Issue Brief. Don C. Richards, Senior Research Analyst. 05 IB 001 Date: January 5, Author: Updated Estimated Fiscal Impact of 2003 HB 87 Veto

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1 05 IB 001 Date: January 5, 2005 Issue Brief Author: Re: Don C. Richards, Senior Research Analyst Updated Estimated Fiscal Impact of 2003 HB 87 Veto PURPOSE Given known natural gas pricing history, identify the range of estimated fiscal impacts resulting from the veto of 2003 HB 87. Explain relevant issues related to the estimates. Summarize any pertinent developments that may influence the analysis of the estimated fiscal impact of 2003 HB 87 and 2005 HB 49, if adopted. RESULTS IN BRIEF The initial LSO estimate of the fiscal impact resulting from the veto of 2003 HB 87, prepared in November 2003 (LSO Issue Brief 03IB011), suggested the impact to the state ranged from a loss of $11.2 to a gain of $1.4 in payments, depending upon the outcome of several issues currently in litigation. Since the natural gas valuation methodology incorporated in HB 87 impacts the payment of es and ad valorem taxes, the total impact to the state and its political subdivisions could be roughly doubled. As of December 31, 2004, two full calendar years have passed under which time HB 87 could have been operational. This fact roughly doubles the magnitude of the estimated fiscal impact to the state operating in the absence of 2003 HB 87. Since the November 2003 LSO report, there is additional actual natural gas pricing information available. For purposes of this memo, the estimates made for the November 2003 publication have been updated to reflect current known natural gas pricing information. Based upon this new data, the impact of the veto in calendar year (CY) 2003 ranged from a loss of $11.6 to a gain of $1.3. Likewise, the CY 2004 impact is now estimated to range between a loss of $15.9 to a gain of $200,000. The higher estimates are a direct result of the higher average natural gas price present in The reason for the range of estimates is due to a number of unresolved issues of interpretation pending before the courts. For the November 2003 report, LSO was directed to evaluate the fiscal impact statement prepared by the Department of (DOR) and update it with new natural gas pricing information, while holding the estimating methodology as well as all other variables, e.g., natural gas production, capital investment, deductions, etc. constant. Furthermore, the 2003 fiscal note was based upon data that was, at the time, a couple of years old. In 2004, the Joint Interim Committee voted to sponsor a subsequent version of 2003 HB 87, with minor modifications related to effective dates. As a result, DOR prepared a new fiscal impact statement for this "subsequent" version of 2003 HB 87, 2005 HB 49. In reviewing DOR's analysis of HB 49, LSO Research staff identified additional considerations, which arguably modify the fiscal impact estimate had HB 87 been implemented in In order to provide a comprehensive picture of these issues, this memo explores those considerations, i.e., changes to settlement agreements, changes to plant production, changes to capital investment, etc., and makes attempts to incorporate these known developments, to the extent possible, in updated estimates.

2 PAGE 2 OF 5 BACKGROUND In October 2003, Management Council initially assigned the evaluation of the fiscal impact of the HB 87 veto to LSO Research staff. LSO Research staff prepared a report in November 2003, using the average year-to-date Opal gas price of $4.27/mcf for In the November 2003 LSO Issue Brief (03IB011), LSO Research staff estimated that the anticipated fiscal impact resulting from the failure of HB 87 ranged between an estimated loss of $11.2 in es to an estimated gain of $1.4 in es. This estimated impact was based upon updated pricing information and the same methodology and assumptions applied by DOR in the official fiscal note applied to 2003 HB 87. LSO Research staff released the estimations in terms of a range since there may be some question as to what taxing methodology the netback method proposed in HB 87 should be compared against. This difficulty arises since there is dispute between DOR and private industry as to how the value of producer-processed natural gas should be measured under current statute on at least two fronts. First, there is the question of the use of the comparable value method as opposed to the proportionate profits method in certain instances. Second, there is a question of whether taxes and royalties should, or should not, be included in the ratio of direct costs using the proportionate profits method of natural gas valuation. Both issues are currently before the Supreme Court, although at different stages in the process. CURRENT STATUS The outcome of these two disputes dramatically influences the potential fiscal impact of 2003 HB 87, had it passed, or any similar legislation to be considered in the future. The State Board of Equalization (SBOE) has already ruled in favor of DOR on these issues. Therefore, if the Supreme Court overturns the direct costs and the Supreme Court overturns the SBOE decision on comparable value, the failure of HB 87 essentially reduced the es due to the state by $11.2 ly. Alternatively, if the Supreme Court affirms on comparable value, the failure of HB 87 may have "saved" the state $1.4 in es, all else being equal. Since the November 2003 report, the Supreme Court has disposed of one of these cases, related to the computation of direct costs. However, given the manner in which the Court resolved the case, the outcome did not address the issue of direct cost calculations. Nonetheless, three similar cases are currently before the Court, all of which speak directly to the issue of the calculations in the direct cost ratio. (See the 2003 LSO Issue Brief 03IB011 for a full explanation of the various valuation methodologies, a discussion of the assumptions applied in the fiscal estimates, and other related issues regarding natural gas valuation. For example, some individuals have suggested that HB 87 was unclear as to its treatment of coal bed methane production. The fiscal note and this analysis do not assume the inclusion of coal bed methane.) SUMMARY OF ESTIMATES Applying the same methodology used by LSO in the November 2003 Issue Brief, the estimated range of lost (or gained) revenue as a result of the veto of HB 87 has essentially shifted up due to higher than predicted natural gas prices. Specifically, according to Bloomberg pricing information retrieved on January 3, 2005, the average daily price of natural gas at the Opal hub from January 1, 2003 (the effective date of 2003 HB 87) and December 31, 2004 was $4.36/mcf for CY 2003 and $5.25/mcf for CY This compares to an average daily price of $4.27/mcf used in the November 2003 estimates. As a result, the range of potential fiscal impact has shifted up from the previous estimates, as described in Table 1. In addition, two considerations have been raised as a result of the DOR fiscal impact response to 2005 HB 49. First, there have been at least three major developments with respect to settlement agreements between taxpayers and the state. All of these further complicate the analysis of what would have happened had HB 87 been in effect. Two gas plants, Brady and Painter, are now paying es under a settlement agreement with DOR. As a result, it is no longer appropriate to compare various scenarios of what those taxpayers would pay under HB 87 compared

3 PAGE 3 OF 5 to what they actually pay or, alternatively, to what DOR thinks taxpayers should remit. A third plant, Shute Creek/LaBarge, was paying taxes under a settlement agreement in 2003; therefore, it was not included in the fiscal analysis for HB 87. However, DOR has declared that agreement null and void, which has resulted in yet another difference of opinion as to what methodology should be used to establish the value of gas produced at Shute Creek/LaBarge. Second, the two gas fields served by the Whitney Canyon plant and the Carter Creek plant are mature. While overall natural gas production is rising in the state, the production level served by these two plants, both of which contribute significantly to the fiscal analysis of any valuation changes, is actually declining. Holding all variables except for price constant ignores these developments. Therefore, DOR (in preparation of the fiscal note for 2005 HB 49) and LSO Research staff (in this memo) attempt to make some allowance for the new settlement agreements and the decline in production. Table 1 includes three major columns, indicating different analyses: (I) Restatement of estimates prepared in November 2003 by LSO; (II) Updated estimates for known natural gas price levels through CY 2004 and holding all other variables and methodologies constant; and (III) Estimates that attempt to update other variables, where known, for each plant's production, including settlement agreement changes, changes in natural gas production volume, changes in deduction levels, and changes in capital investment.

4 PAGE 4 OF 5 Table 1. Estimated Annual Fiscal Impact on Severance Taxes for 2003 HB 87. If HB 87 had Passed AND 1) The Supreme Court overturns the state courts overturn on comparable value 2) The Supreme Court overturns the state courts affirm on comparable value 1 3) The Supreme Court affirms the state courts overturn on comparable value 4) The Supreme Court affirms the state courts affirm on comparable value 1 (I) severance tax impact (Nov $11.2 $1.4 $300,000 $1.4 (II) Applying Same Methodology Used in the Fiscal Note for 2003 HB 87, updated for price only impact (CY 2003 updated $11.6 $1.3 $400,000 $1.3 impact (CY 2004 updated $15.9 $200,000 $1.8 $200,000 (III) Using Actual and Estimated Volume, Price, Investment, and Settlement Agreements for Each Affected Gas Plant, Individually impact (CY 2003 updated $11.8 impact (CY 2004 updated $9.4 Not reported separately due to the following factors: A) Two of the plants are now paying taxes under settlement agreements. Therefore, these questions are moot. B) One of the larger disputes involves not just the selection of valuation methodology but also the existence of a prior settlement agreement. C) Reporting any remaining values could result in direct identification of certain disputed amounts for a discernable taxpayer. As a result, what can be said is that if the DOR positions are upheld in all disputes, movement to netback would have resulted in a net loss of approximately $4.7 in 2003 and $3.4 in A major reason for the from prior year projections is this total includes a dispute over a prior settlement agreement not incorporated in previous analysis. Source: LSO, applying all estimates contained in 03IB011. See 03IB011 for a full list of assumptions. Note: (1) Given the methodology used and the data supplied at the time, it is not possible for LSO to include the combination of these two decisions completely for each plant's production. Therefore, the largest impact (that resulting from disallowing comparable value) is assumed in these instances. All of the estimates are provided in terms of an estimate. As a result, the high end estimate for the es lost or gained as a result of the HB 87 veto over the period from January 1, 2003 through December 31, 2004 exceed $25, depending upon the methodology applied. Alternatively, in the event all disputes (including some not currently pending before the courts) are resolved in favor of DOR, the lack of implementation of 2003 HB 87 may have saved the state as much as $8 in es over the past two years. Much of that disputed is a result of disagreement over one settlement agreement in effect at the time of the veto of HB 87, and it is arguably inappropriate to include that disagreement within the confines of this analysis. An alternative approach, excluding disputes over settlement agreements, but still assuming all judicial decisions in favor of DOR, shows the lack

5 PAGE 5 OF 5 of HB 87 being implemented may have saved the state approximately $2.2. ADDITIONAL CONSIDERATIONS Adding the Impact of Ad Valorem Taxes. W.S (d) largely limits fiscal note estimates for draft legislation to impacts incurred at the state level. In an effort to be consistent with the original fiscal note, only es are considered in the above estimates. Ad valorem taxes are not contemplated. Since the average, non-municipal mill levy statewide is roughly 64 mills (very close to the 6 percent in severance taxes), one could roughly double all of the above impacts to arrive at the total fiscal impact to the state, its non-municipal political subdivisions, and the School Foundation Program. Judicial Developments. Since the November 2003 release of the LSO Issue Brief on the fiscal impacts of HB 87, two important judicial developments have occurred; however, neither provides much additional information for estimating purposes. First, the Supreme Court ruled on Amoco Production Company v. Department of, State of Wyoming and Board of County Commissioners of Uinta County, 2004 WY 89 on July 23, The Supreme Court concluded, "Uinta County should not have been allowed to intervene in the contested case." The Court further concluded, "The result of this is to reinstate the initial determination of the Department that production taxes and royalties should not be included as a direct cost of production in the proportionate profits equation." That said, the Attorney General's staff indicates that due to the issue of Uinta County improperly intervening, the Court ultimately did not address the issue of direct and indirect costs of production in determining the value of natural gas using the proportionate profits calculation. Beyond this case, there are three subsequent State Board of Equalization (SBOE) decisions that have been certified to the Supreme Court that address the issue of direct costs of production. 1 The three cases have been joined, and consolidated for oral arguments, and the plaintiffs filed their opening briefs in mid December. The State's briefs are due March 17 in these cases, since the state recently received an extension from late January. Since oral arguments have not been made, or even scheduled, decisions on these cases are not expected any time in the next several months. Second, the Supreme Court, on June 15, 2004, received oral argument in a case that could address the use of comparable value as an appropriate valuation methodology (BP America Production, et al v. State of Wyoming and Board of County Commissioners for Uinta County, Wyoming, docket number ). This case deals with three taxpayers and the use of the comparable value method in determining the value of natural gas in 2000 in the Whitney Canyon field. According to the Attorney General's Office, and based solely upon prior experience with the Court, a decision in this case is not anticipated prior to this spring. CONCLUSION The cumulative impact of 2003 HB 87 is mired in multiple lawsuits and even other disputes that have not yet developed into formal lawsuits. In light of this environment, it is not possible to provide a clear, direct answer to what the likely fiscal impacts have been in the absence of 2003 HB 87. Succinctly, accurate estimation depends upon what baseline for comparison is used. On one hand, it can be estimated that the state and its political subdivisions have forgone a total of $40 to $50 in severance and ad valorem taxes as a direct result of the veto of HB 87 over the past two calendar years. Alternatively, in the event DOR is successful in all its formal disputes, other than the disagreements over the Shute Creek/LaBarge settlement agreement, the state and its political subdivisions may have gained on the order of $2 to $8 as a result of the veto of 2003 HB Louisiana Land and Exploration v. Wyoming Department of and Fremont County Commissioners (Docket # ); RME Petroleum v. Wyoming Department of (Docket # ); and Chevron USA v. Wyoming Department of (Docket # ).