One of the most confusing concepts in petroleum supply economics is how oil and natural gas can be both complements and substitutes in production. To guide understanding, consider agriculture. A rancher can sell both beef and leather products at the same time because they come from the same source. So, beef and leather are what economists call complements in production. Regardless of whether beef or leather prices go up, the rancher makes more money.
However, corn and wheat are economic substitutes in production. If corn prices rise, then a farmer may substitute corn production for wheat production, and vice versa if wheat prices increase. He simply cannot produce both wheat and corn on the same acre of land the way a cattle rancher can produce both beef and leather on the same acre of land. So while beef and leather are complements in production, wheat and corn are substitutes in production.
Oddly, shale gas and shale oil are complements in production when you are looking to supply shale gas, as they do in the Lower 48; however, they are substitutes in production when you are looking to supply shale oil exclusively, as we want to do in Alaska. The reason for this contradictory situation is because when you produce shale gas in the Lower 48, not only will your shale gas be near a pipeline, making it easy to get your product to market, but you also will have to separate out the gas impurities, the conditioning of which automatically produces the heavier liquid shale oil if it exists. Therefore, when you produce shale gas, you often produce shale oil on the side and simply cart it away and sell it for additional profit. Basically, shale oil complements shale gas production or vice versa as long as a natural gas pipeline is nearby.
Now think Alaska. Remember we have stranded gas: There is no pipeline ready to take our gas to market. When you want to produce shale oil exclusively, there is no way to remove any natural gas you discover. Simply to produce shale oil you must contend with shale gas, which—if you are only interested in the oil portion of your shale resource—is unmarketable, unstorable and expensive to deal with. Therefore, shale gas is suddenly an obstacle in the way of producing shale oil. And indeed shale gas can often prevent shale oil production entirely unless you have considerable flaring of the gas or have other uses for it. That makes shale gas and shale oil substitutes in production, like corn and wheat, the moment you find the shale gas with the shale oil. Either you give up or you drill in an alternative location.
This confusion of substitutes versus complements in shale resource development is one reason behind the very generous oil tax credits that Alaska gives. You need incentives here to drill for shale oil because you tend to find a lot of shale gas instead. The high level of drilling in the Lower 48 is incentivized by the natural gas itself, so no tax credits are needed.
Unfortunately, shale oil reserves, even when found, tend to be small, expensive and short-lived. Instead of finding Prudhoe Bay, you end up finding the equivalent of 100 of your neighbors’ backyard fuel oil tanks, extracting their contents in three years, and then going to the next neighborhood to repeat. Think Tour de France, not Indy 500. Thus, oil tax credits create a lot of shale drilling but very little oil. The conventional fields do not need those credits since they are three or more magnitudes in size, a bucket compared to a drop.
Still, the confusion leads to a belief that Alaska’s oil tax credits are helpful in finding more oil, even shale oil, and are therefore a huge benefit to Alaska. In fact, we are just giving away the equivalent of thousands of residents’ PFDs to subsidize corporate welfare and out-of-state workers.
Therefore, producing shale oil here is going to be a challenge at most and unprofitable at least. Contrast this to the large conventional fields that do not need incentives, and we have a poor revenue base for a strong state.
Any policymaker who claims that BP is leaving Alaska because of oil taxes should not be afraid to hire an independent oil tax consultant to analyze our fiscal revenues. The alternative is an oil tax credit initiative led by the people to stop the giveaways and start bringing in additional revenues.
Doug Reynolds is a professor of petroleum and energy economics at the University of Alaska Fairbanks. His email address is DBReynolds@Alaska.edu.