Tuesday, April 21, 2015

Triggering Compromise in North Dakota: Oil, Taxes, and Planning Ahead

In North Dakota, the state has seen drastically falling revenues due to low oil prices.  Lower revenues makes it more challenging for the communities in that state that are still trying to provide the necessary infrastructure and services that remain a challenge due to the enormous growth over the last several years.  The response from some in the North Dakota legislature? Cut taxes

Oil companies always seek lower taxes because they are rational actors.  Lower taxes means higher revenues. This was true with sky high oil prices and is even more true with lower prices. From a company perspective, the position makes sense.  From a legislative perspective, the position should be more nuanced. 

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Back in 2012, I discussed some 2011 proposals that were put forth to lower oil taxes to "keep the drilling going." As I explained then, "a high enough [tax] rate will stop drilling and impede the viability of the oil market, but the key here is the taxes must make it uneconomic (i.e., not profitable) to continue drilling."  That was plainly not the case then, as drilling continued to increase and the oil flowed freely.  Cutting taxes at that point would have been paying oil companies to do what they planned to do anyway. 

In recent months, with oil prices dropping dramatically, the tax rate is properly on the table.  A relatively high tax rate in boom times helps generate the revenues needed to support the boom.  A high tax rate in down markets can negatively impact economic activity.  Legislators are properly looking at options to support the industry, and the tax rate is a proper consideration.  

Tax rates, like interest rates, provide options to stimulate growth, but only when the rates are high enough that a reduction in the rate can provide access to more funding.  North Dakota's high oil tax rate could be reduced to support more drilling in the state, though one would still need to analyze whether the tax rate cut puts the companies is in a zone that incentivizes companies to drill more than they would without the cut. If oil prices are low enough, even a tax rate of zero won't motivate new activity, so cutting the tax in that instance would just resulting in foregoing tax revenue on existing wells. 

In the current climate, it does appear that easing some tax rates would boost activity. As such, discussing a reduction in tax rates during low price markets makes sense.  Unfortunately, current law in North Dakota has a trigger to cut oil taxes in half if oil prices stay below $55/barrel for five straight months (we're closing in on that).  Rates would go back to normal if oil prices go above $55/barrel for five months in a row.  The state is appropriately concern that the revenues are about to become a problem if the trigger is triggered.

A current proposal now suggests that the trigger should be eliminated and the tax rate reduced from 11.5% to about 9.5%.  The oil industry suggests that the variability of the trigger rates creates uncertainty that negatively impacts planning, so the reduction makes sense.  This argument is not too compelling.  Oil companies deal with many moving parts and fluctuating costs, from international oil prices to labor costs to transportation costs.  And, unfortunately for oil companies (when making this argument), many of the people I know in the industry are extremely good at what they do.  They are smart and savvy, and a fluctuating tax rate is more an annoyance than anything else.  

As a now outside observer, I find this whole debate a little confounding because the solution seems clear. Cutting taxes to incentivize drilling is a reasonable move and seems right.  The oil industry and local communities seem to agree that 9.5% would be a good option to help motivate some additional drilling and keep revenues stable enough to support the communities that support the industry.  Why not just change the trigger to reduce taxes to 9.5% when prices are maintained below $55/barrel and go back to 11.5% when are maintained above $55/barrel? 

I understand that oil companies would like the lower rate all the time, but there are others who would prefer to keep the rate at 11.5% all the time. Still others probably like the current trigger rule. But that's compromise -- find a spot that accomplishes some of what most people want, and we all win by losing less than we would have otherwise.  

I sincerely hope the legislature considers keeping the trigger option at some level, because it gives the state some leverage and ability to work with the industry in down markets and support communities in hot markets.  If the tax rate keeps dropping, the state loses its ability to stimulate growth in down markets, while reducing the state's ability to plan ahead for down markets.  

North Dakota has been a forward-thinking state in recent years by saving oil revenues in the state's Legacy Fund, which reports that "[a]s of December 19, 2014, total deposits were $2,769,415,738.78." Keep in mind, that's for a state with a population of roughly 700,000 people.  Here's hoping the state takes a pragmatic view and finds a compromise that supports the communities, economic growth, and long-term planning.  


Financial Markets, Joshua P. Fershee, Law and Economics | Permalink


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