Brad Keithley’s chart of the week: Dealing with OPEC

From the perspective of most Alaskans, the actions of the Organization of the Petroleum Exporting Countries (OPEC) affect the Alaska economy in two major ways.

The first is the impact on the overall level of the state’s revenues, up or down, resulting from the link between oil price and state government revenues. The second – and what some sometimes focus on first instead – is the impact on the price of fuel in the global and state economies and their resulting impact on the cost of living in Alaska.

In our experience, however, there is a third, more subtle impact that has an equal – and perhaps, even greater – significance over time than the first two. That impact is on the volatility in oil price – and, thus, the significant, ongoing disruptions in the state’s revenue stream – that result from OPEC’s actions.

The state largely is unable to do anything about the first two impacts. Adapting a phrase from economics, Alaska is a “taker” of those impacts. We are at the far end of the tail of the proverbial dog.

As we explain below, however, the state is well positioned to reduce, if not eliminate, the impact of the third. By not addressing it, the state is, in fact, allowing what in this instance is the OPEC tail to wag the Alaska dog.

As most reading these pages recognize, oil prices go up and oil prices go down, but the percent at which they change from year to year is somewhat breathtaking.

From Fiscal Year (FY) 2000 – 2022, Alaska North Slope (ANS) oil prices have increased overall at a compound rate of roughly 6.3% per year. But that hardly has been in a straight, predictable line. In only six of those years has the rate of change, up or down, been in single digits. Instead, in some periods oil prices have gone up by as much as 70% year-over-year, and in others have gone down by nearly the same amount over a two, consecutive year period.

Because Alaska uses a projection of the next year’s oil revenues in budgeting, the resulting impact on the state’s fiscal plans have been equally as breathtaking. As it did last session, in periods of high oil prices, the state has rushed to increase spending, patting itself on the back if it manages to save any of the increase, and raising expectations among constituents of additional spending in the years beyond.

In periods of low oil prices, the state has panicked in filling the resulting deficits, grasping at a combination of rapidly draining savings accounts carefully built up over time, making cuts in previously established programs built up during periods of (and in the expectation of continued) high oil prices, and in recent times, regressively taxing middle and lower income Alaska families through cuts in the statutorily established Permanent Fund dividend (PFD) to raise additional revenues.

In our view, this volatility largely has been at the core of many of the state’s current fiscal challenges. We believe legislators and administrations would have budgeted much more responsibly had they been dealing over time with a relatively steady and predictable revenue stream.

Some argue that adopting the Percent of Market Value (POMV) approach for draws from the Permanent Fund, and using a portion of those to help fund government has instilled the sort of steady and predictable revenue stream required for responsible budgeting.

But it hasn’t really. As last year’s session demonstrated, oil revenues still play a significant role in Alaska budgeting. During years of high oil prices, the legislature and administration are unable to restrain themselves from spending more, much more. Those years are then followed by years of regret as oil prices fall and significant gaps between the expectations created during the good times and reality have to be addressed.

We believe that the state can move to address the problems caused by OPEC-induced oil price volatility simply by changing the state’s current method of budgeting traditional oil revenues, something entirely within the state’s own control. Rather than basing each year’s budget on a forecast of the coming year’s oil prices and production, we believe a longer and more backward looking, “cash in hand” perspective can help significantly reduce state revenue volatility.

Such an approach is not new to Alaska fiscal policy. Alaska has used the approach for decades – at least until the recent, “ad hoc” era – in calculating PFDs. Statutorily, PFDs are calculated based on the average of Permanent Fund earnings over the previous five years.

A similar approach has been used since 2018 for managing overall draws from the Permanent Fund. Again statutorily, overall POMV draws are based on the average value of the fund over a previous five year span.

Similarly, the same sort of “averaging” approach could easily be used to determine oil revenues available for budgeting in any given year.

Here is the actual level of traditional unrestricted general fund (UGF) revenues (oil revenues plus existing taxes and fees) used for budgeting from Fiscal Year 2000 to 2022, and then projected forward on the same basis through 2032, the forward time span covered by the most recent Spring Revenue Forecast.

Just like the underlying oil prices, the changes have been breathtaking. From FY 2000 – 2023, traditional (or “trad”) UGF revenues have grown at a compound rate of roughly 2.4% per year. (The lower rate of growth for traditional UGF revenues, compared to the rate of growth for oil prices over the same period, is largely due to declining production over the period.) But just like the underlying oil prices, that growth has hardly been in a straight, predictable line.

In only four of those years has the rate of change, up or down, been in single digits. On the other hand, in two of those years revenues have gone up by more than 100% (i.e., more than doubled) year-over-year, and in seven others revenues have plunged by more than 20% from the previous year. The high point (2008) is nearly 7 times higher than the low (2020).

Here is the result which would have occurred if, like the PFD and POMV amounts, traditional revenues available for appropriation had been calculated instead from 2006 forward on the basis of a five year rolling average (red):

Instead of more than doubling twice, the largest rate of change upward year-over-year would have been only slightly more than 50% and then, in only one year; revenues would have plunged by more than 20% year-over-year only three times instead of seven.

But even then the rate of variability would have remained significant. In six years, the rate of change still would have been larger than single digits and the high point (2014) still would have been more than 4 times higher than the low (2022).

To address the continued volatility, we have looked also at what the effect would have been of introducing “sideboards” into the calculation.

Here is the result which would have occurred if, like the PFD and POMV amounts, traditional revenues available for appropriation had been calculated from 2006 forward on the basis of a five year rolling average, but subject to the limitation that they could not increase or decrease in any given year by more than 15% from the previous year (dark red):

Because of the sideboards, the largest rate of change in any given year either upward or downward would have been only 15%, and the high point (2016) would only have been a little more than three times larger than the low (2007).

An even “smoother” (less volatile) curve results if a ten year rolling average is used instead:

Using that approach, the largest rate of change upward in any given year would have been only a bit over 30%, and downward changes would have exceeded 15% only twice. The high point (2016) would have been still more than three times the low (2006), but the average change year-to-year would have been much smaller than using the five year average, even with the sideboards.

For those interested, applying 15% sideboards to the ten year average would have generated very little impact, restraining the rate of change in only three years:

As anticipated, others have raised issues when we have discussed the approach with them.

Some have argued that, because the average (under any of the approaches) is below currently projected futures prices at least for the next three years (FY24 – 26), implementing the approach now would serve to deprive current Alaska families of the benefits of higher oil prices just as the prices are recovering from multi-year lows.

Others question whether the approach might result in higher future deficits, and still others suggest that, while the approach may have merit in theory, the legislature would never be able to pass implementing legislation.

We don’t view any of these as “show stoppers.” In our view, now – when the average is below currently projected futures prices – is the perfect time to implement the approach. Doing so will help build fiscal reserves, rather than continue to drain them. While in the past the state effectively has distributed oil revenues immediately as they have been realized, there is no requirement to do so and, as we discussed above, the state previously has adopted different policies with respect to calculating the PFD and POMV.

We understand that some want the immediate gratification of enjoying higher oil prices as they become available, but as with the Permanent Fund, Alaska’s oil and resulting revenues belong to all Alaska generations, not just the one that happens to be in place when higher oil prices occur. In our view, spreading the benefit over multiple years through averaging is much more consistent with Alaska’s obligations to both current and future generations than the current approach.

Whether the approach creates overall deficits is a function of where oil revenues go after the approach is implemented. If they follow a perfect sine curve, surpluses which build up during periods when revenues exceed the trailing average should completely offset deficits occurring when current revenues are lower than the trailing average.

To the extent traditional revenues increase over extended periods, surpluses resulting from using the averaging approach should help build a reserve against the potential for future periods of extended declines.

To the extent traditional revenues decline over extended periods, using an averaging methodology could result in higher future deficits than the current approach, but only if you assume future administrations and legislatures otherwise are prepared to reduce spending in those future periods simultaneously to match the decline in annual revenues. Given the history of the various administrations and legislatures over the past decade, we think that is highly unlikely. As a result, as a practical matter we believe that averaging should result in lower deficits even during those periods.

Finally, implementing an averaging approach doesn’t require the adoption of implementing legislation. There is no legislation currently that requires the use of next year’s projected oil revenues in developing a budget. Instead, doing so is simply a matter of practice. Either a governor or a legislature, or both working together, could implement the averaging approach simply by changing that practice.

Over time, OPEC creates some opportunities, as well as a lot of problems, for the Alaska economy. Unfortunately, Alaska is a “taker” of most of them. But as we explain above, there is at least one problem largely generated by OPEC that Alaska can do something about on its own. We should do so.

Brad Keithley is the Managing Director of Alaskans for Sustainable Budgets, a project focused on developing and advocating for economically robust and durable state fiscal policies. You can follow the work of the project on its website, at @AK4SB on Twitter, on its Facebook page or by subscribing to its weekly podcast on Substack.

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