This week, we publish Part 1 of our initial look at Governor Mike Dunleavy’s (R – Alaska) recently proposed FY 25 Budget and 10-year Plan. Part 1 focuses on proposed and projected revenues and, because of their impact on revenues, oil production levels. In a subsequent column, we will focus on proposed and projected spending and deficit levels.

In both Parts, we discuss how the Dunleavy administration addresses each component in its FY25 proposed budget and 10-year plan. To us, the 10-year plans are as important as, if not more important than, the more detailed budget for the coming year.

The purpose of the 10-year plan is to chart the rocks, shoals, and icebergs ahead on the state’s current fiscal course and to identify and suggest course corrections that minimize the difficulties of that journey. As in any navigation, making small course corrections now can avoid needing big ones later.

Oil Production Levels

While others have focused on various aspects of proposed spending, to us, the most significant development in Dunleavy’s budget package is the change in projected near-term Alaska North Slope (ANS) oil production levels. As we will explain, that is because the change in production levels is driving equally significant changes in revenue and, as we will explain in our next column, deficit levels.

Here are the revised Fiscal Year (FY) 2024 and forward projected ANS production levels contained in the most recent Fall 2023 Revenue Sources Book (RSB), compared to those projected over the same period in the two previous forecasts, the Fall 2022 RSB and Spring 2023 Revenue Forecast (RF).

As is clear from the chart, the most recent forecast (in dark blue) materially (5% on average) reduces production levels from the previous forecasts over the next three years – the remainder of FY24, FY25, and FY26 – before holding steady for the following two, and then materially (8% on average) increasing them over the remaining five years of the forecast period.

We will explore the reasons for both in greater depth in future weeks, but at first blush, it appears that the reason for the near-term drop is materially lower projected production volumes from the Prudhoe Bay field, and the reason for the later increase is materially higher production volumes from the National Petroleum Reserve-Alaska (NPRA) than included in the previous two.

Traditional Revenues

Many have noted the increase in oil price levels projected in the Fall 2023 RSB compared to the price deck included in the previous Spring 2023 RF.

The price increases are indeed significant in the early years of the forecast period before transitioning ultimately into small price reductions in the later years of the forecast.

But because of the production drops in the early years, the significant price increases don’t translate into equally significant increases in traditional revenues.

This chart shows the fiscal impact of the production drops in the early years. The two left columns for each fiscal year show the drop in forecasted production levels between the Spring 2023 RF (blue) and the Fall 2023 RSB (red). The two right columns for each fiscal year show the drop in projected revenues at the price level projected in the Fall 2023 RSB for the same period.

For example, had the production levels projected for FY24 stayed constant at those projected in the Spring 2023 RF, projected FY24 traditional revenues would have totaled $3.30 billion. However, because of the drop in production levels, in the Fall 2023 RSB projected FY24 traditional revenues only total $2.96 billion, a reduction of approximately 10% from where they would have been had production volumes stayed the same.

While similar drops in projected production levels have lower impacts on projected FY25 and FY26 revenue levels because of lower forecast price levels, they remain material. At the projected oil price levels for FY25 and FY26, projected traditional revenues are roughly 8% and 5% lower, respectively, than they would have been had production levels not dropped.

The impact on FY24 is especially significant. The FY24 budget is constructed in tranches, with revenues above a baseline level divided equally between a supplemental Permanent Fund Dividend (PFD) and additional contributions to the Constitutional Budget Reserve (CBR), subject to a cap. At the production levels projected in the Spring 2023 Revenue Forecast, the threshold for beginning the split started at around $73 and maxed out at around $83/barrel.

Because of the reduced revenue level resulting from lowered production volumes, however, in the new forecast, the split doesn’t start until approximately $78/barrel and builds slower, not paying out the full supplemental PFD until around $90/barrel.

In addition to lower production volumes, there may be other reasons for the lowered revenue levels. This chart expands on the one above by extending the period reviewed through FY33. While revenues rise in the latter years when production levels are materially increasing, the revenue levels don’t rise anywhere near proportionately to the volumes.

As we started digging into that, we noticed something curious. Despite the significant increase in projected production levels in the latter years between the Fall 2022 and the Fall 2023 RSBs, overall projected production tax revenues in the Fall 2023 RSB (in dark blue) continue to fall materially below those projected in the Fall 2022 RSB, contrary to the intuitive assumption that production tax revenues should increase as production volumes increase.

Part of the reason for the drop likely is the projection of significantly lower levels of so-called “non-Gross Value Reduction” (“old” oil) volumes throughout the period in the Fall 2023 RSB than the Fall 2022 RSB. “Non-GVR” volumes generate a significantly higher effective production tax rate than ”GVR” (“new” oil) volumes. As a result, material drops in “non-GVR” production will negatively impact production tax levels, even if offset volumetrically by “GVR” volumes. (For a definition of “GVR,” “non-GVR,” and other production tax acronyms, see Chapter 6, Table 3 of the Fall 2023 Revenue Sources Book.)

A strong indicator that “non-GVR” volumes are dropping below previous projections is that per-barrel production tax credits, which are the largest for non-GVR volumes at projected oil price levels, are also running consistently below previous estimates over the same period.

There also is likely a significant downward impact on production tax revenues between the two forecasts arising from the higher level of “allowable lease expenditures” projected in the latest update. Under the current tax code, “allowable lease expenditures” are deductible from taxable income. By reducing taxable income, any increase has the effect of reducing production tax levels.

The growth in “allowable lease expenditures” likely reflects increased projected investment levels between the two forecasts – a good thing for some purposes – but its adverse impact on state revenue levels could be significant.

As with projected production levels, we will continue to dig deeper into what’s happening with traditional revenues in the weeks ahead.

But for now, an important takeaway is that the substantial increase in production volumes in the latter years of the forecast period is projected to translate into nowhere near proportionate increases in traditional revenues.

Given how much emphasis Governor Dunleavy, others in his administration, and some legislators continue to put on increased volumes as the (often sole) solution to the state’s fiscal situation, this trend is a highly troubling factor.

Another significant disappointment about Dunleavy’s latest budget proposal is that he did not take the opportunity, as he could have, to propose using some form of averaging in calculating oil revenues for budgeting purposes in the future. As we have explained in previous columns, such an approach could do much to help inject stability into Alaska’s fiscal situation.

It is deeply disappointing that Governor Dunleavy – and his Revenue Commissioner Adam Crum – decided to continue to use temporary spikes in oil prices to help obscure the depth of the state’s fiscal problems rather than building a much more solid foundation for the future using averaged oil revenues.

Permanent Fund Earnings Available for Government

In addition to changes in traditional revenues, there are also some slight changes between the Spring 2023 RF and the Fall 2023 RSB in the amount of Permanent Fund earnings available for government.

As we explained in last week’s column, under current law, the amount of Permanent Fund earnings available for government is the difference between the level of the percent of market value (POMV) draw made from Permanent Fund earnings, less the amount of the statutory PFD.

Here is the calculation under each of the two revenue forecasts, using our analysis of projected PFD levels at the time of the Spring Revenue forecast and those most recently reflected in the Governor’s FY25 10-year plan.

While projected annual POMV draws over the period are down slightly in the Fall 2023 RSB from those in the Spring 2022 RF, projected “current law” PFD levels are down even more. The result is an increase in the amount of Permanent Fund earnings available for government under current law in the near term and on average overall.

Substitute Revenues

As we explained in a column earlier this month (“Preparing for next week’s ‘Budget Day’”) and will go into additional detail in Part 2 of our analysis, the governor’s proposed budget runs huge, unoffset deficits throughout the forecast period.

Given that, we had hoped that Governor Dunleavy would follow through in this budget proposal on his statement made earlier this year to propose “a broad-based solution [to balance the budget] that doesn’t gouge or take huge parts from one sector (of Alaska) or another, or penalize one sector for another ….”

But, as others have noted, this budget doesn’t follow through on that proposal, instead leaving huge fiscal gaps that, if left unaddressed currently, will quickly drain the state’s remaining savings and, if left unaddressed beyond that, will likely bankrupt the state.

At least at first blush, the failure to propose an approach for closing those gaps appears to violate AS 37.07.020(b), which requires that each 10-year fiscal plan that the governor submits “must balance sources and uses of funds held while providing for essential state services and protecting the economic stability of the state.”

But even if it doesn’t violate that statute, Dunleavy’s proposed budget and 10-year fiscal plan is horrible fiscal policy and an abdication of the governor’s responsibility, if not to lead, at least to participate responsibly in discussions about the state’s fiscal situation.

We will have much more to say on his failure to offer substitute revenues in future columns. But for now, we wanted to recognize as part of our initial review of revenues that there’s a huge hole in Dunleavy’s presentation where substitute sources of revenue should be.

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.