A Citizen’s Guide

Something must be wrong.

The governor proposed last month to completely replace the oil production tax. Two Democratic Legislators have been proposing changes to the oil tax for the last three years. And the state’s Department of Revenue has been considering a change for at least five.

“The time has come to make a change,” said Chuck Logsdon, who served as the Department of Revenue’s chief petroleum economist for 25 years and now works for the governor as a gas line advisor.

So what’s not working?

First, some oil fields are not subject to any production, or severance, tax at all. Others are taxed at a very low rate, even when they are very profitable.

Gov. Frank Murkowski and Rep. Les Gara, D-Anchorage, both say their plans would bring Alaska up to an extra $1 billion from oil companies per year at current oil prices.

Second, the current tax system doesn’t offer sufficient incentives for investment in Alaska oil fields. Murkowski argues improved incentives will benefit Alaska in the long run by keeping the oil flowing.

THE PROBLEM

The current system for taxing oil production was developed in 1977, the year the pipeline was built and Alaska’s oil production kicked in.

Prudhoe Bay, an “elephant” field, dominated the scene.

“You stick a straw in that lake and you can suck on it for a long time,” said Dennis Witmer, who heads a research center under the University of Alaska Fairbanks’ Institute of Northern Engineering. Of the 15 billion barrels of oil produced on the North Slope since 1969, about 11 billion have come from Prudhoe Bay.

To encourage oil companies to dip into other, smaller fields, the Economic Limit Factor, or ELF, was included in the state’s production tax system.

Fields that were only barely worth it for the companies would not be taxed. (The development would still benefit the state through royalties, land leases and state corporate income tax.)

In 1977, a well producing 300 barrels of oil a day was considered “marginal,” or not that interesting to developers. Under the ELF, such small fields wouldn’t be taxed.

ELF lets companies willing to pursue the marginal fields pay a fraction of the state’s standard production tax of 12.25 percent for a field’s first five years and 15 percent after that.

That fraction, a number between zero and one, is based on a field’s total daily production, as well as the production of each well within it. That production number is then multiplied by the standard production tax.

The governor likes to use the example of the Kuparuk oil field, one of the largest on the North Slope. In 2000, the field produced 212,000 barrels a day and had an ELF of 0.6. Multiply 0.6 by 15 and you end up with a 9 percent production tax. By 2003, with declining production at the field, the ELF had dropped to 0.25, reducing the tax to 3.75 percent. By 2007, the field will not be taxed at all, despite continuing to produce 125,000 barrels a day, according to a February report by Pedro van Meurs, the governor’s lead consultant on oil and gas issues.

By 2010, all the fields on the North Slope outside Prudhoe Bay will pay an average tax of just over 1.5 percent, according to the state’s Department of Revenue.

That would make sense if those wells were still only marginally profitable.

But they’re not.

In 1977 and 1989, when the ELF was adjusted, a well producing 300 barrels a day was considered marginal. In the late 1980s and during the 1990s, the price of oil barely topped $20 a barrel. Now, with oil selling for about $60 a barrel, a company can make money on a well pumping just 10 barrels a day, according to the van Meurs report. “With higher oil prices, you need to produce fewer barrels to cover your direct operating costs,” said Logsdon, the petroleum economist. The production tax system has become “illogical,” he said.

Gara says the tax gives oil companies a break. “We give them help even when they don’t need it,” he said.

The other big problem, the governor says, is that oil companies aren’t investing as much as they could in Alaska’s oil fields. Production has fallen steadily since a peak in 1988, and the Department of Natural Resources expects continuing decline with some interim leveling.

Companies need good incentives to go after small oil fields and ones with thicker, harder to pump, “heavy oil,” according to the governor. The “elephant” fields are history, and oil prospectors are more likely to find fields with 50 to 150 million barrels. (Prudhoe Bay had about 13 billion.)

Even though many of these fields wouldn’t pay any production tax at all, the governor believes more incentives are needed.

But the big problem with the ELF—from the state’s point of view—is the first one, that when oil prices are high, companies can make large profits on oil fields without paying any production tax at all.

“Nobody was complaining about ELF when oil was cheap,” said Witmer, head of the UAF research center. “Now that oil prices are high, it’s like, ‘These guys are stealing our oil!’”

THE GOVERNOR’S SOLUTION

The current ELF system could be implemented differently or modified, but new proposals in Juneau favor eliminating it completely.

Last year, Murkowski administratively lumped together a number of smaller fields around Prudhoe Bay into the Prudhoe Bay field, increasing their ELF and forcing their operators to pay a higher tax. The governor claims the move brought in an extra $200 million to $250 million.

The bills Gara and Sen. Hollis French, D-Anchorage, introduced in 2004 and again in 2005 would keep the ELF but impose a minimum 5 percent production tax and increase the tax rate as oil prices increased above $20.

This year, French, Gara, and the governor each put forward bills that would do away with the ELF completely and create a production tax system based on oil company profits.

Under Murkowski’s plan, a company that makes more than $73 million producing oil and gas in the state in a year would pay a 20 percent tax on profits.

Those that earn less would pay no production tax. Credits would also be given for investment in oil production.

The Democrats’ plan would have an exemption only for very small fields and would impose a 30 percent tax. Gara says the governor’s $73 million exemption is “insane”—only BP, ConocoPhillips, Exxon Mobil, and likely a few others would pay the tax.

“His tax proposal is probably way too generous,” Gara said.

The governor argues his plan finds a necessary balance between taxation and incentives.

In either case, the tax is based on how much money a company makes rather than the size of its oil wells or fields. Even if the governor’s plan lets companies that make less than $73 million escape the production tax, the state would benefit in other ways.

In fiscal 2005, production taxes accounted for only about a quarter of the state’s revenue from oil and gas development. Of the $3.59 billion the state received, $1.94 billion came from royalties, $863 million from production taxes, $524 million from state corporate income taxes, and $261 million from property taxes.

Both plans would ensure that when Alaska’s big three oil producers post some of the biggest profits ever recorded, Alaska will get a bigger piece of the pie.

Staff writer Stefan Milkowski can be reached at smilkowski@newsminer.com or 459-7577.