Alaskanomics

Understanding the Current Oil Price Environment- part 3

By Mark Edwards

To wrap up our look at the current oil price environment, I show the reasons for optimism and reasons I believe that prices will not go much lower and will rise in the coming year.

Reasons for optimism that Alaska can withstand the current price shock:

• Deficit spending from savings, coupled with measured, incremental cuts to the state budget should be the fiscal solution that helps Alaska bridge the current low price oil environment without causing broader economic issues.
• Energy investors in Alaska understand that it takes a decade to explore and permit new oil production.  Then they expect to produce from Alaska’s large fields for two to three decades or more.  They are investing based on long term price averages, not on short-term price swings.
• Multi-billion dollar developments like Point Thompson, and new projects like CD5, and Site 2S at the Kuparuk River are not going to be stopped due to current price levels.  There are development requirements with their state leases that must be met.  There are expectations prices will be higher by the time this oil will be sold into market.
• The three largest producers made public pronouncements during the recent election they would support maintaining the current tax system with long-term capital investments in Alaska.  If they backed off from these promises so soon after their efforts were successful they would lose serious credibility with Alaskan voters and politicians.
• The state government can withstand short term price swings because of our enormous savings accounts.  What is most critical is the length of the price decline.  Sustained low prices for more than a year will start to put serious pressure on government budgets. 
• The state withstood a similar low price shock only five year ago.  The current prices started to fall in September of 2014 from an average of $96 a barrel for Alaska North Slope crude (ANS), to only $61 a barrel average in December.  During the national recession in 2008 oil prices followed a similar path.  They averaged $102 a barrel in September and fell to a low of only $37.7 a barrel by December of 2008. 
• The state Department of Revenue predicts prices will average $76 a barrel and $66 a barrel for the next two fiscal years, but return to averages over $100 by 2018.  The U.S. Energy Information Administration (EIA) forecasts prices to rise by this summer and average $71 for West Texas Intermediate (WTI) in 2016.
• State oil production estimates are positive.  The two decade decline in Alaska is projected to end in FY 2016 with a 15,000 barrel per day increase and then grow again in 2017 to a peak of 547,100 barrels per day due to new fields coming on line.

Reasons to believe prices will not go much lower and rise in the coming year:

 

• Prices are set by the marginal cost of supply.  In the case of oil the world demands roughly 92 million barrels of oil a day.  In the long-term prices will go no lower than the highest cost producers who supply the last million barrels.  If those marginal producers cannot make a profit they will go out of business and the supply will drop.  This causes prices to increase because demand is not being met by the now shorter supply.  Once prices rise, marginal high-cost producers can re-enter the market.
• Inventories build up when the supply of oil grows faster than demand.  This is an easy signal to investors in the oil futures market that prices should fall.  In 2013, oil inventories were at the lowest level they had been in a decade.  The price for ANS averaged $108 a barrel that December.  However, the producers responded to over three and a half years of prices above $100 a barrel with a dramatic increase in production.  In 2014, non-OPEC countries like the U.S. added over 2 million barrels per day (bpd) in production.  Global oil inventories added 0.8 million bpd on average in 2014.  This over supply sparked the price declines we have been experiencing.  The U.S. Energy Information Administration (EIA) predicts the inventory build-up will continue for the first half of 2015 at a rate of 0.9 million bpd.  They expect this to taper off by mid-year because marginal producers will not be able to profitably produce at these lower prices.  Companies can only operate at a loss in the short-term by spending savings and using debt financing.
• The real demand drivers for energy consumption are global population growth and higher standards of living, which lead to more energy usage per capita.  The EIA estimated global oil demand increased by 0.9 million bpd in 2014 and will increase another 1 million bpd each of the next two years.  This is driven by global GDP growth estimates (weighted for energy intensity usage) by 2.9% in 2015 and 3.2% in 2016.  These are both higher than the 2.7% GDP growth experienced in 2014. 
• Demand growth for oil in the next two years              is being driven by continued gains in consumption from China, India and other under-developed nations.  The U.S. is ending a multiyear decline in demand for oil and is expected to increase consumption by 0.3 million bpd as our economy rebounds from a prolonged recession.  Japan, Europe and Russia are projected to decline oil use due to economic problems.
• You can see the long-term black trend line in prices on the graph on page one and global demand on the graph on page 6 are both sloping upwards over time despite volatility in the short-run.

• Non-OPEC countries increased their production by 2 million bpd in 2014.  The EIA estimates this will slow to only 0.7 million bpd this year and decline further in 2016.  Production slowing is predicted in the U.S., Canada, Central and South America.  0.6 million bpd of unexpected supply disruptions have also occurred mainly in South Sudan, Syria and Yemen due to terrorism and political unrest.

Conclusion

Continued growth in global demand for oil, coupled with a higher cost of supply to meet that demand should lead prices higher in the coming year as oil inventories burn up.  Alaska has sufficient savings to offset large current budget deficits.  Needed cuts in state operating and capital budgets will likely create a 2% drag on the economy in 2015.  Current events are always changing, so continued vigilance of this critical economic topic is required.  If prices stay low longer than expected more serious issues could arise.  In the near term Alaska oil production levels should be stable and multi-billion dollar investments from the energy industry are expected to continue through the low price environment.

Understanding the Current Oil Price Environment- part 2

Yesterday, I outlined the background of Alaska's economy in relation to the price of oil and how the current price is affecting the economy. Today, I will show the root causes for the recent decline and will wrap up on Friday with the reasons we should be optimistic for the future.

What are some of the major root causes of the recent price decline?

• Sustained high prices led to an increase in new exploration investment.  Many previously marginal fields became economically viable at $100, which in turn led to dramatic increases in supply.
• The U.S. market became a net exporter of energy from a boom in domestic supply coupled with a slight decrease in demand. 
• More energy intensive manufacturing moved to other parts of the world like China where coal is more prevalent.
• Technology has reduced the marginal cost of production in some fields and allowed previously uneconomic fields to be produced using new techniques.
• Saudi Arabia has not supported falling prices like they have in the past by using OPEC to constrain supplies.  They appear to be trying to punish rival Iran, who is more sensitive to prices in their budget, and possibly see a chance to put smaller high-cost producers out of business to recapture market share.
• The U.S. dollar strengthened against a global basket of currencies last year.  Oil is traded globally in dollars, so a strengthening dollar allows you to buy the same amount of oil for a lower price.
• Global economic concerns have led to lower world GDP expectations and therefore lower oil demand growth in the future.  The European economy is still fragile, Japan has been stagnant for  two decades and China is seeing slower growth rates.  Weakening US power, turmoil in the Middle East and Russian aggression have added to the instability in global trade.

Understanding the Current Oil Price Environment

Over the next couple of days, I will post a three part series about the current oil price environment in Alaska.

It is well known that Alaska’s economy is highly sensitive to the price of oil.  Billions of dollars in investment capital flow into the state each year as energy companies both explore for new oil and maintain their existing fields.  This activity has an enormous positive multiplier effect on the rest of the economy as major service industries including trucking, construction, finance, legal, engineering, retail and countless others see a direct benefit from the contracts and employment required to support this massive effort. 

The current low price environment has many people rightfully concerned about the possible impacts on Alaska’s economy.  However, based on currently available information and analysts’ estimates, prices should begin to increase this year.  The over-supply of oil that led to the recent price drop should moderate as higher cost producers are not able to operate profitably.  Continued global demand for energy is expected to move prices higher by this summer when excess inventories are consumed.  Prices in the $60 to $80 range should keep long-run capital investments from the energy industry stable.

Arguably, the most impacted by a decline in the price of oil is the State of Alaska government.  We are the most structurally imbalanced government in the country in terms of the diversification of revenue sources.  In fiscal year 2014, 88% of the state’s unrestricted spending came from oil taxes and royalties.  On a positive note, this does not include the $11.5 billion in revenues from other sources such as Federal government contributions to the state and returns from our investment portfolios.  If you include all revenue sources, including those restricted by law or by tradition to be spent on specific purpose like the Permanent Fund, than the oil contribution was only 33% of all revenues.  This is smaller than a typical year because returns on investments in the stock market were higher than normal.

It is important to concede that oil prices are highly volatile.  Variance is normal and future predictions are nearly impossible to make with a high degree of certainty.  Therefore, making conservative budget estimates and spending decisions is the only safe way to avoid the fallout from sharp price declines, which at some point are inevitable due to global circumstances that are outside our control in Alaska.

We have been experiencing an unprecedented good run of oil prices over $100 a barrel for over 3 years.  The state tax rates were changed to rise progressively with the price of oil during the Murkowski administration.  Tax rates were raised further during the Palin/Parnell years.  A modification was made prior to the fall in oil prices that raised the base tax rate, but reduced the relation to prices.  This helped protect the state from losing even more revenue during the current low price environment.  The current price drop would have been even more severe if the voter initiative on oil taxes had passed.  At lower oil prices the current law earns hundreds of millions of dollars more in production taxes.  These changes led to a windfall of billions of extra dollars for the state government over the last decade due to high prices and high taxes, despite falling oil production levels.

The problem has been the level of government spending is not sustainable unless prices stay over $100 a barrel and continue to rise in the future.  That never seemed likely, despite Department of Revenue predictions that the Legislature used to justify high spending levels in the operating and capital budgets.  Now it is likely that tough decisions will need to be made to control spending levels, which will inevitably be a drag on the statewide economy.

Of all 50 states, Alaskans receive by far the highest amount of state and federal government spending on a per capital basis and also pay the least in taxes.  We even go one step further and receive a cash dividend of over $1,000 per person back from the State.  This has been possible only because of our vast energy resources and our small population.  Over $52 billion has been saved in the Permanent Fund and it grows despite the roughly $800 million a year spent on dividends due to investment returns and continued deposits from ongoing natural resource projects in Alaska. 

Additionally, the state has over $50 billion saved in other investment accounts.  The largest portion, $28 billion, is reserved for the retirement system obligations for state employees.  Other funds are dedicated to specific department operations, such as $1 billion for airport bonds, $1 billion in the power cost equalization endowment fund, $586 million in the public school trust fund and many others.  To balance an estimated $3 billion budget deficit this year the Legislature can draw from the $11 billion Constitutional Budget Reserve, $3 billion in the Statutory Budget Reserve, and $5 billion was in the General Fund at year end 2014.

The current budget deficit is expected to force the Governor and Legislature to freeze the growth in the operating budget and cut the capital budget.  Research from UAA’s Institute of Social and Economic Research (ISER) has confirmed the widely held belief that the state government has been spending in excess of its long-term sustainable levels.  The Gross State Product in Alaska is $51 billion.  A $1 billion reduction in state spending would reduce aggregate demand in our economy by about 2%.  A positive way to look at this would be despite government cuts we would still have a $50 billion economy.

Join us tomorrow for our look at the root causes of the recent price decline.

Commonwealth North Annual Assets Review

Commonwealth North hosted its 9^th annual Alaska Assets Review on February 18. The program recognizes that as shareholders of “Alaska Inc.” the citizens of Alaska need to be informed about how the assets of their company are performing. This year Northrim Bank President and CEO Joe Beedle and former Lt. Governor Mead Treadwell presented the performance review.

A bit of a history lesson on the reason Alaska has the wealth of assets that it does. During the statehood debate, it was recognized that the state’s population would likely never have the critical mass to finance government through conventional means employed by other states, primarily per capita taxation. In recognition of the need for Alaska to have means to produce its own revenue, the state was granted 104 million acres of land and mineral rights to significant acreage on federal lands. From this, it was felt that Alaska could build and sustain an economy and pay for necessary government services. The annual program tracks the performance of Alaska’s assets, including natural resources, financial assets and enterprises.

The full report and presentation can be found at www.commonwealthnorth.org. A few highlights of the discussion are below.

Alaska's natural resources are abundant and a large part of Alaska's economy.

• The tax revenue from fisheries has increased and the industry is strong, but there is a potential challenge ahead because not all of last year’s harvest has been sold.
• Within the Division of Mining, Land and Water, Alaska’s land position is strong. The state had 100.4 million acres in FY2014, which does not include the 65 million acres of submerged land acquired at Statehood.
• There are five area wide oil and gas lease sales a year. At the most recent sale in November 2014, 300 tracks were leased for $60 million. There is encouraging development occurring on the North Slope and in Cook Inlet.

Financial assets are an important topic of discussion because of the budget issues being seen in Alaska.

• The Permanent Fund Corporation is strong. In FY2014, the fund saw a 15.5% return, which was only slightly lower than the 15.7% benchmark. There are many investment opportunities that are doing well and the corporation is looking to expand into real estate outside of the United States.
• The Constitutional Budget Reserve is one of the options that could be used to bridge the budget gap. It currently holds $12.8 billion.
• Alaska Mental Health Trust Authority is utilizing their land well and making dividends. The state is served well by their investments.
• Alaska Industrial Development and Export Authority has paid $350 million in dividends to the state since its inception.
• Alaska Housing Finance Corporation paid $30 million in dividends to the state during FY2014. Energy and low income housing programs have benefitted Alaskans around the state.

The state’s enterprises are facing challenges, but are working to stay strong.

• The Alaska Marine Highway operates in the red, but is essential for Southeast Alaska.
• Alaska Energy Authority is also operating at a loss but the situation has not changed significantly in the past few years.
• The Alaska Railroad shows a small net revenue, but is facing some major challenges in federally mandated safety regulations. Its income from freight is strong and will continue with increased activity on the North Slope and in Cook Inlet.
• The International Airport System faces challenges, but the fact that Anchorage has the fourth largest cargo airport in the world helps add revenue.
• The Alaska Aerospace Corporation is also challenged, but lawmakers understand its strategic importance and will continue to fight for its survival.
• The University System has a strong endowment and the investment is doing better than recent years. The system has some challenges ahead but will continue to be a priority because additional human capital is necessary to grow Alaska.

To wrap up, Alaska is challenged, but it is also well funded and well endowed. Many people are working on ways to find solutions to the state’s fiscal problems. Commonwealth North has produced a report for Alaska’s leadership. This report highlights some opportunities to work through the fiscal problems and ways to fix the budget gap. This report, Alaska’s Operating Budget: Critical Crossroads, Choices and Opportunities will be presented in Anchorage on February 25 at a lunch hosted by Commonwealth North.

Maximum Sustainable Yield: FY16 Update and Model

The Institute of Social and Economic Research (ISER) has published the update for the State of Alaska’s Maximum Sustainable Yield for FY16. Each year, Dr. Scott Goldsmith outlines the amount the state can afford to spend as part of the general fund. This outlines how much the state can spend without risking valuable petroleum assets.

For FY16, Goldsmith predicts that the state can spend $4.5 billion, which is less than the $5 billion that he predicted last year. The sustainable spending level is lower than last year due to the decrease in expected oil revenues. Goldsmith notes that the state should be moving towards sustainable spending due to the drop in oil revenues. “Budget cuts will affect the economy, which relies heavily on state money – so the cuts should be gradual rather than precipitous.”

The FY16 update has an interactive model that helps readers understand Alaska’s fiscal challenges and see the implications of different assumptions about state revenues and fiscal policies. Download the model at www.iser.uaa.alaska.edu/

The state is currently over spending what can be sustained in the future. This issue is top of mind due to the significant drop in oil prices during the last half of 2014. Goldsmith’s model recognizes ups and downs and the spending is still too high to maintain. If the state does not move towards sustainable spending, the Permanent Fund will be depleted. The Permanent Fund comprises the largest part of the state’s nest egg. As with any fiscal changes, the longer the state waits, the harder the changes become. It is much easier to make small changes, than it is to make sweeping cuts across the whole budget.

The state budget must be brought to a sustainable level soon and Goldsmith provides a strong case for the maximum sustainable yield in the FY16 update.

For further information about Maximum Sustainable Yield, visit: http://www.iser.uaa.alaska.edu/Publications/webnote/2015_01-WebNote19-2016MSYandMODEL.pdf

AEDC Economic Forecast Luncheon

Anchorage Economic Development Corporation (AEDC) hosted its annual Economic Forecast Luncheon on February 5^th. The sold-out crowd of 1,600 business professionals heard from Mayor Dan Sullivan about the upcoming Centennial events in Anchorage. Bill Popp, President and CEO at AEDC then gave his 2015 Anchorage Economic Forecast presentation.

A survey of business leaders in Anchorage found that most were still optimistic about parts of Anchorage’s economy, but overall confidence in the economy had dropped and was slightly pessimistic as compared to years past. This year was the first time the confidence had dropped below 50 percent since 2010. The barriers for growth come as no surprise, with 77 percent of respondents saying the state economy is as large barrier for economic growth. Availability of a professional/technical workforce is also a large barrier, as well as the national economy. The changes to health insurance laws and the cost of labor round out the top concerns for local business leaders. In short, businesses feel good about where they are and what they are doing in 2015, but do not have the same optimism for the economy as a whole.

A brief recap of the 2014 jobs situation outlined that counter to predictions, Anchorage saw a net decrease of 400 jobs in the past year. There may be some revisions of the final numbers, but 2014 was definitely not what was predicted for jobs.

The prediction for 2015 is as follows:

• Oil and Gas- decline -100
  • There are still 15,000 statewide oil and gas industry jobs and the small decline does not reflect projects being cancelled, only a shift from 2014 staffing
• Health care- growth +300
  • continues to be a growing field in Anchorage
• Transportation- flat +0
• AEDC feels there could be a small bump in transportation in 2015 because of air cargo, but will wait to see if the climate remains positive for Alaskan transportation
• Professional and business services- flat +0
• Construction- decline -100
• there has been positive growth in Anchorage construction, but capital projects are decreasing, which will have an effect on the overall construction jobs number
• Leisure and hospitality- growth +100
• Retail trade- growth +300
• continues to be strong due to national retailers entering Anchorage as well as local businesses increasing their footprint
• Financial activities- decline -100
• Government- decline -500
• we will continue to see a decline in Federal jobs in Anchorage, but state government will account for a good portion of the decrease predicted
• Other sectors- growth +100
• Overall- flat +0

Everyone in the room was well aware of the issues with the state’s budget but as both Mayor Sullivan and Bill Popp noted, Anchorage’s economy is strong and this drop in oil prices is much different from the crash in 1986. Anchorage will not see a significant drop in jobs and in fact, the private sector should increase by 500 jobs this year.

We all know that much depends on oil prices and future production as well as the 2016 state budget. Alaskans need to understand that there is a lot of work to be done to build the state economy and that difficult decisions will need to be made by Governor Walker and the Legislature. This is a serious issue, but solutions for increasing revenue and curbing spending are out there. The solutions are long-term strategies and require a good, hard look at the state’s budget process for both revenue and spending.

A midyear look at the employment numbers will be provided at AEDC’s summer luncheon. For the full reports and slide show from the forecast luncheon, visit http://aedcweb.com/2015-economic-forecast-luncheon-reports-available/