The gross value reduction tax credit given by the state of Alaska to the oil companies is complex, but here is a way to simplify the issue. Consider a very specific example: If the price of oil is $50 per barrel and the cost of extracting the oil from a particularly small, hard-to-reach pocket of oil is $45 per barrel, including local taxes, transport tariffs and fees, then that specific oil reservoir is profitable to extract.
To this we must add a royalty, which is the original agreed-to payment per barrel, independent of costs, that goes to the state as the owner of the mineral right. If a royalty is set by lease contract at say 20%, then that entitles the state to $10 per barrel, making the final cost to the producer to extract the oil rise to $55 per barrel, which is too high of a cost for a $50 per barrel sales price. In that specific case, the oil becomes uneconomic to produce. If the royalty were less or other costs were less, it might be manageable.
The idea of the gross value reduction tax credit is that by giving back a credit, say for example $7.50 per barrel, that $45 cost will only have a net royalty of $2.50, i.e. the $10 royalty minus the $7.50 credit, and then the oil becomes profitable to extract. Here the state and the producers both win.
The hard part here is actually knowing what “the cost” is. Sometimes there are pockets of oil that could on average be $30 or $40 per barrel to extract but could be more expensive if an appropriate cost estimate were done, and this can affect how costs are averaged over many barrels and in turn how many credits you get.
For example, your average time at the grocery store per item bought might be one minute per item. But if it took 5 or 10 minutes to wait at the meat counter for them to cut a special cut of meat, then given your average time, the other items take less than a minute to get. This is parallel to cost complexity of oil extraction. There can be a single pocket of oil costing more to reach, but its cost per barrel would be averaged over lower cost oil, making it seem as if many of the barrels are more expensive and deserving of credits. Many an engineer, accountant and manager will have a hard time placing costs appropriately. To simplify things, take away the credits and let them decide if they really want to get each pocket of oil or not.
In the first example above, if an additional barrel is available at $35 per barrel and would normally be produced, now you can average it with the $45 barrel for two barrels at $40 and now both become unprofitable with the $10 royalty. Here both obtain tax credits when only one of the barrels needed the credit.
However, technology does get better over time and these costs do go down over time. In addition, the price of oil will increase again. So instead of making something only slightly profitable to extract with the credits right now, why not wait for prices to rise and technology to improve to make those pockets profitable so that credits are unneeded? Getting a smidgen of value now for such pockets of oil compared to waiting for better returns later is not worth it. The credits tend to incentivize too many marginal pockets of oil that could better wait. This is why I am voting yes on the citizens’ oil tax initiative.
Some will say that oil will be lost forever if any of these pockets of oil are bypassed, which reminds me of when Russian oil in the old Soviet Union was being extracted using water-flooding techniques and all the engineers said the oil would be lost forever since many of the reservoirs were flooded. Even so, technology advanced, was adapted and those fields came back to life. Therefore, when petroleum engineers say oil will be lost forever, I am not buying it. I think at this point we are paying too much of their costs for too little benefit to us.
The other issue is the trans-Alaska pipeline system, which needs to be addressed and will not be unless we vote yes on the citizen’s oil tax intuitive. The panic over the pipeline is overblown, and we need to review other options for transporting the oil as the industry naturally declines.
Doug Reynolds is a professor of petroleum and energy economics at the University of Alaska Fairbanks. He can be contacted at firstname.lastname@example.org.