ELF vs PPT: Making sense of the contract

Posted: Wednesday, June 14, 2006

If there is one thing supporters of competing projects aiming to bring Alaska’s wealth of North Slope natural gas to market appear to agree on, it’s that the current system by which the state levies severance taxes oil and gas production is broken.

Alaska currently levies severance taxes on all oil and gas production (except for government royalty production). The rates vary with the ages of fields and when they came into production and the system provides for minimum taxes. (See accompanying box.)

Production is subject to the economic limitation factor, or ELF, which was originally created in 1977 when Prudhoe Bay began production to differentiate it from Cook Inlet’s aging fields, according to the Department of Revenue.

In 1981 and ’89, amendments focused on stimulating production on new and undeveloped smaller fields by lowering the severance tax bite. The ELF also varies according to field size and productivity.

A critical decision in a quicksand of variables

The basic severance tax on oil is 12.25 percent, which is good for the first five years of production, after which it rises to 15 percent. That applies to all fields coming into production after June 1981. Fields in production prior to that are charged the 15 percent.

The severance tax rate on natural gas is 10 percent.

There are minimums that must be charged — 80 cents per barrel for oil, and 6.4 cents per thousand cubic feet of gas.

A draft contract negotiated by Gov. Frank Murkowski with three major producers — BP, ConocoPhillips and ExxonMobil — which could lead construction of a pipeline from the North Slope to Chicago to deliver gas to consumers in the Lower 48, includes provisions for a new tax system — a petroleum profits tax, or PPT, based not on production, but on net profits.

The PPT was negotiated concurrently with the pipeline contract and went to state lawmakers under separate legislation.

Oil companies say they’ll buy into a negotiated tax rate, but they want a guarantee the tax rate on oil won’t change for 30 years, and on gas for 45.

Not only would that require legislative approval, it is not clear if setting rates for that long is even constitutional. State lawmakers were unable to agree on the structure of a PPT during the recently completed regular and special sessions. The Alaska Supreme Court is likely to decide the constitutional question.

The current state severance tax is a wholly different animal from a tax based on profits.

Simply put, the severance tax is levied on the production value of the oil drawn from the ground determined at the point of production, the wellhead. To determine the production value, the Department of Revenue considers several factors, such as reported crude oil sales prices, as well as transportation, infrastructure and other costs.

Complicating issues include the fact that more than one company may hold leases on fields and production sometimes entails joint-operating agreements and even separate operating companies. Thus, the Department of Revenue calculates the production value as the average of all wells on a field and calls the “wellhead” the edge of the lease area.

Complicated enough for you? There’s more.

Those oil or gas severance tax rates and minimums are all subject to the ELF. That is, they must be multiplied by the ELF to set the proper tax rate for a field. The ELF formula basically aimed to apply lower tax rates to small, low production fields, and higher tax rates to large, high production fields.

“It worked for well over a decade,” said Richard Tremaine, a revenue department economist.

But changes in prices, technology, types of oil, economies of scale and other factors have changed the financial picture in recent years. The result is some very large fields are close to paying or now pay no severance taxes whatsoever. If production falls far enough, the ELF factor becomes zero, and anything multiplied by zero is zero.

“It just isn’t working any more,” Tremaine said.

The field at Kuparuk is a case in point. It could have a zero ELF factor by next year. But it is still producing.

“We have to suspect (the producers) are making money there,” he said.

The PPT abandons the production value calculation altogether. Taxing what is pumped out of the ground is replaced by taxing how much the producers make — their net profits. Therein lies the rub: Who gets to do the accounting first?

The proposed contract would put a 20-percent profits tax on oil. (The tax on gas would be more complicated, Tremaine said.) Companies would get a tax break of 20 percent on any future capital investment in exploration and production in Alaska.

Tremaine said there would certainly be an element of trust associated with calculating the tax under the PPT regime, but the state would have access to such things as billing statements — the fees lease holders pay the companies actually operating a field, for instance, which presumably would get cross-party review and would be accurate, he said.

Another thing to consider about a PPT, Tremaine added, is that under any of the PPT ideas so far considered, if oil prices were to fall once again into the low $20 range, the state would get less revenue than it does under the problematic ELF.

“That’s an important point to remember,” Tremaine said. “The PPT provides security and a reduction of taxes on the downside to oil companies.”

If the ELF was complicated by variables, the proposed PPT may be even more so. It includes assorted tax rates, capital credits, possible ways to recover past investment, various deductions, in all likelihood some additional variability in tax rates when market prices are high, and alternate points in the calculation where various factors might be incorporated, all of which could produce differing bottom lines, Tremaine said.

“The PPT is like a tractor with multiple throttles,” he said. “And there are lots of throttles.”

Tremaine tells people there is one critical issue to cull from the minutia, from all the rhetoric.

“What is the difference in revenue between what we have got (the ELF) and what this (PPT) is going to do for us?” he said.

In the present high-price climate, short-term returns to the state could be substantial, reaching well into nine figures, perhaps. Over the long-term, average market prices could be much lower, and revenues nowhere near as attractive.

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