If you're not dead, you have been blasted lately with all sorts of bombast about "oil industry" tax loopholes and subsidies and the gallant efforts underway to do away with them. I thought it might be a good idea to simply explain what these "loopholes" are, how they came into existence, and what happens when we get rid of them.
One important fact to remember is that up until recently, everyone agreed that energy security was important and that domestically-sourced energy preferable to foreign-sourced energy. That is apparently no longer the case.
First, lets establish who this is targeted at and what kind of product it is meant to discourage. If you, like most Americans, think it is targeted at "Big Oil", you would be, lets see if there is a nice way to say this, Dead Wrong. First, Big Oil... the big integrated American Oil Companies that produce less than 12% of the world's Oil (REAL Big Oil is the National Oil Companies owned by the countries that contain the supergiant oil fields), left the US in the late 1970's and early 1980's. Today, they produce only 35% of domestic oil and 20% of domestic natural gas, and drill less than 10% of the wells in the US.
Next, if you are like most Americans, you think that Dirty Oil is the commodity being targeted by this tax proposal, right? Again... DEAD WRONG. 80% of the wells drilled in the US today target Natural Gas. Yep, the "Clean Burning Natural Gas" that Nancy Pelosi enthusiastically endorsed when she jumped on the Pickens Plan.
By now, you are probably thinking "What the Hell? This isn't what I was told at all!" Unfortunately, we seem to be living in a world where truth often takes a back seat to politics and agenda. In any case, now that we have that settled (and, by the way, these aren't "spins" from "an anonymous oil executive", these are basic objective facts), lets go understand Taxes. I have to be crazy to write on something this dry!
Intangible Drilling Costs- First, lets start with capital investing in general. If you want to build a commercial building, you buy the land and you build the structure. The structure has a fixed life and a salvagable value that goes down every year, thus its treated as an item that is capitalized and written off over the lifespan of the building, ideally at the rate the building rots. Also ideally, the investor in that building reinvests the dollars s(he) is depreciating into capital investments in that building so that the building has an indeterminate lifespan, or that the investor can buy a new one when the old one falls down.
This commercial building will fluctuate in value somewhat with market conditions, but, in general, will generate income on a flat line basis in current dollars. Also, unless you are a complete bonehead (ie a member of congress anytime during the last decade), you won't build this building where you can't rent it out. This is why, at least historically, you could borrow up to 80% of the cost of building to leverage your investment. It only took $0.20 to buy a dollars worth of building... the building paid the rest. You can borrow this money because the risk of loss is pretty small.
An oil or gas well, on the other hand, has a finite life span, and is, by definition, a depreciating asset. It loses value every day it is in existence, and, unlike a commercial building, it has very little salvage value associated with it. No amount of reinvestment in that well can make it "good as new".
Combine this fact with the low likelihood of profitability on a one on one basis (only 30% of the wells make money, but they make enough to cover the cost of those that lose money), and the fluctuations in cash flow based from oil or gas wells from highly volatile oil and gas prices, no banker in their right mind would lend significant amounts to you to drill new wells, so investment leverage is much less than in commercial real estate or other industries. Oil and Gas bankers make rational lending decisions in OUR industry because they are "unregulated"... ie no greasy Fanny Mae or Freddie Macs for oil and gas lending that decouple people from making rational lending decisions.
The relative lack of salvage value of an oil or gas well versus other capital investments along with the high amount of risk associated with drilling an individual well is similar in scale and risk to R&D investments by US industry in general, which, incidentally, is allowed to be wholly expensed for the same reasons. This is why we treat Intangible Drilling Costs as an expensable item rather than a capital item.
Clearly, although one can disagree with oil and gas drilling in general, this treatment of drilling costs has a clearly defined and rational basis, and is no more a special interest give away than expensing R&D is a corporate give away. Recall once again... Independents and Natural Gas are the ones targeted to pay this change... not Big Oil and Oil. The attached is a nice synopsis on this issue. http://www.heritage.org/research/energyandenvironment/IB86.cfm
Depletion Allowance- The next item that is currently being attacked is the Percentage Depletion Allowance. Since this is called an "allowance", it is easy to see why people think "corporate welfare" by name alone. I can hear you now. "By Golly, how can you defend a "depletion allowance, 'choke?"
The Depletion Allowance was a result of the Revenue Act of 1913 and applied to timber, mining, and oil and gas extraction. The Revenue Act istelf was enacted to deal with the taxation issues surrounding revenues derived from selling these "depleting assets" because the 16th Amendement of the US Constitution allows the Federal Government to tax income but NOT property.
Since the revenue derived from our hypothetical office building is just revenue derived from a non-declining asset base, the "golden eggs" produced by our building goose, it is appropriately taxed as income. However, if I were to sell my building, the income I receive would be taxed as Capital Gains, which has historically been taxed at a lower rate than income, because you are now selling the goose rather than each of the eggs. The "goose" can no longer provide you ongoing income.
Since oil and gas income is REALLY the sale of property, ie each barrel or MCFG produced depletes the original amount of property, how do you constitutionally tax the income derived from selling pieces of this declining property?
For virtually all other properties, this is done via a Capital Gains tax. The Depletion Allowance essentially "splits the baby" by treating this incremental sale of assets by recognizing that some part of the revenue is a sale of property, and thus subject to a lower rate than pure income... somewhere between Cap Gains and income.
For major integrated oil companies (Big Oil), this is can only be done statutorily on a cost basis... ie they can deduct the cost of acquiring the asset. For smaller independents, it can be done on a percentage of sales basis. Lets look at an analogy.
For you homeowners out there, "percentage depletion" would be the equivalent of taxing you at your income tax rate after you deducted 15% of the sales price of your house, instead of straight capital gains on the difference between your original cost and sales price. So, if you bought your house for $25k and sold it 20 years later for $200k, you would pay 15% of $175k, or $26.5k to the Feds under current law.
The independent oilman equivalent would be that the house was taxed at 35% of 85% of the net profit, or a tax of $52.05k, nearly twice the capital gains rate. The Major Oil Co. would pay 35% of the whole $175k, or $61.25.
In essence, under the current schema, oil and gas companies pay twice the tax burden of a guy flipping houses! See how we PROMOTED people to speculate in buying homes with our tax policy? Too many did, and we had a crash. Eventually people built many more homes than there were people to live in them. This oversupply is bad because people that already have homes are faced with a value collapse because of the glut. With Oil or Gas, we don't have that same problem, since we don't horde oil or gas, but rather burn it for fuel and energy. We need as much as we can get because we currently import over 60% of our oil, which means we send our dollars to non-American sellers and remove them from our economy. Unlike with houses, if we overproduce domestically and the market collapses for oil and/or gas, the consumer is happy! Ecstatic, even! Even better, domestic production hugely benefits our trade balance, in that every dollar of domestic production is a dollar not sent overseas! But, alas, instead we are in the process of choosing to penalize domestic oil and gas. Remember, these proposed taxes don't apply AT ALL to foreign imported oil and gas!
Major Oil had this treatment removed, perhaps not so coincidentally, around the time they abandoned the US. Is it any wonder why Major Oil is NOTa substantive player in US oil and gas production today?
So, do you still think of percentage depletion as a subsidy or give-away, or merely an effort to correct slightly the differential between Income, as its treated, and Capital Gains, which it really is? Ironically, removing Percentage Depletion, as President Obama has proposed, does not affect Big Oil at all, it only further penalizes Independent Oil. A good read on this is included here. http://www.answers.com/topic/depletion-allowance
As I described above, it is very difficult to borrow money to drill oil and gas wells. Independent oil and gas companies have historically invested 100% of their cash flow back into drilling new wells. New capital comes into the business when prices are high, and flees when prices are low. For idependent oil companies, the cash flow of existing operations dictates how many wells can be drilled and how many Americans can continue to be employed in this business.
The Obama Administration's proposed tax regime would raise the US Independent Oil and Gas industry's all in tax rate from 37% to 45%, compared with the average of all other US industries of 33%. Again, the target is painted squarely on the backs of Mom and Pop independents that produce Domestic Oil and Gas, and not Big Oil one iota!
So what does this mean over a few years of a well's life? Essentially, it takes the majority of its cut from the first year of production. Importantly, this means it directly reduces the number of new wells drilled in year two onwards, because, remember, we operate out of cash flow. The chart below shows that over a 6 year period, over 20% fewer wells would be drilled due to cash flow limitations.
This, overall, is a case in point about taxes in general. Some industries horde cash. Some industries have access to lots of credit. Big Oil itself hordes cash due to issues of scale. Industries with the ability to horde cash or with access to big credit are strongly buffered from the negative consequences of taxation.
The Independent Oil Business, with a demonstrable history of 100% reinvestment of its revenues in order to replace and grow a depleting resource base is particularly susceptible to tax increases, especially front-loaded tax increases, as our President currently proposes. In other words, every dollar that is extracted from the independent oil and gas industry via taxation and tariffs comes directly and on a one to one basis from dollars NOT invested in private sector jobs, business to business investments, and new wealth creation (as opposed to moved around wealth) from domestic resources!
Common sense dictates that if we want an economy that grows, we should keep the following standard... if government provides better returns, it should get the dollar, if private enterprise provides a better return IT should get the dollar. Equally unambiguous and demonstrable is the answer to that previous rhetorical statement. Yet today we see government taking dollars from the better stewards, and expanding its franchise beyond safety, defense, and regulation of commercial infrastructure into the intentionally poorly-served commercial banking and private equity investment realms of subsidizing private entities that a) don't make things anyone wants to buy or b) abject marketplace failures, such as troubled banks and General Motors!
We all hope that we can develop cost-effective alternative energies. While we are getting there, we should be supporting domestic supplies, particularly natural gas, the MOST carbon neutral dependable energy supply. Creating a tax schema that kneecaps our current capabilities to produce energy while promoting increasing trade imbalances and exporting even more US jobs overseas and that result in more and more foreign natural gas and oil imports cannot be in ANY American's best interest, can it?
Oh, for those that want the raw data and assumptions for the analysis above, here it is...
Current Tax Regime
Proposed Tax Regime
I hope this clarifies a complex and politically bombastic subject for you.
I started in this business as a roustabout in and around Midland, in the mid-fifties, as a teenager. Roughnecked through high school and college. Hung out my shingle as an independent in 1964. You all know the rest of the story down through the years. Now, with this crap coming down the road, seems like a good time to roll my clothes, go the the house and check on my old lady.
Posted by: John Castleman | March 10, 2009 at 11:35 AM