Beware of deep ponds: Legislators’ tinkering could be at cost of future revenues

Voices Of The State

Posted: Thursday, April 06, 2006

There is an old proverb about a cute puppy carrying a yummy bone past a calm, deep pond. He stops to peer into the water. It is so calm that it reflects his face, holding the bone, perfectly. Thinking his reflection is another dog holding another yummy bone, he opens his mouth to grab the bone from the other dog. In doing so, he drops his own bone into the deep water. He goes hungry.

Legislators who are busily considering just how high to raise taxes on Alaska oil producers need to walk right past the calm, deep pond of short-term revenue temptation. For they already are carrying a delicious, meaty bone in the form a massive oil tax increase proposed by the governor. Great care must be taken to avoid dropping it.

The percent profits tax (PPT) proposal introduced by Gov. Frank Murkowski would raise taxes on the Alaska oil industry by nearly $1 billion annually at current oil price levels. It is a massive tax increase. As legislative committees tinker with raising taxes even further, they run a real risk of maximizing short-term revenues at the expense of future production and revenue, effectively dropping this yummy bone.

The crux of the matter lies in the difference between “average” cost and “marginal” cost, concepts familiar to any student of economics. As Alaska’s oil fields age, they require enormous amounts of new investment just to slow their rate of decline. These new investments must be economically viable on their own merits.

Consider that North Slope production already has fallen from a high of over 2 million barrels daily in 1988 to less than 900,000 today. After a brief flattening trend in recent years, the production decline worsened to 6 percent again last year.

Industry engineers know investment levels of $1 billion to $1.5 billion each year are required just to maintain a 6 percent annual decline and keep it from accelerating to 10 percent or more. Indeed, that is the investment pace of recent years under the current tax system. If this rate of new investment is rendered uneconomic by high taxes, Alaska’s production decline curve will steepen.

Alternatively, if the tax system were to encourage new investment such that it actually doubled, the annual production decline would fall in half to only 3 percent, according to oil field engineering estimates.

The size of the annual production decline matters greatly. After 20 years of 3 percent declines, we would be producing at over half of today’s levels. At 6 percent we would fall to less than 30 percent of today’s levels. At a 10 percent rate of decline, we would lose nearly 90 percent of our production in 20 years and be only a minor producer at about 100,000 barrels daily.

Unless large new fields are found against unlikely odds, new field discoveries will not fundamentally alter this picture. The vast majority of new production potential on the North Slope is believed to lie under existing fields.

Indeed, not only could our yummy bone end up in the pond, Alaskans could end up under water themselves.

Aside from the obvious production dangers of high oil taxes, there is the real danger of an economic boom-bust cycle caused by a short-term revenue windfall.

Many Alaskans, including me, harbor painful memories of the last time state government experienced a revenue windfall: a few years of fiscally driven economic overheating, followed by a severe economic crash that devastated businesses, jobs and home values, followed by well over a decade of mediocre economic performance.

Unfortunately for Alaska, large governments are almost never associated with dynamic economic performance over time. Alaska already is saddled with the largest government sector — all levels combined — of any state in the United States.

Having the largest government sector means we have the smallest private sector. Private “basic” industry is in particularly short supply. When a government spending binge overheats our economy, there is precious little to fall back on when it ends — and end it always will.

All Alaskans have a stake here. This can be a great year. It can be the year legislators walk right past the proverbial cold, deep pond of short-term revenue temptation and deliver a yummy, long-lasting bone to their constituents. It can be the year they worry less about growing an already large state government and more about our undersized private sector.

It can be the year they secure a vibrant oil industry, a gas pipeline and a bright economic future for the next 50 years. It can be the year that a majority of legislators show themselves to be wise, far-sighted puppies indeed.

Scott Hawkins is president of Alaska Supply Chain Integrators, LLC, which does business with major oil companies in Alaska. He is also a former Alaska bank economist and past president of the Anchorage Economic Development Corp.

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