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.

A survey was recently conducted for the American Petroleum Institute (“API”) that that highlighted many of the common misconceptions about the oil and gas industry. 

The survey found that most Americans continue to underestimate the amount of oil and gas that will be needed to meet future demand as predicted by governmental experts.  It was also noted that most respondents overestimate the role that renewable energy sources will play in the future demand, the amount of oil that is imported from the Middle East and the amount of oil and natural gas industry earnings. 

It is estimated by the Energy Information Administration that the US energy demand will increase 9% during the next 20 years.  The majority of respondents in the survey thought that demand would increase somewhere between 16% and 21%. 

Fossil fuels such as oil, gas, and coal are expected to make up approximately 85% of global energy demand – only 10% of respondents answered this question correctly.

The US Department of Energy estimates that 12% of oil consumed last year in the US was obtained from the Persian Gulf countries.  The majority of respondents in the survey thought that our dependence on fossil fuels from the Persian Gulf countries was over 30%.  Further, according to the DOE, Canada is the largest supplier of imported crude oil and more than 73% of oil and gas consumed in the US is actually produced in North America.

Finally, the oil and gas industry has paid over $242 billion in taxes in the past three years and earns just below $0.06 on every $1 of sales.  Most respondents believed that the industry contributed less than $100 billion or were not sure how much was contributed in taxes over the past three years and thought that the industry earned more than $0.20 per every $1 of sales.

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.

 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.

So what’s behind the recent (and continuing) downturn in in the price of oil and natural gas?  I found an interesting article at Time.com written by Ari J. Officer. 

As Mr. Officer writes, “The financial crisis was the spark, de-leveraging the fuel.”  As the mortgage crisis rose to a panic, the U.S. dollar that had long been in a slump of its own began to make a comeback.  With the stronger dollar, the price of oil purchased in U.S. dollars had to come down.

Further complicating things, as the financial markets tumbled and talk of a bailout began to take shape, speculators holding long positions in oil were forced to close out those positions to cover mounting losses. 

Altogether it was a perfect storm.  Unfortunately, I don’t think the eye has passed us by.