Lex Oleum

There is a lot of smoke being generated these days about the supposedly unfair “tax breaks” for the oil industry. A lot of this discussion is a textbook example of “spin”. And a lot of it depends for its effect on the presumed ignorance of its audience regarding the oil and gas business.

It is worth looking at the facts. Here is a summary from Associated Press, as published in the Thursday, May 12, 2011 Seattle Times:

This is one of the clearest statements I have read regarding these tax rules.

First, note that the domestic manufacturing deduction, the biggest deduction of all, is not specific to the oil and gas business; in fact, the benefit to the oil business is capped at a lower rate than that for other manufacturers!

How can that be called an unfair break, unless it is actually unfair to the oil business? To call this deduction a break for the oil business is spin of the purest sort, the kind of thing which should be held up as a bad example in high school debating class.

Another key point is generally ignored in the public debate over tax breaks for the oil industry.

In both the cases of depletion and expensing of intangible drilling costs, the tax  incentives are provided for independent (i.e. not integrated) oil producers. For the major oil companies such as ExxonMobil, these incentives are not available or are capped. This point is rarely mentioned, since most consumer anger is directed at the majors. Wherever you see the phrase “integrated oil and gas producers”, read “major oil companies”.

Therefore, eliminating these “tax breaks” would hurt smaller, independent domestic producers, who produce about 1 million barrels a day, but have almost no impact on the other 19 million or so barrels of domestic US consumption.

Lastly, and most important, these tax deductions were not cooked up out of stone soup; they represent standard accounting practices as applied to mineral production.

Uncertainty

Now, before going any farther, it is worth making a point which is easily missed in the glib discussion of how many billion dollars these “breaks” are worth, and in most discussion of the oil & gas business.

The oil business is highly uncertain.

When you drill a well, you just don’t know beforehand if it is going to produce or not. Of course, there is geological data leading you to be optimistic, or you wouldn’t be drilling at all, but the reality is that up to 90% of new wells are dry. In my own company’s experience over the last decade, about half of the wells in which we have invested have come up dry, and that is in spite of a lot of factors pushing the success rate up: for example, the large number of reentries, where the odds are as good as they get. (In a reentry, you already know going in what the original driller found; there have been a lot of potential reentries in recent years, because the barrel price was so low in the 1990s that many low-producing wells were not economically viable and had to be abandoned).

Another thing you don’t know is whether the market price will be adequate to allow you to profit. Sure, these are good times now. But in the 1990s, when the barrel price was around $10, it still cost domestic producers $30-$40 to produce that barrel. There is a reason why an entire generation left the oil business.

So a lot of the criticism of oil business “tax breaks” ignores the elephant in the room – all those failed drilling attempts and all those wells which produced but were not economic at low barrel prices. It is a classic example of the “fan-in” fallacy, better known as “20/20 hindsight”. The oil business survivors have done very well indeed, but a balanced discussion must also recall those who lost everything when the market was down and/or their geological data proved incorrect.

Intangible Drilling Costs

Expensing of intangible drilling cost (IDC) is derived from the generally-accepted accounting principle that mandates an immediate write-down of costs of a failed enterprise. In the case of a dry hole, to demand anything other than immediate expensing of all unrecoverable costs (IDC) would fly in the face of such an accounting principle. That’s why IDC is often called “dry hole cost”.

I don’t know exactly how the Associated Press calculated its figures for the worth of each kind of deduction. I assume that the reporter obtained Treasury data regarding the total national amount for each type of deduction. If the data simply totalled all IDC deductions, without regard to whether the well in question produced or not, then the actual revenue which could be recovered by repeal of the IDC deduction  would be a small fraction of the amount claimed.

And even successful producing wells can and often do go dry unexpectedly. This is especially true of small, marginal reservoirs. Once a well went dry, all its costs would have to be expensed.

So, yes, it would be technically possible to demand that IDC be written down over time, as opposed to expensed immediately; large, integrated producers are required to do so. However, the number of exceptions would be large and the complexity of the accounting would be daunting.

Making the accounting even more complicated is the possibility of secondary and tertiary recovery. These are technologies, such as water and CO2 flooding, and hydraulic fracturing (“fracking”), which allow additional production from a well which would otherwise have run dry.

Percentage Depletion

Let’s look at percentage depletion. When any company, oil or otherwise, pays for an asset with a useful life extending over a number of years, standard accounting practice is to write down a fraction of the cost of that asset each year. This is termed depreciation. Depletion is akin to depreciation, but applied to natural resources (the term of art is “wasting assets”).

Integrated producers (the ExxonMobils of the world) are required to use cost depletion, writing down a fraction of the original acquisition, exploration, and production cost every year, until the full original cost is written down. Independent producers are allowed to deduct 15% of revenue for production up to 1,000 barrels a day; this allowance continues indefinitely.

If such a well is operating at breakeven, it will recover its costs in approximately 7 years. Therefore, it is possible, if prices are high and a well produces for a longer time, for the producer to receive more in deductions than paid out in original costs. Sounds like a great deal, doesn’t it? Well, there are few problems.

Even if a well produces, you really don’t know how long it will produce. You also don’t know when you will need to employ secondary and tertiary recovery techniques to extend the productive life of the well. 7 years is actually a pretty good run for a small well.

And, needless to say, you don’t know what will happen to oil prices in that time.

Again, I do not know the calculation technique used in the AP report. However, it is clear that the value of the percentage depletion allowance is highly dependent on the current market price per barrel of oil and on the average lifetime of small wells. Furthermore, general accounting principles would mandate some form of cost recovery in any case. Therefore, the estimate for the amount of tax revenue which could be recovered by elimination of percentage depletion must be highly speculative.

If you mandate cost depletion for all wells, then drillers of small wells, which are more likely to go dry quickly, face a difficult business decision if well production falls before the original cost has been fully amortized. If the original costs were significant, there might be a perverse incentive to plug and abandon (“P & A”) wells which could otherwise continue to produce under secondary recovery.

There is no question that percentage depletion is a great incentive to produce marginal wells in a boom time, when the barrel  price is high. In some such cases, the value of the tax deduction may be greater than the original capital cost. However, the producer is still taxed each year based on 85% of revenue, and in a down year for barrel prices, or with a well which goes dry in less than 7 years, the  cost recovery may be less than the full original cost. It’s a risky business.

Conclusion

I hope that I have shown that the apparent “tax breaks” for the oil industry are neither as pervasive nor as arbitrary as critics have claimed. They are not as beneficial to the major oil companies as they are to small independent producers, and their replacement by different accounting methods would unquestionably increase the complexity of tax preparation and auditing, and reduce incentives for the large fraction of domestic production which comes from independent oil companies, while providing an uncertain increase in tax revenues.

Appendix: CBO Report

The following quote is from the Congressional Budget Office (CBO) 1986 Report on Reducing the Deficit (Spending and Revenue Options). Italics below are mine.

Percentage depletion allows firms to deduct a certain percentage of the gross income from a property as depletion, regardless of the firm’s actual capitalized costs. For example, nonintegrated oil and gas companies are allowed to deduct 15 percent of their gross revenue from their first 1,000 barrels per day of oil and gas production each year, regardless of their capitalized costs. (Integrated oil and gas producers are required to use cost depletion for recovering capitalized costs.)

Mine development costs and oil and gas drilling costs are also immediately deductible, except in the case of integrated producers. Under the Deficit Reduction Act of 1984, the Congress limited expensing of producing wells for integrated oil and gas producers to 80 percent of intangible drilling costs, with the remaining 20 percent deducted over a 36- month period.

…

The current tax treatment of mineral properties has been criticized because many of the preproduction expenses of mineral properties can be deducted faster than the value of the assets they “produce” declines. For example, drilling expenditures by oil companies produce assets (that is, producing wells) that gradually decline in value as oil reserves are depleted. The tax code, however, allows firms to deduct most of these costs in the year incurred. Moreover, percentage depletion often allows firms deductions in excess of their original investment. In some cases, percentage depletion (in present-value terms) is even more generous than immediate expensing of all depletable costs.

The result of these provisions is that mineral producers face effective tax rates that are lower than statutory tax rates and, for many producers, lower than effective tax rates on other industries. This tax advantage could be mostly eliminated by replacing the current set of provisions for mineral capital costs with a new system of cost recovery that required all expenditures on mineral rights, exploration, development, and drilling to be capitalized. Under this proposal, all producers would be allowed the option of recovering these costs through the current provisions for cost depletion or amortizing them over 10 years (using the 250 percent declining balance method, switching to straight-line depreciation after six years). Expenditures on dry holes, unproductive mines, or worthless mineral rights would, however, still be expensed.

The discussion of the so-called oil tax breaks is too often just an exercise in spin. Here is an example quoted in an article in the NY Times May 15, 2011:

“Or take prices at the pump. In a memorandum to Senate Democratic leaders on Wednesday, the nonpartisan Congressional Research Service said that eliminating the tax benefits would have virtually no effect on the price of gasoline. The impact on industry profits — the Big Five earned a robust $35 billion in the first quarter of this year alone — would be trivial.”

My thoughts:

1. So exactly why are these tax breaks being blamed for the high price of gasoline?
2. The profits of the Big Five oil companies should not be confused with those of smaller domestic independent producers, who would be seriously harmed by the elimination of these tax provisions.
3. The current profits accruing to the oil industry should not be confused with average long-term profits, which are in the middle of the pack for US business. The oil business is exceptionally cyclical, a basic fact which seems to be completely ignored in this discussion. When prices are high, the business does well. When prices are low, as for instance from 1980-2002, the business struggles, but nobody seems to pay any attention.

“The report also addressed one more industry claim: that ending the tax breaks for the oil companies alone would be discriminatory. Most of the breaks — deductions for well depletion, intangible drilling costs and the like — are unique to the industry.”

These two tax provisions are two out of four under discussion; by my math, that is half, not “most”. And these two provisions are not unique to the oil industry. First, they are shared with all mineral producers. Second, they are based on accounting principles which are shared with all industrial businesses:

1. Depletion is analogous for the mining industry to depreciation of a capital asset. Percentage depletion exists because straight-line depreciation is an accounting nightmare for an asset which might be renewed (by secondary recovery or drilling).
2. Expensing of intangible drilling costs is not unique either. Any business is allowed to expense the costs of a failed project – one which does not produce revenue. The oil business is allowed to expense intangible drilling costs because 1) most wells are dry (average: about 90%), and 2) even wells which do produce can run dry unexpectedly, so trying to track which intangibles could be expensed would result in another accounting nightmare.

“The exception is a deduction for domestic production, designed to encourage all manufacturing companies to invest in this country. But as the research service pointed out, industry is not going to stop drilling on American territory as long as the oil is there and yielding big dollars.”

This rather blithe statement shows a basic misunderstanding of domestic production. Smaller independent producers account for about 1m bbl/day of total domestic production of 7m bbl/day. However, 1) the production cost of domestic onshore oil is far higher than that of Middle Eastern and offshore production; an estimate (based on personal experience with deal flow) would be in the range of $35/bbl versus $10/bbl. Therefore 2) the major oil companies have largely abandoned domestic exploration; most new domestic oil is found and produced by small independent companies, who would be seriously affected by the loss of these tax provisions.

Seattle Times, May 12, 2011

“Given profits of $35 billion in just the first quarter alone, it’s hard to find evidence that repealing these subsidies would cut domestic production or cause layoffs,” Senate Finance Committee Chairman Max Baucus, D-Mont., told the oilmen.

This remark shows the same ignorance as the previously-cited one. Big Oil, whose profits are cited, has already stopped drilling on American territory, at least the onshore part of it. The tax breaks being argued over have little impact on Big Oil, but do have a disproportionate impact on smaller, independent domestic producers, who are the ones actually drilling on US soil.

Consider by comparison that Microsoft made $5b on 1^st-quarter revenue of $16b. That is about 31%, a far higher profit percentage than the 9% received by Big Oil, and Microsoft is not particularly even a darling of tech investors anymore!

Everyone who looks seriously at the energy issue recognizes that oil consumption will not decrease unless the price of oil is high enough that alternative energy sources are competitive. Whether you are worried about climate change or about America’s dependence on foreign oil, this question of price is inescapable. You can’t legislate economics away.

But allowing the oil price to float higher has serious consequences for businesses and individuals. The US economic infrastructure is very adapted to cheap oil, in the sprawl of our cities and the “just in time” scheduling of our businesses. Particularly hard-hit by price increases are the poor.

Several proposals have been made to introduce market incentives to reduce carbon pollution. “Cap and trade” is an approach to pollution control pioneered by Ronald Reagan and then George HW Bush, who directed its application to reduce the use of leaded gasoline and fluorocarbon refrigerants.

Under cap and trade, carbon permits are given out to historical polluters, who then can buy and sell them. Thus there is a strong incentive to reduce one’s own pollution since one can then sell permits at a profit (as well as an incentive to overstate one’s historical level of pollution!).

Cap and trade is attacked on these grounds: 1) it generates profits for polluters, and 2) it increases consumer prices, which is generally regressive. The first point is exactly correct – that’s the incentive without which the polluter would presumably not spend money to reduce pollution. The second point is also true, but it needs to be weighed that any pollution control action will have economic costs.

“Cap and dividend” is a relatively new and untested proposal, supported by several Democratic Senators, including Maria Cantwell of Washington state, whereby anyone who introduces carbon into the economy has to buy the right to do so, which means it is a levy on upstream producers and importers. There doesn’t appear to be any trading component, just an auction of the rights to produce. So it doesn’t really bear any resemblance to cap and trade.

Cap and dividend addresses the second objection to cap and trade by redistributing revenue from a permit auction to consumers, in the form of a dividend per person or household, thus offsetting the impact of higher prices. It addresses the first objection to cap and trade by not generating profits for polluters in the first place: they will have to spend to purchase permits, thus increasing their production costs.

Let’s do some numbers:

• Carbon content of oil = 19.9 metric tons / TJ (terajoule)
• Oil has 6.1 GJ / bbl, so about .12 mt / bbl = .13 short tons / bbl
• Proposed C&D bid estimated at $200 / ton, so this would = $26 / bbl
• Carbon content of NG = 14.4 mt / TJ
• 1 cf of NG produces about 1,000 BTU, so
• 1 mcf = 10e6 BTU, with 1,055 joules / BTU, so 1 mcf = 1.06 GJ
• Carbon content of NG therefore = 0.017 tons / mcf or $3.34 / mcf at $200.

These figures would be very difficult for the domestic independent oil & gas industry to handle. The NG levy is almost equal to the current price. An additional $26 cost per bbl of oil would probably put the domestic oil breakeven above $60 per bbl.

It is then possible that the Saudis or other foreign producers could use cap & dividend to harm US independent oil production, since they could bid up the auction rights to a level that would eliminate any domestic industry profits yet still be profitable for them. The domestic independents break even at around $35-40 per bbl. Assume a barrel price of $80; then a C&D auction bid of $45 per bbl would suffice to drive domestic producers into the red. This corresponds to a carbon levy of $346 per short ton. The Saudis’ lifting cost is around $10 / bbl (transport costs are relatively insignificant) so they would still be making a $25 / bbl profit or about 60% gross margin.

The Saudis drove the Soviets to their knees in the 1980s by flooding the market with cheap oil. They no longer have the production headroom to do that again, but C&D would give them a different weapon.

Of course, much of this assumes that the cost is mostly borne by the producers. To the extent that producers push the cost downstream, it will reduce demand and increase the incentives for efficient use of derived products. This is all good from a carbon reduction perspective; in other words, you want the producers to push the cost increase downstream as much as possible, so that the entire supply chain has an incentive to reduce carbon use. The dividend reduces the price signal to end users; however, there is still an incentive for individuals to conserve, since the dividend is not usage-based.

The real devil is in the details. How would a cap and dividend system actually work in the energy business? A lot of oil exploration is highly speculative: even with modern analytic tools such as 3-D seismic, wildcat success rates are none too high (10% or so). A producer would have to project not only the future price of oil or gas, but the future auction price of permits. Of course, producers already need to get permits to drill, as well as filing with state oil and gas boards to assure all mineral rights are respected.

When a well is producing, the extra cost associated with C&D can, depending on demand, be pushed downstream. However, a wildcatter would need some kind of insurance that a permit would be available at a reasonable price should the well come in. Thus there would necessarily be a market in derivatives against the permit auction price. Otherwise the volatility of the oil market would only increase dramatically. That would not be a good outcome for anyone.