The proposed tax law changes for the energy industry contained in President Obama’s fiscal 2010 budget will have a major impact on U.S. energy producers if passed into law, and I don’t like what I see in these changes.

It appears this administration is attempting to increase the cost of production to the point that alternative energy sources become economic options. Unlike many in Washington, I expect the market to react with changes in behavior if these proposals are enacted. The results could force producers to move overseas or even force them out of business, as well as significantly increasing prices for consumers. Of course, this may be just what the President is hoping for.

Here are some of the more significant provisions for oil and gas producers and their impact.

Losing the tax deduction for IDC is a big deal since this generally represents the vast majority of the drilling costs for a well. By requiring these costs to be capitalized and spreading the deduction over a number of years through the cost depletion deduction, the result will be higher taxes and reduced net present value of cash flow on the properties.

The loss of percentage depletion is another direct tax increase. While this affects all interest holders, it will significantly impact royalty holders. Most royalty owners are only able to take percentage depletion because they have very little cost basis against which to compute cost depletion.

Another change to the depletion deduction is the explicit requirement to have a reserve report to support the cost depletion calculation. Since not all companies pay for a reserve report to be completed each year, this will require an additional cost in addition to the increased taxes due to the loss of percentage depletion.

The specific exclusion of oil and gas companies from the manufacturing deduction is simply done to raise money and will have the ancillary effect of slower economic growth.

Repealing the passive activity exception for working interests will mean that many holders of working interests will be required to treat the income and losses as passive. The net effect will be a deferral of the net deductions in many cases.

The repeal of the Marginal Well Tax Credit will remove the ability for many wells to be economically productive. Collectively, these wells represent about 20% of the nation’s oil and 12% of its gas. Many of these wells may end up abandoned.

Increasing the recovery period for geological and geophysical costs from 24 months to 7 years will increase the net present cost of exploration activity.

If you’ve got questions on any of the proposed changes or how they could impact your business, please contact us.

Assistance on this post provided by Emily Strong.

A tax partnership is a tool used in certain drilling arrangements to ensure that the working interest owner who bears the cost of drilling a well also gets the tax benefits related to those costs.

Consider the following example.  A working interest owner who doesn’t have the cash to drill and develop his property strikes a deal with a third party operator to fund all of the drilling costs in exchange for a working interest in the property.  Even though the operator will incur all of the costs to drill that well, he can only deduct IDC in proportion to his ultimate working interest percentage.  The remaining IDC is treated as additional leasehold cost and is depleted (deducted) over time.  As a result, tax deductions for IDC paid in one year are not realized for tax purposes until later years. 

Here’s where a tax partnership  can be a huge benefit to the operator.  By establishing a tax partnership and contributing all of the property and the costs of drilling and development to that partnership, all of the costs incurred (and resulting tax benefits) can be allocated to the operator regardless of the ultimate working interest percentages.

Using a tax partnership is not without its hassles.  The biggest headache is the administrative burden of accounting for the activity of the partnership and the requirement to file a federal partnership tax return each year.  Therefore, you should carefully consider the tax implications before deciding to use a tax partnership.

If you have questions about whether you might benefit from using a tax partnership, we can help.

On February 2, T. Boone Pickens made the following prediction:

“We got a break here, a little bit of a breather (with current oil prices), but within 60 days we’ll be back up to $60 oil and by end of the year we’ll be on our way … at $75.”  Full article.

This prediction seems to presume either a declining supply, an increasing demand or both for oil in the very near future.  Just six months ago the fear (and focus of much of the political speak during the election campaigns) was that we had too much demand for the supply that could be produced causing prices to soar.  This sparked the debate about alternative sources of energy to decrease our dependence on foreign oil, and the complaints that the U.S. oil producers were making too much money in the process of trying to keep up with this demand. 

A factor that plays into Pickens’ scenario is the rig count in the U.S.  For several months, due to a decreasing demand and the resulting drop in oil prices, we have seen an increase in the number of rigs taken out of service because it is now economically unfeasible to produce the reserves.  OPEC is also reducing production in an attempt to moderate global oil prices. 

Eventually, this reduced supply will drop below the level necessary to sustain the market’s demand.  This could be amplified if demand for oil also begins to increase.  Once prices begin to rise, it may be too late for U.S. producers to react quickly since bringing rigs back online will be expensive and time consuming.  As a result, prices will rise quickly at a time when the economy may still be struggling.  If OPEC can ramp up production faster that our U.S. producers, we may end up purchasing even more foreign oil to relieve the burden of rising prices on the U.S. consumer.

Instead of trying to find ways to penalize our domestic oil producers, it might be wise to begin removing barriers to their ability to produce enough oil domestically so we can keep more of these dollars invested in our own economy.