Reduce, simplify Alaska oil taxes, consultant says

JUNEAU — A consultant retained by Alaska’s Legislature has recommended the state rein in taxes on oil production to attract industry investment but also to dismantle a complex set of exploration and development incentives that gives away too much, with the state paying as much as 80 percent of the cost of new exploration wells, state lawmakers were told in hearings.

The Legislature is reviewing the state tax system in hopes of encouraging new investment to slow or reverse a decline in production from the North Slope.

Following several days of joint hearings by the Resources and Finance committees of the state Senate, Pedro van Meurs, a Calgary-based expert on international fiscal systems, suggested the state revise its taxes so the total state take including royalty is no more than 75 percent on existing production and 65 percent on new production.

To encourage heavy oil development, the Legislature may have to lower total state take to 45 percent, van Meurs said.

The current tax system has the state taking more than 80 percent at high oil prices, which van Meurs said is too high. There is also a disconnect in the incentives in the tax system, he said. The exploration and development tax credit system now in the law is generous in assisting companies in finding oil, but once discoveries are made, the production tax burden becomes very high and is a big disincentive.

“For the large companies who are now producers, there’s no attraction for development any new oil found, so why even explore? They have alternative investment opportunities around the world that are much more attractive,” van Meurs said.

On the other hand, the tax credit system is attractive to smaller companies that can enjoy the lower up-front costs, with the state picking up most of the expense of drilling.

Another criticism is that Alaska’s existing tax system is too complex, and discourages companies from considering Alaska projects. Repsol, for example, told van Meurs it had sought assistance in deciphering the Alaska system from four major accounting firms as well as the state revenue department and was never able to get answers for certain questions, he told the legislators.

Repsol went ahead with its Alaska exploration anyway, which is currently under way, but a simplification would make the tax system more transparent, van Meurs said.

Van Meurs’ most substantial criticism, however, was on the way crude oil and natural gas are combined for tax purposes when they are produced together, such as would happen on the North Slope if and when commercial gas production begins.

If gas has a much lower value than oil, as it does today, the effect of a tax on the combined barrel of oil equivalent, which the current tax imposes, would be to sharply reduce the revenues compared with what they would have been if imposed on the oil and gas separately.

“Once you start to produce gas as well as oil you’ll lose billions. If you do a large gas project, you could wipe out your revenues. This is the most nonsensical system in the world,” van Meurs said. “Alaska cannot develop its gas resources as long as this is on the books.”

Van Meurs suggested that the state simplify its taxes by removing the progressivity formula that sharply escalates tax rates at higher oil prices, leaving a flat 25 percent tax on net profits, which is the base tax rate in the current law.

He would do away with an array of exploration tax credit but leave a basic 20 percent credit on all industry capital investment. To capture more gains from oil price escalation, he would include a 2.2 percent severance tax on gross revenues.

Van Meurs said this basic structure could be adapted with special tax rates for new oil and heavy oil. Natural gas would have its own, separate tax, so that gas production would not dilute oil revenues as would be the case under the current law.

If the Legislature chooses to establish a lower tax rate for new rather than existing oil production as an incentive for producers, the tricky part will be in defining just what constitutes “new” oil. One way to do this is to simply measure the decline rates of specific fields and if producers can increase production to slow the decline or even reverse it, the increment of added production between the original decline rate and the new rate would be considered “new” oil and qualifying for the incentive, he said.

As for heavy, or viscous, oil and what van Meurs called “ultra-heavy” oil, or oil like the Ugnu oil deposit on the North Slope, additional incentives would be needed. Again, van Meurs recommended applying the basic 25 percent tax rate and 20 percent capital tax credit, but to build in added feature to lower the effective tax. He recommended the same for the ultra-heavy oil, but with more of a reduction.

Van Meurs said that about 40,000 barrels per day of heavy oil is now being produced on the Slope, much of it from the West Sak, Schrader Bluff and Nikaitchuq deposits. Sometimes called viscous oil, this heavy oil has API gravity (a way of measuring oil quality) ranging between 19 degrees and 22 degrees API, as compared to the conventional “light” oil on the Slope, which measures about 29 degrees API and up to 40 degrees, depending on the field.

Heavy, or viscous, oil is thick and flows like maple syrup, and one problem is that it must be mixed with conventional oil to get it to flow through the Trans-Alaska Pipeline System, van Meurs said. As heavy oil production expands there must also be enough conventional oil to mix with it.

Alternatively, a gas-to-liquids plant built on the Slope could convert natural gas to a liquid that could be put into the pipeline, diluting the heavy oil, van Meurs said.

There is now only a pilot test production program for the ultra-heavy oil found in the Ugnu formation. BP is testing several production techniques but these are focused on weather this oil, which measures 10 degrees to 15 degrees API, can be produced at all. Once that is established, the question of whether it can be economically produced will be addresses, BP has said.

Natural gas will need its own tax rate and van Meurs suggested the Legislature move immediately to separate gas and oil taxes. Gov. Sean Parnell has suggested waiting until 2013 before doing this, and after North Slope producers have decided whether to further pursue a major gas project. Van Meurs recommended against this, saying the Legislature should put gas tax terms on the table now as a signal to the industry.