It has been two and a half months since the Legislature adjourned its special session on oil taxes. Lawmakers have long since returned home to ponder the failure of the session, and to busy themselves, in most cases, on re-election campaigns. There was a lot of work done on oil taxes in the 2012 session and despite the failure, in the end there was some progress on this divisive and controversial topic.

Here’s the problem: As is well known, oil production on the North Slope is declining at rates of about 6 percent a year. The Trans Alaska Pipeline System is approaching rates of oil “throughput” where operating problems will occur – that rate is about 550,000 barrels per day. Countermeasures Alyeska Pipeline Service Co. is taking, such as heating the pipeline, will cost money. The best solution, Alyeska says, is to get more oil flowing through the pipe.

There are a lot of undeveloped oil resources on the North Slope but most of them are higher-cost and technically-challenging. Alaska’s state oil production tax is among the highest in the world. Given the relatively modest amounts of oil remaining to be discovered on state lands of the North Slope and the high costs in the region, the investment climate for the industry is relatively poor. Worse, the boom in shale oil drilling in the Lower 48 is not only drawing investment away from Alaska to those places but also skilled workers and contractors.

In 2011, Gov. Sean Parnell introduced House Bill 110 to lower the state tax. Parnell argued it would attract more investment. HB 110 passed the House but did not pass the Senate. Senators had many objections, among them that the bill had inadequate guarantees that investments would actually be made if taxes were lowered.

Stung by criticism, the Senate worked to develop its own proposal for oil tax “reform” in the 2012 session. The Senate’s main proposal was Senate Bill 192, which was developed in the Senate Resources and Finance Committees. SB 192 tried some new approaches to the problem, but in the end the Senate foundered on getting final agreement on the bill. In the final days of the regular session, part of the bill, one section that senators could agree on, was carved out and sent to the House as a part of a bill dealing with another subject that had been passed by the House. By then it was too late, however. Many believe the problems could have been worked out had the clock not run out on the 90-day session.

However, as the regular session adjourned at midnight, April 15, Gov. Parnell issued a call for a special session and introduced a new proposal for oil tax change that was a combination of several ideas that had been advanced by the Senate. The governor took a gamble in calling the special session right at the end of the regular session, because many thought he should have waited a few weeks to allow a cooling-off period for legislators. Things went sour, however. Special sessions can last 30 days but in this case, after about a week and a half, Parnell withdrew his new proposal. Legislators hung around a few more days to work on House Bill 9, which dealt with an in-state gas pipeline plan, but when an impasse developed on that (there were several issues with it) lawmakers went home. In hindsight, Parnell’s decision to call the session may have been mistake, and his unexpected decision to pull the special session bill he had introduced seemed to acknowledge this.

 Some background on Alaska’s oil and gas production tax

Alaska has a net profits-type production tax, a change made in 2006 from the gross-revenues production tax Alaska has had since before statehood. The gross-revenues approach imposed a tax expressed as a percentage of the revenue values on the North Slope after transportation costs had been deducted from market sales income. This is relatively straightforward and many U.S. states have similar taxes on oil and gas. The net profits tax goes a step further in allowing production costs to be deducted to derive a “net revenues” (sometime called net profits) value. The present tax is 25 percent of net revenues calculated on the value of the oil in the field after costs including production costs have been deducted. In addition to the 25 percent base tax rate, a “progressivity” formula in the tax ratchets the tax rate up when oil prices climb and bring the net production value of the oil (that is, value after expenses) up as well.

The per-barrel expenses of production and getting the oil to market, paying the pipeline and tanker costs, are now about $30 per barrel and rising. Assuming these costs, when oil prices exceed $60 per barrel the progressivity formula kicks in, and the tax rate starts climbing above 25 percent of net revenues. At present oil markets prices of about $100 per barrel, the production tax rate of the state is now close to 40 percent of the net-revenue value. This changes, of course, as market prices change.

When the state royalty (one eighth of the oil) and other special taxes on oil – a 20-mill oil properties tax and special corporate income tax – are included, along with the federal income tax, the total government “take” on North Slope oil is in the range of 70 percent of the net value of the oil per barrel. If oil prices climb higher, the government take increases quickly.

This tax structure leaves only 30 percent or less of the net revenues to the producing companies, and they complain they are finding it difficult to get capital to invest in new projects. The new boom in shale oil in North Dakota and Texas offers more attractive terms (and lower taxes) and investment funds are being diverted from Alaska to these states. The perverse effect of the current Alaska tax, higher taxes as prices go higher, is now widely agreed in the Legislature.

There are other “levers” in the current tax that affect the amount of tax owed, and changing these will affect the effects of the tax. One is the oil price threshold at which the progressivity formula triggers. Currently it is $30 in net value (market sales revenues minus expenses) but there have been proposals to put the trigger at higher levels, which would reduce the tax, and to put a “cap” on the tax at different percentage points, such as 50 percent.

The complex mechanics of the tax aside, the political problem was that there were a number of legislators, mainly in the state Senate, who were loathe to reduce taxes on industry and give up any significant state revenue. This debate is essentially about money, so here’s the monetary difference between the two “bookend” proposals – the governor’s and the Senate’s last version of SB-192. HB 110 would have reduced taxes by about $1.4 billion a year in Fiscal 2017, the Department of Revenue has estimated. Using that same year as a benchmark (the numbers vary from year to year) the department also estimated that SB 192 would reduce taxes by about $450 million in the same year. There was about a $1 billion difference between the two sides.

Had SB 192 gotten out of the Senate and into a House-Senate negotiation, there would certainly have been changes that would have narrowed the difference. That didn’t happen, mainly because the Legislature ran out of time. Meanwhile, the new proposal introduced by the governor in the special session, called after the regular session adjourned, seem to come down in the middle between HB 100 and SB 192, reducing taxes just over $1 billion a year in Fiscal 2017, according to the revenue department.

What were the mechanics of the different proposals?

House Bill 110 reduced the rate of the tax increase in the “progressivity” formula mainly by “bracketing” the progressivity portion of the production tax, the formula that raises the tax rate as oil prices rise. The proposal to bracket the tax would make it similar to the federal income tax, so that as prices rise the higher tax rates apply only to the increments of production above certain price points rather than all of the oil production. This change would effectively reduce the overall tax.

One other important change HB 110 would have accomplished is to allow higher tax credits for certain intangible drilling and other well expenses, expenses like labor and supplies that are allowed in Cook Inlet but not on the North Slope.

The Senate disliked HB 110 not only because it reduced taxes by too much, in the opinion of many senators, but because there were no “guarantees” that investments would actually be made, in that a tax reduction was not tied to investments, unlike the investment tax credit with which legislators were familiar.

The Senate struggled all through the 2012 regular session to develop an alternate approach, not only to figure out how much to reduce taxes and when, but also how to build in mechanisms to ensure investments would be made. The last version of SB 192, developed unfortunately too late in the regular session, proposed a number of structural changes, such as targeted incentives for “new oil.” However, as the regular session ended in mid-April the senate was unable to muster enough votes to actually pass its proposal, to send it to the House.

An important objective for senators

An important objective for many senators was to provide incentives for new oil within the existing producing fields. There was sharp disagreement on how to do this, however, and this was the main cause of the late-session failure of SB 192. There was more agreement on a reduced tax rate for entirely new oil fields, outside of existing fields. HB 110 contained a similar concept for new fields, but SB 192 attempted to improve on that.

The concept of incentive tax rates for new fields is more accepted politically partly because the impact on immediate state revenues is virtually zero. It usually takes several years to drill wells, build pipelines and other infrastructure and bring new fields into production, so the revenue effects from a reduced tax on new fields is delayed. Another factor is that the outlook for major new discoveries outside the existing producing fields is modest. The long-term effect of tax reductions on new fields will not only be delayed but modest and, in any event, unknown. A reduction for new fields is an easy vote for legislators.

In contrast, setting up a reduced tax for new oil in fields that are already producing, a major goal in SB 192, proved to be more complicated both mechanically and politically. It is politically sensitive because the reduction in tax revenues will occur more quickly in existing fields, and would be significant because much of the remaining oil yet to be developed on the slope is within existing fields.

The effect is fairly quick, too, because new wells drilled from existing infrastructure within producing fields can bring on new oil within two or three years. Thus, a legislator’s vote to reduce taxes on new oil from existing fields is a sensitive one.

It is mechanically complicated, too. How can the revenue department distinguish “new oil” from “old oil” when the new oil is developed with wells from existing facilities, and are often wells drilled off old wells underground, so that the new and old oil is mixed?

Committees in the Senate did finally develop a way to do this, although it was complicated. The mechanism that was considered in SB 192 was a tax break for oil produced above an existing “base” rate of production. This was made more complicated because the wells are also in natural decline, and that has to be factored in.

The method finally settled on was to establish a base rate of production that included a decline rate that was a producer’s actual rate over three years of prior experience. Any oil produced in addition to those volumes would get a reduced tax rate.

When the Finance Committee version of the bill went to the full Senate, however, its members balked. Disagreements over the decline rate formula and how to measure the decline rate (which would affect the “new oil” calculation and the tax reduction) resulted in a deadlock on the bill in the Senate Majority.

In the final days of the session the Senate did finally vote to send only the new field reduction back to the House attached to a bill that established new exploration incentives in the Nenana Basin and other unexplored regions. The House balked, however, desiring a more fundamental change.

The end result was that nothing at all passed in the regular session .

Parnell decided to have another go at it, and called lawmakers into special session. The governor’s proposal for the special session borrowed from several ideas the Senate developed, including some that never actually got put into bills.

For entirely new fields, the most important provision was to allow an “exclusion,” or reduction in net profit in the amount of 30 percent of the gross value of production before calculating the production tax owed. This exclusion applied to both the base tax of 25 percent and the additional tax due to the progressivity formula. For existing fields, the exclusion would be 40 percent but only on the part of the tax obligation due to the progressivity formula. The 40 percent exclusion would not apply to the base rate of 25 percent of the net profits.

The proposal was more generous for new fields because of the 30 percent reduction off both the base tax and the additional tax due to progressivity. In contrast, the 40 percent reduction for existing fields is only on the progressivity portion of the tax.

The complexity of this approach was its undoing, mainly. Tempers were short, legislators wanted to go home, attention spans were short, and there were technical questions from senators over the Parnell’s proposal. The governor decided abruptly to drop the proposal on April 25, and the special session ended soon after.

All this will be back in 2013, of course. The decline in oil production continues, the state operating budget continues to grow, and the first technical deficit in the state budget in years – a gap between revenues and spending – has appeared in the Fiscal 2013 budget, which started July 1. Unlike previous deficits, this one is due entirely to the drop in oil production, not any projected decline in oil prices (although, if current oil price trends continue that could be a problem too).

These are technical deficits because the state has ample financial reserves, about $15 billion, to cushion the decline for the short-term. Unless the trend in oil production is reversed, or dramatic cuts in spending are made, we could be soon burning through those reserves.