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.

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.