oil revenue figure is not an official number. CO-CHAIR PARNELL Is that the same figure that was used for the December 15 release of the budget? MR. LOGSDON Yes. If oil production or prices changed, the projected CBR fund draw would change as well. Handout: CBRF Depletion Matrix, $ per Barrel This illustrates how long the CBR would last under different spending and oil revenue scenarios. 557 Handout: Revenue Sensitivity to $1 per Barrel Change in Oil Price FY 1988-2010 This shows the spendable money for every dollar in the oil prices. The amount has steadily decreased since 1990 and expected to continue through 2010. Handouts: Oil Revenue and the BP/ARCO Merger - Production Tax The tax base is the netback value of production calculated as the destination sales price less transportation to that destination. The destination value is defined as market value and is currently set as ANS spot price. We believe that oil prices will continue to be determined in the world market and that the merger will not affect destination prices. Handouts: Oil Revenue and the BP/ARCO Merger - Production Tax Because of there are some structural changes in who owns refineries and tankers, we will continue to closely monitor contracts to ensure that spot prices is an accurate measure of destination value. It is unclear whether we will be able to continue to rely on spot prices as a dependable indicator. 578 Transportation costs are the basic deduction from the destination value. Those are specifically defined in regulations. The allowable costs will be largely determined by what assets are employed and not who owns them. We are hopeful that the merger will lead to cost savings and even reduce some of the transportation costs. There is a strong audit function. Handouts: Oil Revenue and the BP/ARCO Merger - Royalties Royalties are also based on the netback production value established by contract with the State Of Alaska. Contracts have been reactive and any final agreement on transportation and or value will be retroactive. 588 SFC 00 #3 Side B 9:57 AM MR. LOGSDON We believe we have sufficient protection. The production divestiture and other concessions by BP were designed to protect the state's interest post manager. One of the major things that could affect our revenue over the long run is how much oil gets produced. We would like to see a healthy rate of investment in exploration and development. 582 Handouts: Oil Revenue and the BP/ARCO Merger - Property Tax Property tax should be largely unaffected by the merger since the production and transportation facilities are commonly owned and subject to appraisal methods based either on regulated cash or historical cost. If the merger results in higher levels of investment the tax levels could increase. Handouts: Oil Revenue and the BP/ARCO Merger - Income Tax It is virtually impossible to calculate the effect of the merger on this tax type because modified apportionment is based on so many elements. Summarize, Department of Revenue does not think the merger will have any short-term negative effects on the state's revenue. We will have to be diligent at watching possible long-term effects. 565 Conclusion 564 MR. PERSILY 565 CO-CHAIR TORGERSON Are the contracts reopened only for negotiation of transportation costs? Who is negotiating those contracts? MR. LOGSDON You would have to ask the Department of Natural Resources. I think both destination and transportation costs are being discussed. CO-CHAIR TORGERSON Is that part of the charter agreement that was signed by the Governor? MR. LOGSDON This actually goes back to original agreements established in earlier settlements. All of the agreements contain clauses that allow renegotiations of the terms. CO-CHAIR TORGERSON Do they require legislative approval? MR. LOGSDON I do not know. CO-CHAIR TORGERSON What is the actual reduction of income tax? MR. LOGSDON I don't know. We will get you that information. 546 SENATOR ADAMS What do you suggest the Committee watch for in the March 2000 Petroleum Forecast? Do you believe OPEC will continue to hold oil production at the present level? Do you believe that cold weather will continue and allow for higher prices? Should we be concerned that Iraq could flood the market to help pay for its past wars? Or that Russia will increase its oil development with the change in government leadership? What should we be watching for? 537 MR. LOGSDON Our source book identifies our prediction that prices will go down for all those reasons. OPEC will increase production and agree to an increase in quotas at their March meeting. Iraq is currently producing all they are allowed, three million barrels per day, but has the potential to produce more. The United Nations has extended Iraq's ability to shift $5.2 billion worth of oil under the current embargo and a new agreement is being written that will reestablish a monitoring and inspection committee. This agreement will completely lift the cap on the amount of oil Iraq can export and will allow some of the earnings to go toward purchase of oil production services and equipment. Cambridge Energy is a good source for more information on the situation in Iraq. Because I cannot predict the weather, I can't say if cold weather will be a factor in keeping oil prices high. The Russian economy is improving partly because of high oil prices. The key is getting pipelines to access some of the production and the US is involved in this endeavor. There is a real potential for additional production from Russia. It is just these kinds of scenarios that the futures market is already considering and incorporating. This is one of the reasons why oil prices are much lower in the futures market than they are today. 510 SENATOR ADAMS Do you provide the House and/or Senate Finance Committee co-chairs weekly updates on price changes or information that could affect oil revenues? 506 CO-CHAIR PARNELL We wish we were. SENATOR ADAMS We should request that every two weeks. 506 MR. LOGSDON We update our web site daily with info on production and oil prices. 501 SENATOR WILKEN I appreciate the information you provided regarding the BP/ARCO merger and your short-term expectations that the merger won't affect state revenues. I would like an analysis of BP's new exploration budgets. While I am not privy to confidential information, I understand the exploration budget is only 50 percent of the pre-merger amount. Have you looked at that and assessed the long-term affect on the state's revenue flow? MR. LOGSDON I have not but it is something we will be looking at. We will hopefully have an assessment in the Spring 2000 Forecast. CO-CHAIR PARNELL We learned last year about the tie between energy prices and inflation. Please comment on current inflationary pressures and how they might have a bearing on the forecast. 487 MR. LOGSDON Generally, even though oil prices have gotten very high, the US economy has not been significantly affected. I assume that is because other prices, such as agricultural products that may have offset oil prices. CO-CHAIR PARNELL Conclusion of meeting. 470 Adjourn 10:10 AM SENATE FINANCE COMMITTEE LOG NOTES 01/11/00 Page 17