To avoid the unavoidable price volatility that accompanies oil and natural gas development, states that have become dependent on energy revenues should consider creating permanent trust funds that overcome boom-and-bust price cycles, the Brookings Institution said Tuesday.
The Metropolitan Policy Program at Brookings, in the report "Permanent Trust Funds: Funding Economic Change with Fracking Revenues," outlined what states could do -- if they haven't already -- to prepare for the inevitable "resource curse" of unconventional horizontal drilling and hydraulic fracturing. Authors Mark Muro and Devashree Saha reviewed the current bust in unconventional oil and gas extraction and surveyed the resulting budgetary problems in multiple states.
For those energy-rich states that have not already, enacting severance taxes and permanent funds help to better navigate future unconventional drilling downcycles, the researchers said. Permanent funds may offer a way to avoid a U.S. version of the third-world "resource curse" by managing revenue to invest in economic diversification.
Debates on whether to enact production taxes "are underway in Pennsylvania, Ohio and New Mexico, while multiple states are in bad straits," Muro said. "The boom-bust cycle of unconventional oil and gas development highlights the need for strategic management by state governments of fracking-related revenues, not only to minimize the less desirable aspects of the boom-bust cycle but also to enhance long-term prosperity.
"States can address these challenges by imposing a reasonable severance (extraction) tax on their oil and gas industry and channeling a portion of the revenue into permanent trust funds. In doing so, states can convert volatile near-term revenues from unconventional oil and gas development into a longer-term and continuous source of investment funds for building sustainable and dynamic economies."
Despite a long history with state-controlled permanent trust funds in the country, not enough states with unconventional production have established both severance taxes and permanent funds.
"Neither Pennsylvania nor Ohio -- two of the states most heavily enmeshed with the shale energy boom -- have set up trust funds," researchers said "And now both of them are grappling with questions related to management of their fracking-generated revenues. Pennsylvania is the only major gas-producing state without a severance tax and recent efforts by Gov. Tom Wolf to impose one have failed so far. And in Ohio, Gov. John Kasich has been advocating to increase the state's severance tax to 6.5% on high-volume horizontal oil and gas wells -- a proposal that has not been supported by state lawmakers."
It is in Ohio and Pennsylvania, "at the epicenter of oil and gas growth, where the best opportunity to create permanent trust funds lies. Specifically, Pennsylvania would be wise to levy a severance tax on its oil and gas industry and deposit a portion of that in a permanent trust fund, while Ohio should increase its severance tax in line with other oil and gas producing states and use a portion of that revenue to create a fund."
Researchers offered compelling evidence for enacting trust funds that benefit of state residents over the long haul. For instance, Texas dedicates funds from drilling on state-owned land to two funds that support education, and the funds now total a massive $55 billion. Montana, which has for the past 40 years used a trust fund for about half of its coal mining severance taxes, now collects more in interest from the fund than from direct taxes on mining.
Using permanent trust funds, which are "prudent and non-ideological tools," could ease budget constraints in other energy-rich states, Muro said.
"Severance taxes linked to well-managed permanent trust funds offer a significant economic development option for states that have just witnessed the huge potential of unconventional oil and gas development to generate significant, albeit cyclical, economic activity and revenue. Having missed the last decade's opportunity to link an oil and gas boom to transformation through targeted investment, states should prepare now to leverage the next windfalls.
"They should put in place the tools and management to channel oil and gas-related revenue targeted investment to bolster innovation activity, cultivate a skilled workforce and help accelerate the decarbonization of their economies."
The authors acknowledged that top advisers to Pennsylvania Gov. Tom Wolf, who has advocated for a severance tax, contributed to the Brookings report, Cindy Dunn, of the Department of Conservation and Natural Resources, and John Quigley, of the Department of Environmental Protection. Research also was funded by the Rockefeller Foundation and Nathan Cummings Foundation.
Separately on Tuesday, Moody's Investors Service published three reports examining how the local governments of Oklahoma, North Dakota and California have suffered material declines in overall tax revenue as low oil prices and slowed production have "directly and indirectly suppressed income, sales and severance taxes to varying degrees."
In Oklahoma, for instance, revenues from severance taxes on oil production have declined 51% in the 12-month period ending in March year/year.
"Low oil prices have already caused sharp declines in revenues collected by Oklahoma and its local governments, but more pain is on the horizon as the rest of the economy slows down due to muted drilling activity," said Moody's Associate Vice President Julius Vizner. The state is constitutionally required to balance its budget, and has used reserves as a means to mitigate the impact of low oil prices on public finances.
North Dakota's finances are indirectly exposed to low oil prices through sales and income taxes, and total revenues are projected to be $1 billion below budget in the current biennium. "Job losses and resulting revenue declines opened a $1.07 billion state budget gap, equivalent to 22% of North Dakota's biennial budget," said Moody's Senior Credit Officer Baye Larsen. Moody's anticipates the gap will be closed with a 4% budget cut of roughly $244 million across all agencies, plus $828 million in reserves from state funds.
And while California is the country's third largest oil producer, the bulk of production occurs in Kern County, so the state's finances generally unaffected by persistent low oil prices. However, the slowdown will continue to lower assessed valuations of oil properties, placing negative pressure on localities reliant on local property tax revenue. The county government is anticipating a loss of more than $61 million in property tax revenues from fiscal 2015 to fiscal 2017, according to Moody's.
Canada’s chief oil and gas producing province, Alberta, set up the “Alberta Heritage Savings and Trust Fund in the 1970s. It was meant to be used to create diversified industries to save the province from the oil boom-bust cycles. However, it got mired in politics and very little beyond minor public works projects were built. Some of the funds were used as “rainy day” funds to shore up the provincial budget during the downturn in the 1980s. There currently is about C$15 billion in the fund and the new provincial government has pledged to use the funds to aid petrochemical projects, but has not come up with a comprehensive plan.