Obama Targets Small US Producers
The following letter was written by the head of a small oil producer in the Mid-West. Obama's proposed changes to oil and gas taxes will have perverse effects. These are not "windfall" profits taxes. Obama has instead proposed changes to the tax treatment of intangible drilling costs and percentage depletion. This is like, so, totally boring, that, like no one will, like, pay attention, right?
As usual, the devil's in the details. The changes will impact mom-and-pop producers operating the U.S.'s large number of "stripper" wells - those making a 5-10 barrels per day. The changes do not impact "Big Oil," only companies making less than 1,000 barrels per day.
Note: He and the letter below he reproduces are right that the percentage depletion change won't affect "Big Oil" but the intangible drilling cost change will, though it won't be significant for them. He's right overall that it will mostly be small and medium producers hurt most.
The practical impact of the changes will be to reduce the roughly 1,000,000 barrels per day the U.S. produces from these "stripper" wells, reducing U.S. oil production, ultimately leading to higher prices.
And more imported oil.
Somewhere, in a smoke-filled room, "Big Oil" is sitting back with a scotch and a cigar, smiling. Ironic, don't you think?
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The Obama budget proposal has directly targeted this country’s small independent oil and gas industry.
The Democratic campaign promises to levy a windfall profit tax on “major” oil producers has been abandoned and in its place major tax increases on small producers has been proposed. The repeal of the expensing of intangible drilling costs and percentage depletion are tax “preferences” only available to companies that produce less than 1000 barrels per day (bpd). To put it into context, Exxon Mobil produces about 4 million bpd, whereas our company produces 500 bpd.
Intangible drilling costs are those costs associated with drilling a well such as labor, contract services, crop damages, or other services that aren’t tangible material or supplies. Intangibles are anything you can’t drop on your foot. Tangible costs are pipe, pumping units, tanks, electrical panels, valves, fittings etc. . The ability to write off intangible costs stems from the fact that you cannot recover those costs by act of construction of the well. Should you build a factory building and buy any piece of equipment to place inside it, there are inherent intangible costs (labor) in that investment. However, you can largely recover (or salvage) the value of that investment less depreciation over the life of that facility. It is not so with an oil or gas well. The value of the well comes from the reserves it produces, on which we pay taxes. You cannot sell a hole in the ground. We write off the intangible cost services in the year of investment and depreciate the tangible costs as accounting rules dictate. This is the proper method in our opinion and has a logical foundation.
The write-off of intangible drilling costs raises the capital to take the extreme risks required in our business. Today, even with the extreme drilling density and tools like 3d seismic, only 60% of the wells drilled in Illinois, Indiana and Kentucky are productive. Four out of ten are dry holes. The vast majority of wells are development wells, inside known fields. It is likely that 1 in 7 or less wildcat wells are successful. The reason people are willing to invest in this high risk endeavor is that they are spending 60 cent dollars, they will be able to write-off the cost of the dry hole against their income. It is generally not prudent or practical to borrow money to drill wells. It is a difficult activity to fund. The company owners who engage in this activity do it the old antiquated way- they write a check.
The administration has obviously figured that this write-off is costing the government too much. Should we drill a $150,000 dry hole, we wrote it off and saved $60,000 on our taxes. Note that that entire $150,000 went directly into the local economy. However, if we were fortunate enough to make a well, we invested another $100,000 and brought in on production. Depending on the oil price, for our average well, the government take of that resulting revenue stream would be approximately equal to the risk-takers (us).
The IRS gains nothing if the well is not drilled. It will not be drilled if the intangible drilling deduction is repealed. They claim this will raise approximately $3 billion per year in revenues. It is miniscule given the recent multi-trillion dollar commitments. In an obvious symbolic gesture, the $3 billion will fund more alternative energy projects. The $3 billion a year is a static analysis. The risks that are not taken, the wells that are not drilled- that do not end up producing and pay the income taxes, will easily erase all the revenues they are “losing” under current tax law.
Percentage Depletion means that we get to write off 15% of our sales for every marginal well that makes less than 15 bpd, if our company makes less than 1000 bpd. It is a tax preference item. It was started during World War 1 in the hard rock mineral industry, as an incentive to explore. Consider that our primary asset is a depleting resource. If we do not replace that resource by drilling or developing, we are going out of business. Unlike the fixed factory that can produce indefinitely if maintained, our future is finite. Every royalty owner receives this deduction. They are farmers, and multi-generational heirs of farmers scattered throughout the country. In our operation alone, over 2000 people receive monthly royalty checks from the production on our properties. All of their taxes are increased under the proposed plan.
Should you look around the Tri-State, you will not find offices for Exxon, Shell, Conoco, or Chevron-Texaco. As recently as 30 years ago, they were all here. The percentage depletion is an incentive for small producers to continue producing the domestic stripper wells that supply 25% of this country’s oil production. Note that we while we must compete with 10,000 bpd flowing wells in Saudi Arabia, Iran, the North Sea, and the deepwater Gulf of Mexico, our average well pumps just 6 bpd. There was a time when this was considered vital to our national interests. We thought this economy ran on oil, and then we woke up one day to find it was running on clouds and rainbows.
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