Tax Provisions in 2011 Federal Budget

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Oil/Gas Tax Provisions In President Obama’s Proposed 2011 Budget

Intangible Drilling and Development Costs (IDC) – IDC tax treatment is designed to attract capital to the high risk business of natural gas and oil production. Expensing IDC has been part of the tax code since 1913. IDC generally include any cost incurred that has no salvage value and is necessary for the drilling of wells or the preparation of wells for the production of natural gas or oil. Only independent producers can fully expense IDC on American production. Eliminating IDC expensing would remove over $3 billion that would have been invested in new American production. Cost: $3,349,000,000 from 2010-2019.

Percentage Depletion – All natural resources minerals are eligible for a percentage depletion income tax deduction. Percentage depletion for natural gas and oil has been in the tax code since 1926. Unlike percentage depletion for all other resources, natural gas and oil percentage depletion is highly limited. It is available only for American production, only available to independent producers, only available for the first 1000 barrels per day of production, limited to the net income of a property and limited to 65 percent of the producer’s net income. Percentage depletion provides capital primarily for smaller independents and is particularly important for marginal well operators. Eliminating percentage depletion would remove over $8 billion that would have been invested in maintaining and developing American production. Cost: $8,251,000,000 from 2010-2019.

Geological and Geophysical (G&G) Amortization – G&G costs are associated with developing new American natural gas and oil resources. For decades, they were expensed until a tax court case concluded that they should be amortized over the life of the well. In 2005 Congress set the amortization period at two years. Later, Congress extended the amortization period to five years for large major integrated oil companies and then extended the period to seven years. Early recovery of G&G costs allows for more investment in finding new resources. Extending the amortization period would remove over $1 billion from efforts to find and develop new energy in America. Cost: $1,189,000,000 from 2010-2019.

Marginal Well Tax Credit – This countercyclical tax credit was recommended by the National Petroleum Council in 1994 to create a safety net for marginal wells during periods of low prices. These wells – that account for 20 percent of American oil and 12 percent of American natural gas – are the most vulnerable to shutting down forever when prices fall to low levels. Enacted in 2004, the marginal well tax credit has never been needed. Cost: $0.

Enhanced Oil Recovery (EOR) Tax Credit – The EOR credit is designed to encourage oil production using costly technologies that are required after a well passes through its initial phase of production. For example, one of the technologies is the use of carbon dioxide as an injectant. Given the increased interest in carbon capture and sequestration, carbon dioxide EOR offers the potential to sequester the carbon dioxide while increasing American oil production. Currently, the oil price threshold for the EOR tax credit has been exceeded and the oil value is considered adequate to justify the EOR efforts. However, at lower prices EOR becomes uneconomic and these costly wells would be shutdown. Cost: $0.

Manufacturing Tax Deduction – Congress enacted this provision in 2004 to encourage the development of American jobs. All US manufacturers benefitted from the deduction until 2008 when the oil and natural gas industry was restricted to a six percent deduction while other manufacturers will grow to a nine percent deduction. Many producers’ deductions are capped by the payroll limitation in the law. Cost: $13,293,000,000 from 2010-2019.

Excise Tax on Gulf of Mexico Production – American independent producers hold 90 percent of the OCS leases in the Gulf of Mexico. Offshore federal lands produce 27 percent of America’s oil and 15 percent of America’s natural gas. Producers pay royalties as high as16.67 percent on their production. A portion of this production is produced without royalty payments until it reaches a set volume that was designed to encourage – and effectively so – development of deep water areas. Creating a new tax designed to add a $5 billion burden on US offshore development will drive producers from the US offshore reducing new American production of natural gas and oil. Cost: $5,283,000,000 from 2010-2019.

Passive Loss Exception for Working Interests in Oil and Gas Properties – The Tax Reform Act of 1986 divided investment income/expense into two baskets – active income/loss and passive income/loss. The Act exempted working interests in oil and natural gas from being part of the passive income basket and the treatment of IDC’s, in particular, was deemed to be an active loss that could be used to offset any type of active income. If, in the future, income/loss, arising from the ownership of oil and natural gas working interests, is treated as passive income/loss, the primary reason for individuals to invest in oil and gas working interests would be significantly diminished. Cost: $49,000,000 from 2010-2019.

Letter sent to President Obama

March 18, 2009

Dear President Obama:

American energy for America. We must produces as much as possible in America for the American consumer.

The Texas Alliance of Energy Producers represents more than 3,200 individuals and companies involved in the exploration and production of crude oil and natural gas primarily in Texas. Six-out-of-10 has 10 or less employees and 95% have less than 100 employees. They are small, independent oil and gas companies that are the backbone of the industry.

Independent oil and gas producers drill more than 90% of the wells in the U.S. and produce most of the oil and natural gas. In Texas, independents drill 96% of the wells and produce about 90% of the crude oil and natural gas. Independents typically have 10 or less employees. However, they range in size from large (over 1,000 employees), publicly-held companies to the small mom-and-pop that literally are run out of the family kitchen.

The proposed tax provisions would be bad for all independents. The larger companies would be more affected by the proposed excise tax on Gulf of Mexico production, the manufacturing credit, geological and geophysical amortization and repeal of expensing of intangible drilling costs (IDCs).

The smaller companies are hardest hit by the repeal of percentage depletion, expensing if IDCs, removal of the passive loss exemption for working interest owners and geological and geophysical costs.

If the provisions are enacted, only 498 to 732 rigs will be running one year after the tax proposals take place. The rig count today is 1,170. The lowest U.S. rig count in history occurred in March 1999 with 488 rigs working and when crude oil was $12 per barrel and natural gas was $2.19 per thousand cubic feet.

What does all this mean? Crude oil and natural gas are depleting resources. One of the oldest sayings in the oil and gas business is: “The day you produce your first barrel of oil or gas is the day you start going out of business.” Because oil and gas are depleting resources, independents must continue to drill for new reserves or they will eventually produce themselves out of business.

We estimate that crude oil production will decline from 1.8 billion barrels of oil in 2007 to 1.4 billion barrels in 2012, or 22% decline. Between 2009 and 2012 an estimated 735 million barrels of oil will be plugged unnecessarily in the U.S.

The decline rate for natural gas will be even more dramatic. After increasing production by 6% in 2008, we estimate that because of the lack of drilling, production will decrease 5% in 2009 to 24,743,000 million cubic feet, 8% in 2010 to 22,783.000 million cubic feet, 12% in 2011 to 20,049,000 million cubic feet, and 15% in 2012 to 17,027,000 million cubic feet.

Where will the crude oil and natural gas come from to meet demand? Obviously, OPEC will be a key provider of crude oil. The U.S. imports more than 60% currently and import levels will surpass 70% soon if the tax provisions are enacted into law.

Natural gas has been hailed as the cleanest fossil fuel, and could be a leader in reducing carbon emission in the future as an electric generation fuel and transportation fuel. However, if supplies of natural gas decline 30%, there is little chance that there will be enough supplies to even cover electric demand much less expand to transportation.

In summary, key points to remember about the impact of oil and gas tax provision of the proposed 2010 budget are:

We are enclosing a one page summary pointing out the importance of these tax provisions to independent crude oil and natural gas producers. Thank you for visiting with us, and I hope you will share the severity of these issues with the Congressman.

In closing, we would like to reiterate that America needs America’s energy, that the tax provision in the budget plan primarily impact independent producers not Big Oil, and that natural gas must play an important role in our future.

Sincerely,

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