Tax "Loopholes" for Oil Companies

FORBES - June 4, 2012

Why We Should Keep Tax 'Loopholes' For Oil Companies
By Deborah Byers

Across Washington, D.C., the push to end so-called energy company “subsidies” has become a well-worn political trope – touted as a solution for everything from reducing the deficit to punishing oil companies for high gasoline prices.

The president himself said he was in favor of repealing “billions in tax giveaways” to energy firms during a much-publicized address in March.  But is that really an accurate portrayal of the current tax code?

For the most part, energy companies are treated just like any other industry when it comes to taxes.  Much of what politicians call giveaways are simply timing issues related to when particular items can be expensed – governed by provisions in the tax code established decades ago to strengthen U.S. energy production.  These provisions are not tax credits, which allow for a dollar-for-dollar reduction in tax liability.

For example, the president’s most recent budget proposal calls for the repeal of   a provision that details how energy companies account for intangible drilling costs, or IDCs.   U.S. tax law has long allowed oil and gas companies to deduct IDCs – expenses for labor and services related to drilling a well – at the time they are incurred, versus depreciating those costs over time.

Eliminating those deductions would have dramatic consequences on domestic energy production.  Despite lawmakers’ and the public’s perception of “Big Oil,” approximately 90% of all wells in the U.S. are drilled by independent energy producers, most of whom are small or mid-sized companies.

To independent producers, IDCs are the equivalent of research and development costs that technology and pharmaceutical companies incur – up-front expenses with no guarantee that the investment will deliver results.  Even if a well is successful, it typically takes many months before revenue is captured.  Thus, the IDC provision simply accelerates the actual cash flow of the project but does not eliminate the tax liability.

According to the Independent Petroleum Association of America, IDCs typically account for about 20% to 35% of the capital expenditure budgets of a well.  Without the ability to expense these costs, many independents’ cash flow would be significantly diminished and they would have to immediately reduce their drilling budgets since they lack the cash flow to fund these operations internally and their cost of capital would otherwise increase.

And as producers scale back, production from shale oil and natural gas, which is heavily driven by independents, will be at risk.  In recent years, the shale boom has played a major role in providing jobs, boosting domestic supplies and increasing state and federal tax revenues.  It is not an exaggeration to say that the IDC provision is one of the factors that has allowed the “shale revolution” to ramp up so quickly.

But IDCs aren’t the only tax item under scrutiny in Washington, D.C.  Another provision slated for repeal in the president’s budget governs percentage depletion, a calculation used to determine the decreasing value of a mineral resource as it is produced.  But its use is limited by guidelines that make it applicable only to small companies and individual royalty owners, so it has a minimal impact on federal tax revenues.

Proponents say repealing provisions that deal with IDCs, percentage depletion and the domestic manufacturing credit – available to all industries but used by just a small subset of the oil and gas industry – would bring in close to $40 billion in new tax revenues over a 10-year period.

That $4 billion a year figure – small as it is compared to the overall budget deficit – is based on current levels of drilling.  It doesn’t take into account the fact that domestic activity would most likely decrease as independents cut back on their capital budgets in response and investments in new production dry up.

In other words, changing the current tax code might make lawmakers happy, but it won’t achieve its hoped-for objectives and, in fact, will do the opposite:
• Integrated majors won’t be affected meaningfully
• Cash-strapped independents will be hit hard
• Domestic production will be depressed
• Job growth related to the shale boom will stall
• Tax revenue will fall

The technology advancements that are driving the shale boom, coupled with the existing tax code, have put the U.S. in a position not seen in years – one where domestic production is high and new reserves are creating economic opportunities across the country.  If we want to increase security of supply, keep retail energy prices low and create high-paying jobs, our energy policy should encourage future drilling by allowing proven tax provisions to remain in place.

Deborah Byers is the Transaction Advisory Services (M&A) Leader for Ernst & Young LLP’s Southwest Sub-Area, and she also serves as the Ernst & Young Americas Oil and Gas Tax Sector Leader.  Deborah has represented investors and companies in various types of domestic and cross-border oil and gas transactions. The views expressed in this article are Deborah Byers’ and not necessarily those of Ernst & Young LLP.