For the second year in a row, President Obama has his tax sights set on the oil and gas industry. In the proposed fiscal 2011 budget submitted by the Obama Administration this past week, the President has included $36,500,000,000 (zeros included for emphasis) of oil and gas taxes.  For an analysis of the breakdown of these taxes, see Nick Snow’s article in Oil & Gas Journal.

The President continues to believe that a good way to grow our economy and spur job growth will be to cause businesses to send more money to the federal government than to spend it in the free enterprise system.  The tax increases for the oil and gas industry are the same as the ones I wrote about last March and include:

• Repeal of percentage depletion,
• Eliminate expensing of intangible drilling costs,
• Extend the amortization period for geoligical and geophysical costs,
• Repeal the domestic manufacturer’s deduction (only for oil and gas companies),
• Remove the exception to passive loss limitations for working interest owners in producing properties, and
• Repeal the enhanced oil recovery credit and the credit for production from marginal wells.

It seems to me these proposals will have the opposite of the President’s stated desired impact. These types of policies will most likely result in fewer jobs, reduced government revenue, a shift away from domestic production to foreign production, and more reliance of foreign sources of energy.

Due to the instability of the current economy, companies may find it increasingly difficult to begin production on oil and gas properties currently under lease. The deferral of production might result in the lessee’s requirement to make delay rental payments to lessors in accordance with their lease agreements. It is important to realize the tax implications to both the lessee and lessor of such payments.

Delay rental payments are amounts paid by the lessee for the right to defer development of properties under a lease. Generally, these payments will be treated like other carrying costs and capitalized as leasehold costs. Delay rentals cannot be expensed unless the lessee can establish that the leasehold was acquired for reasons other than development. A lessee’s failure to make the required delay rental payments usually results in the termination of the lease.  As a result, a loss due to worthlessness may be deducted in the year of the lease termination.

Upon receipt of delay rental payments, the lessor must recognize the payments as rental income. The payments are not subject to depletion since the amounts received are not based on the production of the property. This treatment is different than the receipt of a lease bonus payment which often qualifies as depletable income to the lessor.

Many leases were signed prior to the current economic downturn when prices were much higher.  As a result, many leases may not be drilled within the original lease term due to concerns about the economic viability of the lease at today’s prices, forcing a decision on the payment of delay rentals.

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.

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.

 A windfall profits tax is an idea floated by many that would tax an industry based on income in a single year that is much higher than its previous years.  The idea became very popular in late 2008 when the price of a barrel of oil approached $150.  President Obama made a campaign promise to enact such a tax.  Many people continue to push the idea of a Windfall Profits Tax even though oil has since dropped below $40 a barrel as a method to stimulate the economy.  Lloyd Chapman makes this argument in his Huffington Post article.

Just a couple of months ago, with oil prices above $140 and gas prices above $4 a gallon, energy independence was one of the hottest topics in Washington and in the news. After the historic drop in energy prices over the last several weeks, where have all the headlines gone? We may not be talking about energy independence these days, but lower prices certainly haven’t resolved the issue.

In a recent opinion piece in the Fort Wort Star-Telegram,  Senator John Cornyn said that energy should continue to be a focus of the 111th Congress:

While lower gas prices should have given us the chance to catch our breath and redouble our efforts to develop a comprehensive energy plan, instead it signaled an ill-timed break in discussion on one of the most important issues of our day.

According to a recent American Petroleum Institute report, it’s estimated that the United States has undiscovered technically recoverable resources, including onshore and offshore reserves, totalling 116 billion barrels of oil and 650 trillion cubic feet of natural gas.

Accessing those reserves may not solve all of our energy needs, but as our demand for energy continues to grow, where will the supply we need come from?  And more importantly, how much will it cost us?

In October of this year, President Bush signed the Emergency Economic Stabilization Act of 2008.  There are three divisions, the second division, Division B, is the Energy Improvement and Extension Act.

For the oil and gas industry, the 50% bonus depreciation election was extended for costs incurred when expanding a refinery’s capacity. 

The new act extends the suspension of the taxable income limit on percentage depletion for oil and natural gas produced from marginal properties for any taxable year (i)beginning after December 31, 1997 and before January 1,2008 or (ii) beginning after December 31, 2008 and before January 1, 2010.    Go ahead, read those dates again…they are a bit confusing.  This means the suspension applies to 2009, but not to 2008!  In the past, a well producing at a marginal rate could not take percentage depletion,  but for 2008 and 2008 only, it can. 

Under the new law, section 199 domestic production activities deductions are capped to 6% in tax years beginning after December 31, 2009, while the allowable deduction for other types of qualifying income will increase from 6% to 9%.  This limit applies to “oil-related qualified production activities income (QPAI)”, which includes income from the production, refining, processing and transportation or distribution of oil and gas.  This cap is expected to raise  $4.9 billion over the next 10 years.

 Beginning in 2009, the act tightens the rules for oil and gas companies to pay taxes on overseas income.  It extends the special foreign tax credit limitation for taxes attributable to income defined as foreign oil and gas extraction income (FOGEI) to income defined as foreign oil-related income (FORI).  It now includes certain transportation and refining activities that were not previously included.  This provision is expected to raise $2.2 over the next 10 years.

As the economy continues to be volatile, I am sure the government will implement more new laws in response, and we must continue to keep a lookout for those that affect the industry we work in!

According to the most recent Short-Term Energy Outlook, the Energy Information Administration (EIA) projects an average oil price of $51 per barrel for 2009, down from the 2008 average of $100.  The price of natural gas is projected to average $6.25 per Mcf in 2009, down from its average price of $9.17 in 2008.

Where do you think we’ll be a year from now?  Post your prediction as a comment.

According to a report in the Wall Street Journal (subscription required), President-elect Obama is considering appointing and Energy “Czar” to coordinate U.S. policies on climate change, as well as dependence on foreign oil.

One of the great challenges the new administration faces as it relates to energy is how to coordinate and manage the long list of agencies and departments who have a hand in setting energy policy, including the Interior Department, Transportation Department, and the Environmental Protection Agency to name a few.

Is an Energy “Czar” the answer?  Give us your thoughts in a comment.

During the recent presidential campaign, we heard over and over again that energy dependence is an issue of national security. 

I read a recent report from the American Petroleum Institute that really drove that home for me.  According to The Truth About Oil and Gasoline: An API Primer,  40 years ago about 85% of the world oil reserves were owned by investor owned companies (IOC), primarily in the U.S.  Today nearly 80% of those reserves are owned by national oil companies (NOC) and foreign governments.  To take that a step further, the largest U.S. holder of world oil reserves in the U.S. is ExxonMobil with approximately .6% (yes, that’s point 6 percent). 

The campaigning and the election is over, but energy independence should be a big concern of the new administration. How does this concentration affect your company? Tell us by posting a comment.