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Tentative Recommendations
G. Tentative Recommendations
Recommendations are offered tentatively by listing alternative leasing elements in what the consultant now believes to be their order of preference. This listing is not designed to persuade. On the contrary, it may serve to put readers on notice of the consultant's personal judgments which may have unconsciously affected his marshaling of the arguments. Nor is our position ready to be chiseled in stone. This is a complex new field; we have a lot to, learn and the consultant reserves the right to change his mind subject to new information and new insights.
I would screen out the systems based on ex ante forecasts, and go with one of the ex post systems. This means primarily that I would not continue depending on a high front-end bonus. This is not because of any universal antipathy to bonuses. In the analogous matter of timber sales from federal forests, I prefer the bonus system as practiced by the BLM in preference to a stumpage rate based on scaled volume as practiced by the Forest Service. Standing timber may be cruised with tolerable accuracy before bids are made and accepted, and the period of time involved is or can be short.
Here on the other hand, we are dealing with resources much less well known in advance and whose extraction extends over two or three decades following the investment in the bonus. Even a five-year contract, as used in some forest sales, screens out many worthy operators without accumulated wealth and would much better be payable on the installment plan to avoid this problem. To require bidders to pay in advance for an unknown possibility of acquiring a 20- or 30-year supply is virtually to substitute wealth for productivity as the effective basis of allocation. The possession of great wealth suggests there may have been past productivity, although predation and privilege are also sources of wealth. It is no guarantee of present or future productivity.
Whatever system is chosen it needs to be accompanied by vigorous inquiry into the transfer prices being used as the basis of valuation. If costs are to be made deductible the same holds true in spades.
I would place greatest emphasis on that lease element I have called the ad valorem charge (AVC). As indicated earlier, use of this element detracts from the motivation for exploratory drilling and this needs to be compensated for. A high and rising delay rental is recommended.
If we wish to retain the form and terminology of the bonus system, we could describe this as a low signature bonus paid on the installment plan followed by a high production bonus or discovery bonus whose size depends on the flow of production.
To strengthen the State's hand in appraisal and minimize concealment of reserves it would be desirable to accompany this system with a program of State-financed contract exploration with publicity of findings. (Appendix E and Appendix G) This is not, however, absolutely necessary. We could have AVC postleasing, while continuing to rely on the present system of privately financed preleasing exploration.
An ad valorem charge (AVC) at a high rate obviates reservations of acreage for the purpose of getting top dollar at drainage sales. AVC assures that the State will collect these surpluses anyway.
My second choice would be profit sharing without front-end recovery or recovery of interest at a guaranteed rate. This.is a compromise among the pros and cons of different systems. Royalties, on the one hand, impose too much deadweight loss as the landlord shares revenues without sharing the costs. Sharing costs, on the other hand, in a high degree at a high rate is not administrable. There will be excessive padding.
Profit sharing is somewhat less paddable and hence, with severe policing, would be workable. Since costs may be 'written off against royalties, but without interest, its bias is mostly against costs which are incurred long before they result in increased production . . We have noted that there is too much of that anyway, that several factors conspire to stretch out the period between investment and recovery of capital.
There is a substantial policing benefit to compensate for the social cost of not letting interest costs be deductible against production payments. Interest costs are invisible to most people, and somewhat mysterious, and not so easily perceived as padding. Most people perceive padding in terms of putting relatives on the payroll, featherbedding, girlfriends, and other labor-related offenses. These are highly visible and easily understood, hence likely to be overstressed relative to padding of interest payments. But capital can be lazy, too, and undoubtedly will be if interest payments are guaranteed. Profit sharing avoids this problem.
My third choice is a variable royalty with rates varying according to a variety of objective criteria which could be combined in a point system. Rates would be high where costs are low and vice versa. It would not do simply to assume that volume of flow is the only important factor affecting costs and to have a sliding or step scale increasing with flow. Several other cost factors, probably including several not even alluded to in our previous discussion, need to be entered into the formula. We could remove the future shift effect by limiting the term of the lease to about 25 years or less.
The advantage of this system over actual deduction of cash expenses is the absence of opportunities for padding. Royalty rates would be low where the characteristics of deposits indicated that a prudent operator of average capability would incur high costs. Individuals who performed better than this standard would reap the rewards of their own efficiency.
The system could be progressively amended and improved over the years as experience indicated that the cost of overcoming certain handicaps had been overestimated or underestimated.
In some ways this system resembles the AVC, being based on an outside objective appraisal of the differential value of different deposits. It is something like having the Legislature play the role of assessor when it sets up the point system. Whether this is practicable is partly a question of how, many variables there are which affect costs of production. If there are only a few whose effects on costs can be accurately specified then this system might be workable.
My fourth choice would be front-end recovery. This is preferable to guaranteeing a rate of interest because fast recovery is so much more important to lean firms than to rich ones. This system is to be compared ,with the privilege of expensing capital investments for income tax purposes.
The problem is that any capital expenditure could be written off immediately against a flush producer, opening the door to extensive goldplating and dissipation of rent. Auditing problems are not insurmountable: there is a limit to the credulity of any auditor as to what may legitimately be justified in expending to develop a specific mineral deposit, and auditors would be highly specialized in the oil and gas business.
If either the profit-share, variable royalty, or front-end recovery system is adopted it needs to be preceded by a substantial delay rental to commit the lessee to performance.
We would not recommend returning to the non-competitive or other claim-staking system. We would not recommend high front-end bonuses. We would not recommend exclusive reliance on annual rentals determined ex ante. We are mildly enthusiastic about unitization, but prefer a two tier system coupling individual operation of tracts with overall reservoir management subject to control by lessees themselves, and encouraged by the State to maximize discounted cash flow for the group. An effective two tier system might permit parcels to be smaller than now, a subject we have not explored.
We would not object to putting an upper limit on the acreage controlled by any one lessee, but regard this as difficult to enforce, somewhat arbitrary, and probably unnecessary if other suggested changes are made. We would not object to leases' being subject to an antitrust impact evaluation by the Attorney-General, although we view this as legalistic, potentially arbitrary, and less desirable than generalized incentives designed to encourage competition.
We believe that liability for environmental damages down-stream from a lease should be a lien on the leasehold interest (not on the State's interest) up to the full value of the leasehold interest, provided the damages occur in Alaska. It would be desirable for this lien to extend to all the leasehold interests held by the company committing the damages, introducing a progressive element into risk liability.
Leases should be transferable. All information generated on State-owned lands should be reserved to the State and made public immediately. The State should extend its good offices in the form of a guarantee to all leaseholders that they may have equal access to common carrier transportation. Differences among different leaseholders on the same structure as to desired rates of production are to be resolved by transfers from those preferring slower rates to those who prefer faster rates at a field price to be set by State authority, based on an appraisal of true market value.
Various lesser recommendations on a variety of points have been made from time to time as we proceeded.
We believe the measures recommended would constitute an effective response to the challenge of oil and gas leasing policy in Alaska.
http://www.earthrights.net/docs/recommendations.html