Thursday, August 11, 2011

Marcellus Shale Tax Dividend

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Over the past week or so, I've taken issue with public comments from Pennsylvania Lieutenant Governor Jim Cawley (here and here). Cawley is trying to beat back proponents of a greater tax for drilling in the Marcellus Shale. He makes a lousy case, demonstrating a poor grasp of economic development issues. Via Pipeline, the Council on Foreign Relations (CFR) offers a similar critique:

That argument would be undermined if a severance tax threatened to crush the industry. Indeed that is what Cawley has claimed: his op-ed suggests that gas drillers would flee the state if a severance tax were imposed. But the economics of don’t add up. The Marcellus shale is relatively cheap to produce: the recent MIT Future of Gas study, for example, shows breakeven gas prices that are much lower than for any other shale play. A modest severance tax would still leave the Marcellus as the place to be. To be fair, if natural gas prices crashed, it’s plausible that an excessive severance tax could deter production at the margin. But, assuming that gas can’t stay super-cheap forever, that’s not necessarily bad: rational resource management says that you should produce more when prices are high and less when they’re low.

The CFR analyst is describing a unique attribute of the Marcellus: Relatively low cost of production. That means that Pennsylvania could levy a higher tax than other states with significant shale gas plays and still be economically attractive for drilling. I won't mince words. Cawley is lying in an attempt to keep taxes as low as possible. He is defending corporate interests instead of Pennsylvania's.

Cawley is ideologically opposed to tax increases. Yet he is incapable of rationally supporting his position. The debate shouldn't be about how little to tax drilling. My concern is how the increase in revenue will be used. Ideally, Pennsylvania invests in more economic development. In any state, energy jobs are a small piece of the overall picture. Job creation in other sectors would be most welcome during a time of stubbornly high unemployment.

I have in mind research and development. Could Pennsylvania become an innovation leader for safer and more environmentally friendly hydrofracking? Universities could attract state, federal, and industry funding. Talent emerging from such a program would be in demand worldwide.

There is already a model to explore:

To feed its energy demands, the United States is looking for energy in increasingly far-flung environments such as: Ultra-deep offshore oil wells, the Arctic, shale rock formations 20,000 feet underground. The risks involved are often greater, but the industry lacks a set of “best practices” for these new frontiers of energy exploration.

That's a need that researchers at the University of Texas and the Massachusetts Institute of Technology hope to fill. Scientists at both colleges are teaming up to create some guidelines for industry. Their focus would range from guiding principles to government policies to the engineering needs required to reduce environmental impact.

Pennsylvania should be a partner in this. Unfortunately, Cawley has neither the vision nor the leadership skills to get his state in the game. He'd rather bang the anti-tax drum and draw lines in the sand. Thanks to his ridiculous antics, PA residents are so much the poorer.


BrianTH said...

I'm a big believer in the diversification approach to a natural resources windfall. Take the proceeds of an extraction tax and put it into a sovereign wealth fund, preferably not invested in Pennsylvania assets.

Then take the income from the SWF and invest it in general economic development projects for Pennsylvania--education, transportation, communications, and so forth.

I understand the temptation to cycle the proceeds back into related projects, but I think that is unnecessarily risky.

Jim Russell said...

@BrianTH: Interesting take. Isn't there risk with the SWF investment? Regardless, we seem to agree that using the revenue for ED projects is good policy.

BrianTH said...

So according to standard investment theory, you have diversifiable and undiversifiable risks. Higher expected returns should correlate with undiversifiable risks, but not diversifiable risks--holding onto diversifiable risks in that sense is just an unforced financial error.

As applied to sovereign wealth funds in general, this analysis suggests your fund should invest in assets outside the relevant jurisdiction. You don't want something bad happening to your jurisdiction to also adversely affect your SWF at the same time, or more generally, you shouldn't be accumulating diversifiable risk.

Now say your jurisdiction has gotten a natural resources windfall. If you take the proceeds and invest in unrelated assets, preferably outside the jurisdiction, your new investments will likely have some undiversifiable risk (assuming you don't invest in just risk-free assets, which may not even exist anymore), but not much diversifiable risk. But if you invest in assets related to your windfall, including in your own jurisdiction, you are likely accumulating diversifiable risks. You get no financial benefit from that diversifiable risk, so you should avoid doing that.

In more concrete terms--say the price for natural gas dips unexpectedly in some future period. That's not so good for natural gas producers, but it could be good for energy consumers. So if you take your proceeds from the natural gas industry and invest in other assets which will benefit from such a dip, the risk you inherited with your natural gas windfall has been reduced by your diversification strategy.

The one big caveat is if you think there might be some capital/liquidity problem with respect to exploiting your windfall, such that you need to invest yourself to extract the full economic benefit. But I think the argument that Marcellus exploitation isn't in that position is correct--and in fact, that's essentially the same argument to the effect that a reasonable extraction tax should be harmless.

Anyway, no one is talking in these terms--yet. But places like Norway, Alaska, and so on have used natural resources windfalls to create SWFs, and we may yet do the same in Pennsylvania.