Big Oil’s Alaska problem

July 24, 2013, 4:43 PM UTC
Alaska Governor Sean Parnell

FORTUNE– Oil companies operating in Alaska scored a long-awaited victory this spring when Gov. Sean Parnell signed legislation significantly cutting state taxes on oil profits.  But even before Parnell put his pen to the tax cut bill, opponents were seeking to overturn it, raising questions about whether the industry was too ambitious in its lobbying efforts—and whether the legislation will ultimately ramp up production on the state’s North Slope as promised.

Parnell, a former Patton Boggs attorney and oil lobbyist, championed SB 21—also known as the More Alaska Production Act—arguing that the tax cut, which could be could be worth billions to the oil industry over the next few years, would provide ConocoPhillips (COP), BP (BP) and ExxonMobil (XOM), with the “fiscal certainty” they’d need to proceed with big-ticket projects and reverse decades of declining production.

The bill reverses a progressive system that taxed oil profits at higher rates as their profits grew. (That tax plan was implemented by Parnell’s predecessor Sarah Palin, who, as a vice presidential candidate positioned herself as a friend of the oil industry)  But almost as soon as the measure passed the Legislature–a key vote in the state Senate was 11-9 and the majority included two lawmakers who work for ConocoPhillips–opponents began gathering signatures for a referendum to overturn it. Critics worry the law siphons revenue from the state—oil revenue funds about 90% of state operations—and call it a “giveaway” to a profitable industry that, they say, deliberately delayed Alaska projects to create political pressure to reduce taxes.

“SB 21 doesn’t fix the stability issue where the industry was balking under high progressivity,” said state Sen. Bert Stedman, a Republican from the Southeast Alaska town of Sitka. “It just moves the pendulum from one side to another. You’re moving a significant amount of cash that doesn’t need to be moved.”

The upshot? The Alaska oil industry appears to be headed for a political fight that would inject the market with ambiguity—and could once again be cited by the oil companies as reason to delay Alaska projects.

“You have to create a stable investment environment before you attract the big capital,” said Fadel Gheit, an oil industry veteran who is the managing director of oil and gas research at Oppenheimer & Co. “These companies cannot wait for another two years for the politicians to settle their differences. They’re going to look other places and it becomes difficult to get them back.”

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Three days after the Legislature passed SB 21, ConocoPhillips pledged to add a drilling rig to the Kuparuk field on the North Slope and to pursue a new drill site there. A month later, after Parnell had signed the tax cut, BP said it would spend $1 billion in Alaska over the next five years and send two new rigs to the North Slope. These announcements were exactly what Parnell had in mind when he started pushing to cut oil taxes after winning his first full term in 2010.

“There’s real confidence that this has turned things around,” Parnell said in a recent phone interview. “My object in passing this legislation is to grow our economy, create jobs and put more oil through that pipeline.”

So far, the companies haven’t said much about the potential referendum to overturn the tax cut. Asked for comment by Fortune, BP and Conoco pointed to their prior investment announcements. Exxon said it was “committed to Alaska and will continue to actively pursue investment opportunities,” but the company added that a vote to overturn the tax cut wouldn’t help long-stalled plans for a pipeline that would bring the massive amount of natural on the North Slope to the market, a project that has bedeviled Alaska governors for decades.

“Regarding the south central LNG project, a competitive, predictable and durable oil and gas fiscal environment will be required for a project of this unprecedented scale, complexity and cost to compete in global energy markets,” Exxon said in a statement. “The passage of SB 21 signifies achievement. A healthy, long-term oil business will be a key part of the foundation for this complex, world-scale project. We will need to work together with the state to ensure we have the right fiscal environment to support an LNG project.”

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Under Palin’s tax structure, known as Alaska’s Clear and Equitable Share (ACES), there was a 25 percent tax rate on oil profits and the rate increased progressively as oil prices went up. Soon after Palin’s bill passed, oil surged over $100 a barrel. The state’s coffers filled with oil revenue, but the producers argued the high taxes forced them to divert investment dollars elsewhere around the globe and to rival states like Texas and North Dakota with lower tax rates. Parnell eliminated the progressivity feature. The new base tax rate will be 35 percent, with production credits that can steadily reduce the effective tax rate.

It’s difficult to know exactly how much the tax cut, scheduled to take effect in 2014, is worth to oil producers (or conversely how much it will cost the state) – the dollar figure largely hinges on the volatile price of oil and whether or not the new tax climate increases production on the North Slope. If production continues to decline at the current rate of about 5 percent a year – approximately 560,000 barrels per day moved through the 800-mile pipeline from the North Slope to Valdez in 2012, down from a peak of over 2 million in 1988 – and if oil averages about $113 a barrel, the tax cut could cost the state more than $4.1 billion through Fiscal Year 2019, according to a projection from the state Department of Revenue. The state could do much better if oil production ramps up over that period.

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Prudhoe Bay and Kuparuk, two of the biggest oil fields ever discovered in North America, have produced about 16 billon barrels of oil since the pipeline opened in 1977. There’s plenty of oil left on the North Slope, perhaps up to 40 billion barrels – it’s just harder to reach and more expensive to extract. Parnell hopes the tax bill will change the metrics for the oil companies, spurring them to explore more and invest in the equipment necessary to at least stem the North Slope’s declining production. He said it could be three to five years before new production generated by the lower tax rate starts to ramp up. The real question could be whether or not Alaska voters, and their elected representatives, are inclined to wait. And if the political fight gets sticky, the oil companies may leave the untapped reserves of oil under the vast expanse of tundra at Alaskan’s northern reaches for another day.