Oil and Gas in Federal Systems

Transcription

1 Oil and Gas in Federal Systems ** Black Auditorium The World Bank, Washington, D.C. March 3 rd and 4 th, 2010 Organized by the World Bank and the Forum of Federations, with sponsorship from NORAD The Governance of Oil and Gas in the United States Peter Mieszkowski i and Ronald Soligo ii Rice University The Forum of Federations is undertaking a study of the factors that affect the management of petroleum resources in federal systems, of which this draft paper is part. This paper is an informal document which publication is intended to provide reference material for the Conference on Oil and Gas in Federal Systems, organized by the World Bank to further the dialogue on development and public finance issues that are common to federal and decentralized petroleum-producing countries. A revised version of this paper will be included in a publication by the Forum of Federations which is expected to be completed by June The manuscript of this paper has not been prepared in accordance with the procedures appropriate to formally edited texts. Some sources cited in this paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed herein are those of the author(s) and do not necessarily reflect the views of the International Bank for Reconstruction and Development or the World Bank or of the Forum of Federations and their affiliated organizations, or those of the executive directors of the World Bank or the governments they represent. The World Bank and the Forum of Federations do not guarantee the accuracy of the data included in this work. Draft not for citation without author s permission 1

2 1. Overview The US experience with the oil and gas sector is quite unique. Historically, during the period , most development and production took place on privately owned land with privately held mineral rights at a time when there was relatively little regulation by state or federal governments. The fragmented ownership of land meant that there were many individuals in the business of producing oil and gas. This system generated enormous inefficiencies as many rights holders frantically competed to maximize the extraction on their parcel of land. Gradually, states began to reduce this waste by production controls but the principle that these resources should be developed in a socially efficient manner was never broadly accepted as small rights holders preferred to behave strategically in the hope of increasing their share of the economic rents from resource exploitation. At various times the federal government has intervened to regulate prices and support states efforts to limit production. In recent decades, the federal role has grown as offshore production has increased and energy security, environment and conservation of public lands have become more salient issues. This change in the federal role results from expanded and shifting public governance and action rather than the reassignment of responsibilities between states and the national level. Another feature of the US is that ownership of public lands, and the associated mineral rights, is divided between the federal and state governments. The governance of oil and gas is uniquely determined by the way in which public domain lands were disposed of by the federal government. In the mid-west virtually all these lands were made private or were turned over to states. In the west, where oil and gas resources are more plentiful Congress decided to retain a large portion of the public lands. To gain the acceptance by the western states of the continued significant federal presence in their territories, the eastern states, through a process of bargaining, progressively agreed to turn over to the West as much as 90 percent percent of the mineral revenues collected on the federal lands. The federal government has exclusive control over the regulation of exploration, development and production of offshore resources with the exception of a limited area that has been assigned to state jurisdiction as well as revenues generated from them. In these areas the federal agency has the power to mandate cooperation among leaseholders to jointly operate a field to avoid duplication and other inefficiencies but this power is rarely invoked as the degree of voluntary unitization is quite high and many offshore tracts are under the control of a single leaseholder. Moreover, public opinion and congressional politics has had a determining effect on where offshore drilling can occur. Distribution of offshore revenues could yet move in the direction that characterizes federal onshore resources, namely adjoining states being given some access to revenues as an inducement to acquiesce to offshore drilling. Draft not for citation without author s permission 2

3 2. Historical Background and the Development of the Petroleum Industry Importance of oil and gas extraction sector The modern oil industry was born in Pennsylvania in The industry grew quickly and by 1910 the US produced 64 percent of the world s oil. The dominance of the US industry lasted until the rapid development of oil in Middle East after the Second World War. As late as 1940 the US produced 63 percent of the world s oil and was a net exporter of oil until Despite a continuous decline in crude output since 1970, the US is still the third largest producer after Saudi Arabia and Russia. In 2007, the US produced 8.4 percent of the world s oil supply and 13.4 percent of its gas. 2 Only Russia produces more natural gas. While still significant globally the size of the oil and gas extraction sector is quite small relative to the US economy. In 2006 the industry contributed only $159 billion to US GDP of $13.2 trillion, roughly 1.2 percent. The industry is much more significant for several states accounting for 24.7 percent of Alaska s GDP, 16.2 percent for Wyoming, 10.4 percent for New Mexico, 10.1 percent for Louisiana and 7.5 percent for Texas. About 63 percent of US oil production is concentrated in six states and the offshore. Of the total US output of 1,848 million bbl of oil in 2007 Texas produced 397 million barrels or 21.5 percent. Other important producers are Alaska with 264 million bbl, (14.3 percent), California, 217, (11.7 percent), Louisiana, 76 (4.1 percent), Oklahoma, 61, (3.3 percent), New Mexico, 59 (3.2 percent), and Wyoming 54 (2.9 percent). 3 The Federal offshore area produced 466 million bbl or 25.2 percent of the US total. Similarly, the top five gas producing states account for 70 percent of the total of 20.0 trillion cubic ft (tcf) in The major producing states are Texas, 6.1 tcf, Wyoming, 1.9, Oklahoma, 1.7, New Mexico, 1.5, Colorado, Federal offshore (OCS) production was 2.8 trillion cubic feet. The US remains the largest consumer of oil accounting for 25 percent of global consumption. Growing imports have made up the difference between increasing consumption and declining production. In 1970 the US imported 3.2 million b/d of crude and oil products accounting for 26 percent of total supply 6. In 2008 imports amounted to 1l.1 million b/d or 57 percent of total supply. 7 The US is also dependent on imports for roughly 15 percent of its gas consumption. 1 C. Van der Linde, Dynamic International Oil Markets, (Dordrecht: Kluwer, 1991). Tables 2.7 and 3.1. This book presents a thorough historical overview of the world petroleum industry. 2 BP Statistical Review of World energy, June Source: EIA 4 The data are for marketed gas, Marketed natural gas can differ from production as some gas is re-injected either for enhanced recovery of oil or, in earlier years, because of a lack of pipeline capacity. 5 US Statistical Abstract, 2008, p Energy Information Administration, Petroleum Over , Table Energy Information Administration, Monthly Energy Review, February 2009, pg 37. Draft not for citation without author s permission 3

4 Government Intervention Before World War During the US industry s first 100 years the oil was overwhelmingly produced on private land 8. State governments have the authority to regulate industry within their borders as long as their regulations do not interfere with interstate commerce. Regulators first concern was to limit surface and subsurface damage from drilling, extraction and storage and the wastage of casing-head gas. Early regulations addressed wellhead casing, the plugging of wells, and other provisions dealing with the possible contamination of water. They also had to deal with systemic overproduction following the discovery of large fields, in Texas and Oklahoma between Rapid uncontrolled production, reflecting the property law doctrine of rule of capture, created waste as flows often exceeded shared transportation and storage capacity. This legal doctrine entitles leaseholders to all the oil they capture from drilling on their property. If there are multiple leaseholders over a common reservoir, each has the incentive to pump oil as quickly as possible. The too rapid exploitation prematurely weakened the natural drives of reservoirs, lowering ultimate recovery rates. In addition the rapid increase in production often drove prices to very low levels, which threatened the financial viability of producers, especially smaller independents. One way of dealing with such waste problems is to unitize the reservoir or field whereby its leaseholders agree to specific shares of revenues and costs of the common enterprise and a single producer develops the reservoir efficiently to their mutual benefit. In Texas the integrated major producers supported unitization, while the more numerous smaller independents opposed it, as they feared the control of the majors who, because of their larger holdings, would become the unit operators. The Texas Legislature influenced by the politically powerful independents placed the control of the oil fields in the hands of a state agency, the Texas Railroad Commission (TRC) that eschewed compulsory unitization. Unfortunately voluntary unitization is very difficult to achieve except when the number of leaseholders is quite small. Liebcap and Wiggins demonstrate this in their analysis of contracting success in Oklahoma and Texas Oil Fields. 9 As an alternative policy, states adopted prorationing with quotas to control production. However, the TRC set quotas on the basis of the number of wells not acreage, giving leaseholders an incentive to drill more wells. To limit the proliferation of wells, the TRC issued regulations specifying the minimum distance between wells. However, the commission frequently granted exceptions to these spacing rules as well as an exemption to production controls on marginal stripper-wells. This system sustained a large fringe of 8 This section draws heavily from Steve Isser, The Economics and Politics of The United States Oil Industry, (New York: Garland, 1996). Chapter 1. Stephen L. McDonald, Petroleum Conservation in the United States: An Economic Analysis (Washington, D.C.: Resources for the Future, 1970). Chapter 2.Jacqueline Lang Weaver, Unitization of Oil and Gas Fields in Texas, (Washington, D.C.: Resources for the Future), Chapter 3. 9 Gary D Liebcap and Steven N. Wiggins, Contractural Responses to the Common Pool: Prorationing of Crude Oil Production, American Economic Review, 74, 1, (2001) Draft not for citation without author s permission 4

5 high-cost independents that were dependent on preferential treatment under pro-rationing and later on import controls for their survival. The pro-rationing system stabilized prices and controlled above surface physical waste but at the expense of large unnecessary expenditures on wells and overcapacity and inefficiencies estimated at $4 billion a year 10. In the large East Texas field, numerous wells were drilled under the exception rule so that the field ended up with a density of one well per 4 acres, five times the Agency s well spacing standard 11. Jacqueline Weaver states that two-thirds of the 26,000 wells in East Texas were not necessary 12 and that in 1931 the independents with 20 percent of the acreage produced 49 percent of the oil - draining the East Texas field at the expense of larger firms. The Federal Government played a minor role in the governance of oil and gas before During the New Deal Era Congress rejected legislation that would have turned the control of oil production to the Department of the Interior and ratified in 1935 the formation of the Interstate Oil Compact Commission, a body that would coordinate the regulation of production by states. Congress, also, helped to enforce state level regulations by outlawing the transportation of hot oil (production in excess of state quotas) across state lines. The federal role in natural gas markets dates back to the Natural Gas Act of 1938 that regulated interstate pipelines as public utilities. Over time jurisdiction of the Federal Power Commission was expanded to include regulation of the wellhead price for gas destined to move in interstate pipelines. This expansion occurred primarily through interpretations of the National Gas Act by the courts, not legislation. Intrastate pipelines and prices were not within the federal purview. There is no evidence that the inefficiencies and over-production of oil had significance for intergovernmental relations or created tensions between producing and consuming states. One possible explanation was that, because of shifts in supply and lower demand during the 1930s, oil prices were falling. The waste associated with an excessive number of wells shows up partially in higher oil prices and also in lower output and higher prices of commodities produced by industries that would have expanded if the oil industry had been more cost effective and smaller. But the broad diffusion of these general equilibrium effects masks these costs and they are generally not perceptible to the public. Post War Developments M.A. Adleman, Efficiencey of Resource Use in Crude Petroleum, Southern Economic Journal, 31 (October 1964), pp Bradley documents these and other inefficiencies associated with prorationing. Robert L. Bradley, Jr., Oil and Government: The U.S. Experience (Lanham, Maryland: Roman and Littlefield, 1996, vol. 1). Pp Weaver, op. cit. p This section owes much to Steve Isser, The Economics and Politics of The United States Oil Industry, (New York: Garland, 1996), Chapters 2 and 3; the excellent paper, Paul L. Joskow, U.S. Energy Policy During the 1990 s National Bureau of Economics Research, Working Paper, 8454 (Cambridge Mass: September 2003); and Robert Bamberger, Energy Policy, Conceptual Framework and Continuing Issues, Congressional Research Service, March 7, Draft not for citation without author s permission 5

6 After the Second World War demand and supply of oil grew dramatically, US production increased from 5.5 mmb/d in 1949 to 11.3 mmb/d in 1970 where it peaked and then began its slow decline to 6.7 mmb/d in US consumption increased from 5.8 mmb/d in 1949 to 17.3 mmb/d in 1973 and 19.5 mmb/d in By the mid 1950s imports had already grown to 12 percent of domestic demand, the result of prorationing and domestic prices above world prices. Congress responded to demands for protection by independent producers by imposing an import quota equal to 15 percent of US consumption east of the Mississippi. Despite import restrictions, during the late 1950 s and early 1960 s, prorationing was equal to only 30 percent of efficient production capacity. Domestic oil prices were at least 50 percent higher than import prices. Ultimately import quotas became redundant and were abolished in 1973 as US production approached 100 percent of capacity and world prices gradually increased. The period from was a period of major and intrusive federal government intervention in the industry. It is a period of growing US dependence on imports and increasing concerns with energy security as imports were disrupted during the Yom Kippur and the Iran-Iraq Wars and oil prices increased more than ten-fold. Successive administrations responded by emphasizing energy independence to be achieved though increasing the efficiency of energy use, increasing domestic production and promoting alternative energy sources. These policies were pursued by mandatory efficiency standards for automobiles and household appliances, subsidies for alternative fuels and the opening up of more federal lands for exploration. One exception to this pattern was the price controls on domestically produced oil and petroleum products imposed early in President Nixon s first term. These predictably resulted in increased demand and shortages. Other policies including the removal of import quotas and barriers to the development of Alaskan oil were more consistent with supplyoriented policies followed by subsequent administrations. A federally run strategic oil reserve was created in However, its purpose was to provide a stockpile of oil in case of emergencies, not a buffer stock program to stabilize prices. The Reagan administration marks an important shift away from conservation and demandside policies towards a focus on increasing domestic production. This policy was facilitated by collapsing oil prices and the increase in domestic production of oil from Alaska. The price of domestically produced oil was finally decontrolled, and the number of leases offered in the Gulf of Mexico was greatly expanded. Attempts to significantly increase leases onshore were held back by opposition and lawsuits. The George HW Bush administration continued supply oriented policies and proposed to open the Arctic National Wildlife Refuge for development. However, the Energy Policy Act of 1992, crafted largely by Democrats, de-emphasized supply initiatives stressing instead energy efficiency and the development of renewable energy Source: EIA, Monthly Energy Review, February 2009, pg Joskow op. cit. pg 14 Draft not for citation without author s permission 6

7 Attempts by the Clinton administration to promote energy efficiency, renewable energy and more use of natural gas were constrained by Republicans. They designed The Royalty Relief Act of 1995 that promoted deep-water exploration in the Gulf of Mexico. The Clinton years were characterized by low oil prices, falling domestic production and growing imports. The salience of energy security and independence as a policy focus was renewed during the George W. Bush administration as oil prices began to increase in early 1999 and continued throughout the eight years of the administration, peaking at $145 in July 2008 before falling back to the $40-$50 range by the end of his term. Bush s supply side initiatives were only partially successful. Drilling in the Arctic National Wildlife Refuge did not pass Congress but the administration did expedite the onshore permitting process and weakened some regulatory impediments, resulting in a fourfold increase in oil and gas permits. 16 The number of offshore leases also increased significantly. Federalism and energy policy Major energy policies had differential regional impacts and they produced political alignments that sometimes pitted producing states against consuming states. For example, New England, a consumer of oil and Michigan, a producer of cars opposed import controls during the 1950 s and 1960 s. In general, consuming states supported price controls during the 1970 s and opposed tax breaks for the oil industry while producing states were on the opposite side of both issues. However, as the following quotation makes clear, regional coalitions are diffuse and imperfect and political behavior is influenced by ideology. One of the myths of the energy debate is the illusion that it was a regional conflict. While northern states had higher energy costs, and there was a Southwest bloc of energy producing states, support for deregulation was more ideological than regional. The analysis of votes in Chapter 9 show a tendency of southern Representatives to support oil and gas interests but a reverse trend by southern Senators, with the effect much weaker than ideology or party variables. Western state congressmen demonstrated even less unity, as their economic interests in energy were highly divergent, and public attitudes ranged from fiercely pro-environment to intense hatred of governmental interference. Even in the Northeast and Midwest, there were significant differences between the energy poor New England and East Coast states and the coal states. The type of energy produced and consumed in a state was also important in determining policy attitudes, especially the conflict between natural gas and coal General Accounting Office, Oil and Gas Development: Increased Permitting Activity Has lessened BLM s Ability to Meet Its Environmental Protection Responsibilities, GAO , June Isser, op. cit. pg 411. Draft not for citation without author s permission 7

8 3. Federal system and constitutional provisions The original US federation was a union of thirteen independent and sovereign states that carefully guarded both their independence and sovereignty 18. The tenth amendment to the constitution reiterates principles laid out in the articles of confederation: The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people. Over time the role and power of the federal government has increased relative that of the states. There are several provisions in the US constitution that federal administrations have used to justify federal action in the oil and gas sphere. The Commerce Clause authorizes the federal government to regulate interstate commerce and the courts have interpreted this as implicitly forbidding states from actions that discriminate against out-of-state producers or work against unfettered national markets. This implicit prohibition is commonly referred to as the dormant Commerce Clause. Since 1937 courts have interpreted this power broadly. It is under this clause that federal regulation of the oil and gas industry is typically justified. Also, under the Constitution laws passed by Congress are the supreme laws of the land and may override state law under the Supremacy Clause. Dual federal and state regulation is permitted if state regulation or laws do not frustrate congressional purposes, regulate conduct in a field Congress intended federal law to occupy exclusively, or conflict directly with federal law 19. Even when there is no federal statue courts may strike down state statues under the dormant Commerce Clause. The Spending Clause gives Congress the power to raise revenue to promote the general welfare of the nation. This gives the federal government the power to influence state policies by imposing conditions on the receipt of federal funds. For example Congress enacted a law that would withhold a percentage of federal highway funds from states whose minimum age for the purchase of alcohol was less than Onshore (a) Ownership and Jurisdiction The federal government currently owns 650 millions of acres of surface land, about 30 percent of total U.S. area. 20 Most of this land was obtained by the United States in territories West of the Mississippi that did not yet have the status of states. About Kenneth R. Thomas presents an overview of the US constitution with special reference to oil and gas, Federalism, State Sovereignty, and the Constitution: Bases and Limits of Congressional Power, Congressional Research Service, February 1, Fred Bosselman, Jim Rossi and Jacqueline Lang Weaver, Economics, Energy and the Environment (New York: Foundation Press, 2000), pg U.S. General Accounting Office, Land Ownership: Information on the Acreage, Management, and Use of Federal and Other Lands, GAO/RCED-96-40, March 1996, p. 2. Draft not for citation without author s permission 8

9 million acres of original federal public domain lands were distributed over the years to states for various purposes and states continue to own and lease a portion of these lands. The federal government has exclusive jurisdiction over lands acquired by purchase and over those public lands in Alaska in which it has reserved exclusive jurisdiction. For these lands the federal government must give consent before state or local authority can be exercised. More generally, while states may claim to have authority over these lands, federal lands are not subject to state control in the same way and to the same extent as state and private lands. (b) Exploration and production regime 21 Regulation and taxation of oil and gas on federal lands and the division of revenues between state and federal governments is rooted in laws originally designed for the mining of hard rock resources such as gold and silver. The original General Mining Act of 1872 provided that individuals and corporations are free to enter and prospect on public lands and, upon making a discovery, file a claim, subject to an annual fee. Where there is a recoverable mineral deposit, the claimant may apply to purchase, for a nominal amount, a patented title to surface and mineral rights. Most claims, some 98.5 percent, were mined without patenting 22. The claim system did not limit the number of claims a person could obtain, require that mineral production commence or take place with a patent, require the payment of royalties to the government, or place a time limit on how long claims can be held. Initially, oil was placed under this claim and patent system though the needs of the industry were quite different from hard rock minerals. In 1920, oil was placed under the Mineral Leasing Act with its two-stage disposal process for unknown geological structures where non-competitive bids were allocated first to explore and then, upon discovery, to lease and a competitive auction system for known geological structures. Leases on unknown structures had a 5 percent royalty on 25 percent of the permit area, with the remainder at a standard royalty of 12.5 percent. The 12.5 percent rate applied to all leases on known structures. In 1935, the two-stage process for unknown structures was eliminated and a flat 12.5 percent royalty was instituted, while the royalty on some known structures was raised to 25 percent. The Federal Oil and Gas Reform Act, passed in 1987 established competitive bidding for all onshore federal leasing establishing a common system of all federal properties, onshore and offshore. For onshore lands if no bids are received at a competitive bidding auction the land will be put up for non-competitive bidding within thirty days. 21 This section is based on EIA, Office of Oil and Gas Publications, Overview of US Legislation and Regulations Affecting Natural Gas and Oil Activities, December 2005; Aaron M. Flynn and Ryan J. Watson, Leasing and Permitting for Oil and Gas Development on Federal Public Domain Lands, CRS, January 26, Marc Humphries, Mining on Federal Lands Hardrock Minerals, Congressional Research Service, April 30, Draft not for citation without author s permission 9

10 The federal leases promulgated under the Mineral Leasing Act include various directions and regulations on how the properties are to be developed and specify environmental safeguards. However, most Western States, while agreeing that Congress has the right to regulate oil and gas activities, assume that states have concurrent jurisdiction. The federal government can preempt state legislation and state regulation may be deemed invalid by federal acts. But Congressional action may vary on a case-by-case basis and if state or local regulations are different, the Federal Government may accept or ratify conflicting regulations. One feature of the Federal Land and Management Act is the requirement, that federal actions should be consistent with state plans. Nelson has argued that state and local governments have slowly gained de facto property rights in federal land. 23 These rights developed incrementally over time and existed in fact before a landmarks statue rationalized them. Historically the federal government has cooperated with states and has accepted state actions pertaining to the spacing of wells and the rate of development and production. Sections of the Mineral Leasing Act state that various provisions of the Act should be consistent with the laws of the state in which the lease is located. Another section affirms various rights of states and local governments including the right to impose taxes. But Congress has sometimes pre-empted state powers by, for example, requiring federal approval for all pooling and communization agreements on federal lands. Unitization on Federal lands remains voluntary but there are incentives for leaseholders to join units. First, Federal law requires that unitization agreements occur before prospecting and development when leaseholders do not possess knowledge about the resources that lie within their specific lease. In states where unitization agreements occur after development conflicts over relative lease values have been a serious hindrance to unit formation. Second, leases that are unitized are extended from the usual 20 years to the life of the unit and are exempted from acreage limitations. Finally a majority of leaseholders is sufficient to require that all leases within the area be a part of the unit. Revenues and costs are divided according to acreage. 24 Liebcap and Wiggins show that production on field-wide units as a share of total state output in 1975 is 83 percent, 38 percent and 20 percent for Wyoming, Oklahoma, and Texas, respectively. They attribute the higher rate of unitization on federal lands in Wyoming to contracting during the exploration phase rather than the development stage. 3.2 Offshore (a) Ownership and jurisdiction Robert H. Nelson, Public Lands and Private Rights: The Failure of Scientific Management (Lanham, Maryland: Rowman and Littlefield, 1995). pp See Libecap, Gary D. and Steven N. Wiggins, The Influence of Private Contractual Failure on Regulation: The Case of Field Unitization, Journal of Political Economy, 1985, vol 95, no 4. pp This section is based on Adam Van, Offshore Oil and Gas Development Legal Framework, CRS, January 30, 2008; United States Department of the Interior, Mineral Management Service, Leasing Oil and Natural Gas Resources Outer Continental Shelf, undated. Draft not for citation without author s permission 10

11 The modern era of offshore development began with the passage of two Congressional Acts in the Submerged Lands Act and the Outer Continental Shelf Leasing Act (OCSLA). The former granted coastal states jurisdiction over the first three miles of submerged lands, though state jurisdiction off Texas and Florida s west coast extended to three marine leagues (about ten miles) as these states had jurisdiction over a large area before joining the union. The OCSLA provides a framework for management of the development of oil and gas on offshore lands beyond the areas managed by the states. In 1982 Congress prohibited new leases offshore California after a major oil well blow out near Santa Barbara in 1969 had galvanized opposition to offshore development. Similar moratoria were expanded to all offshore areas except for most of the Gulf of Mexico and certain coastal areas of Alaska. Such moratoria were renewed annually until 2007, but have recently been allowed to lapse; the Obama Administration has not announced its intentions on possible expanded offshore leasing. (b) Exploration and production regime Before 1978, Mineral Management Service (MMS) had considerable flexibility in organizing lease sales and the choice of tracts to be leased. Before offering tracts MMS would call for nominations. Potential bidders would nominate tracts they wished to bid on and the government would choose tracts from these requests and would also make nominations of their own. In 1978, the OCSLA was amended to require the Secretary of the Interior to formulate and implement a five-year leasing plan for the OCS. In developing these plans the Secretary must consult the Governors of the affected states. Moreover, federal actions and federal projects in federal waters must be submitted to the state to ensure consistency with its Coastal Zone Management Program. The leasing and operations on the outer continental shelf are also subject to about 300 other federal laws including the National Environmental Policy Act which requires Environmental Impact Statements, the Endangered Species Act and the Federal Water Pollution Control Act which controls in-water discharge of pollutants. 4. Petroleum revenues arrangements in the context of federal fiscal regime A key policy question facing governments is how they should structure their leasing and taxation systems so as to appropriate the economic rents generated from the exploitation of minerals on the public domain. No less important is the division of these rents between federal and state governments. This division is different for onshore and offshore lands reflecting the evolution of land ownership and rules governing the disposition of resource revenues from federal lands. Federal onshore taxation Currently, fifty percent of the mineral revenues collected on federal onshore lands are distributed to the states of origin. Another forty percent of the proceeds are paid into a Draft not for citation without author s permission 11

12 reclamation fund, from which Congress appropriates monies to finance water and power projects in 17 western states. Historically appropriations were roughly equal to revenues but in recent years, appropriations have been only about half of revenues. However, in addition to the reclamation fund general Treasury revenues have been used to finance some projects undertaken by the Bureau of Reclamation. Sally Fairfax draws on political history to explain the evolution of revenue sharing 26. Over time states in which the federal domain lands are located have come to share the royalties collected on the fossil fuels extracted from them. She characterizes the federal legislation pertaining to public lands as the outcome of bargaining and compromise between different groups of states, with changing realignments at different periods of time. In 1780, the Confederation of States passed an ordinance stating that the public domain lands in the west claimed by large states such as Virginia, North Carolina and Georgia would be for the common benefit of all states and would be granted and settled under regulations of Congress. Furthermore, newly formed states would be admitted to the union on an equal footing with the older states. The large states ceded their claims to Western Lands to the national government and in return were guaranteed sovereignty of the lands defined in their charter, which had been under dispute. Fairfax portrays this cession of lands as a bargain between large and small states. The creation of new states led to conflicts between old and new states. Congress, to promote the economic development of new states, granted them part of the public domain to support various public improvements such as roads and schools. Old states claimed these grants violated the common pool principle while supporters of new states argued that land grants enabled investment and would increase the value of the remaining public lands for the common good. New states waived their rights to other public domain lands and agreed not to tax newly patented federal lands for five years but argued that these restrictions violated the equal footing doctrine. As these states grew more numerous they demanded increasing amounts of public domain lands and were granted 5 percent of the revenue from the sale of public domain lands. The distribution of receipts from the sale of public domain lands was a compromise between the common pool principle and equal footing. The distribution bills in 1841 distributed land revenues according to Congressional representation, which favored the old states. But the same act give a 10 percent share of land sales to new states and retroactively gave additional public lands to previous new states. After the Civil War, Eastern and Midwest states both now quite similar in population and urbanization emerged as a block distinct from the Western public land states with substantial federal lands. The conservation movement, reacting against the excesses and corruption of rapid privatization, campaigned for increasing land withdrawals for National 26 This section draws very heavily on the enlightening paper by Sally Fairfax. Sally K. Fairfax, Interstate Bargaining and Revenue Sharing and Payments in Lieu of Taxes: Federalism as if States Mattered, in Federal Lands Policy, ed. Phillip O. Foss, (New York: Greenwood Press, 1987). Draft not for citation without author s permission 12

13 Forests, National Parks and other purposes. The public land states objected and argued on the basis of the equal footing principle that the federal government was obliged to dispose of these lands. As it became increasingly clear over time that the federal government would continue to control a large portion of Western lands, the Eastern states began promoting revenue sharing to compensate the West for its acquiescence. Revenue sharing was made permanent in 1908 when 25 percent of net proceeds from timber sales and grazing in the National Forests were to be spent as prescribed by states for road and school purposes in counties where national forests are located. The Mineral Leasing Act of 1920, which expanded revenue sharing, authorized the Department to lease various minerals, including oil, gas and coal, on federal lands. The public land states demanded 90 percent of the royalties collected in exchange for continued federal control. The legislation gave the state of origin 37.5 percent directly, while 52.5 percent was allocated to the reclamation fund discussed above. In 1976, an Act in Lieu of Taxes provided for a fixed federal payment per acre for access to entitlement lands, including national parks. At the same time, the National Forest Management Act, the Federal Land Policy and Management Act and the Federal Coal Lease Amendment Act were passed and they all augmented federal authority, limited state options, and increased revenue sharing. The share of counties in forestland revenue increased from 25 percent of net revenues to 25 percent of gross revenues, while states share of mineral royalties rose from 37.5 percent to 50 percent. It is clear that these increases in revenue sharing, which accompanied the codification of federal power, were not motivated by consideration of fiscal capacity equalization but were compensation for the continuation of federal authority, as well as in mitigation of environmental and social costs of resource extraction. Federal offshore taxation Under the provisions of the OCSLA Act of 1953 tracts must be leased under competitive bidding using sealed bid auctions. 27 The bidding parameters are typically a cash bonus bid with a fixed royalty rate of 1/6. The primary lease term has been for five years but ten years is common for leases in deepwater or frontier areas. Restrictions have been imposed on joint bids by large firms. The Mineral Management Service is free to reject winning bids, which it deems to be too low or from unqualified firms. In contrast, to the generous revenue sharing of onshore mineral income with the states the coastal states received relatively little from offshore mineral revenue 28. About $500 to $900 million year of offshore income has been deposited into a land and water conservation fund that is administered by the National Park Service. These monies are then appropriated to the federal, state and local governments to purchase park and recreation 27 For an excellent discussion of leasing on the OCS see Walter J. Mead, Asbjorn Moseidjord, Dennis D. Muraoka, Philip E. Sorensen, Offshore Lands (San Francisco: Pacific Institute for Policy Research, 1985), Chapter See Marc Humphries, Outer Continental Shelf: Debate Over Oil and Gas Leasing and Revenue Sharing, CRS, April 7, 2006, updated January 2, Draft not for citation without author s permission 13

14 areas and to plan and develop land and water resources for recreational use. In FY 2003 only $95 million was paid out in grants to state and local governments and as all fifty states receive these funds only a small portion of the payments are received by coastal states, which are potentially impacted by federal offshore development of minerals. Another $150 million a year of offshore revenues are paid into the National Historical Fund, which is used to expand historical preservation activities. The benefits to coastal states from the Historical Funds are also quite modest. The only direct payments to states from offshore revenues stems from section 8(9) of the OCSLA in which states receive a fair share of revenues from the leasing of lands within 3 miles of the seaward boundary of a coastal state containing one or more oil and gas pools underlying both the OCS and lands under state jurisdiction. In FY 2006 coastal states receive a modest sum of $83 million under this provision. In 2006 Congress passed the Gulf of Mexico Energy Security Act, which authorized new leases in the Gulf. This law allocates 37.5 percent of all federal revenue from new leases authorized by this Act to the four affected coastal states. The distribution of the funds will depend on the actual location of the tracts. This legislation, which increases the amount of revenue sharing with the states, undoubtedly foreshadows future revenue arrangements for areas in the OCS which are currently under leasing moratoria. Legislation has been introduced to give individual states the option of allowing their coastal waters to be developed. Another indication that the federal government will be more generous with revenue sharing in the future is the passage of a new Coastal Impact Assistance Program established in the Energy Policy Act of Under this program $250 million a year will be dispersed to producing states. The funds are designed for the restoration of coastal areas and the mitigation of damage to natural resources. Federal tax preferences The U.S. has seen numerous provisions in the corporate and personal income tax, which lower the effective taxes paid by the producers of oil and gas. These tax expenditures are referred to as supply side preferences designed to increase the supply of energy and they characterized the period 1918-l The two main tax preferences granted industry during this period were the immediate deduction of intangible drilling costs (labor and materials) and dry hole costs and the percentage depletion allowance. Federal income taxes are based on the principle that the government should tax the net income of the investment after allowing for the economic depreciation of a productive asset. For a successful well the cost is capitalization, which is depreciated over its productive life. By allowing expensing and not counting dry holes as part of the cost of finding successful wells, the accelerated depreciation lowers the cost of the investment relative to a neutral tax system based on estimates of true economic depreciation. Percentage depletion might give an investor tax benefits over 50 percent greater relative to cost depletion on a typical 29 For a discussion of the policies see Salvatore Lazzari, Energy Tax Policy: History and Current Issues, Congressional Research Service, July 28, Updated June 10, Draft not for citation without author s permission 14

15 well. Depletion allowances were especially generous and wasteful from 1926 to 1975 when the rate was 27.5 percent and states were restricting output by pro-rationing. During the energy crisis period of the 1970s the percentage depletion allowance was eliminated for integrated producers and reduced for independents from 27.5 percent to 15 percent, and limited to 1000 barrels per day of total production by the taxpayer. As well, expensing of intangible drilling costs was reduced slightly for integrated producers limiting them to a 70 percent immediate write-off and 5-year amortization for the remainder. Metcalf estimates that total tax preferences given to the oil and gas industry in 2009 were $2,740 million of which $1,100 million is for alternative fuels (unconventional oil and gas), $790 million in net cost of percentage depletion, and $840 million for expensing exploration and development costs 30. The only tax preference of comparable magnitude is the new technology credit for solar and wind equal to $900 million. Lazzari s estimates are similar, except for his much higher costing of the unconventional oil and gas credit at $4,500 million in Lazzari also reports that the revenue cost of the ethanol tax credit is $60 million. 31 State and Local Taxes on Oil and Gas There is no form of general revenue sharing in the United States. The federal intergovernmental grant system is primarily intended to provide a degree of equalization across people not to equalize sub-national government service delivery with most of the money intended to support low-income people. 32 These grants are substantial totaling $428 billion in fiscal year The formulas which allocate these funds typically depend on poverty rates and average per capita in the state and are not related to the mineral revenues they collect. State governments collect royalties on state lands and impose severance taxes and state corporate taxes on oil and gas production on private land. Some states impose a corporate franchise tax. The rate of severance tax, a gross receipts tax, varies considerably across states. Jurisdictions in which employment in oil and gas is relatively large and where there are a significant number of private royalty recipients impose relatively low rates of tax. Severance taxes are popular because they are easy to calculate and to administer and because for some minerals some portion of the tax burden may be exported to out-of-state purchasers. States income taxes are patterned after the federal corporate income tax. The income or franchise taxes capture a portion of net profits and take away some of the increases in revenues which maybe associated with rising energy prices. As most corporations engage 30 Gilbert E. Metcalf, Using Tax Expenditures To Achieve Energy Policy Goals, National Bureau of Economic Research, Working Paper 13753, January Lazzari Salvatore Lazzari, op. cit., 2006, 2008 (Table 2). 32 William Fox, United States of America, in the The Practice of Fiscal Federalism: Comparative Perspectives, ed. Anwar Shah, (Montreal and Kingston: McGill-Queen s University Press, 2007), pg 361 Draft not for citation without author s permission 15

16 in interstate commerce most states apportion their share of a firm s overall profits according to a three-factor formula giving equal weight to the share of profits, wages and property in a state. Alaska, a major oil producing state, in contrast, has imposed a separate corporate tax based on separate accounting for earnings on Alaska oil production. Also, in some states local governments impose property taxes on mineral reserves and plant and equipment used the oil and gas industry. As it is difficult to appraise the value of reserves in the ground the actual tax treatment of mineral properties vary considerably across states. We distinguish between three types of state practice: states where there is no tax on reserves or land, (Alaska, Louisiana, Oklahoma), states where the gross value of current output is used to determine the assessment of mineral property, (Wyoming, New Mexico) and a state where mineral reserves are assessed in terms of market value (Texas). Analysis of the Finances of Individual States In Table 1 we summarize the annual revenues for six major oil and gas producing states. Table 1 Natural Resource Revenues for Six States (FY 2008 millions of dollars) Alaska 1 Wyoming 2 New Mexico 3 Texas 4 Louisiana 5 Oklahoma 6 Taxes Royalties Share in Federal Royalties 7 Total Revenue Per Capita Revenue Population 2008 (Thousands) $14,873 $3831 $961 $284 $487 $ Sources: 1. State of Alaska, Department of Revenue, Annual Report Taxes come from Wyoming Department of Revenue, Annual Report, 2008 and royalties come from Office of State Land and Investment, Annual Report, Jim Nunns, Tax Policy Director, Overview of Major New Mexico Taxes Memorandum dated February 17, 2009 and Revenue from Oil and Natural Gas Memorandum December 15, Taxes and royalties are from Texas Annual Cash Report, FY 2008, Comptroller of Public Accounts. Property taxes collected on minerals were supplied by Bill Lindsey of the Texas Comptroller of Public Accounts. 5. Department of Natural Resources, Technology Assessment Division, Louisiana Energy Facts. 6. Taxes come from Oklahoma Tax Commission, Annual Report, 2008 and royalties come from Commissioners of Land Office, Annual Report, US Department of the Interior news release Interior s Mineral Management Service Disburses Record $23.4 billion in FY 2008, November 20, Alaska was and continues to be in a class of its own with respect to both total and per capita resource revenue collected. Virtually all of this income comes from a highly progressive production tax on petroleum tied to the price of oil. The state allocated some of its revenues to the Alaska Permanent Fund which currently has an endowment of $23 billion. In 2008 every resident of the state received a dividend of $3,269 from this fund. Draft not for citation without author s permission 16