Throughout the US presidential campaign, the now-President Barack Obama promoted an energy policy focused on boosting the growth of renewable power across the nation by decreasing dependency on imported energy.
To achieve this, the Obama administration has proposed the repeal (the removal or rehearsal of a law) of various tax incentives on the oil and gas industry. According to some estimates, these could cumulatively cause an additional cost of $31bn by 2019 to US oil and gas companies.
Among the key measures under the new budget proposal by the Obama administration that will have strong implications for the oil and gas industry is the elimination of tax breaks such as the intangible drilling and development costs, percentage depletion and manufacturing deduction.
It also includes an excise tax focused specifically on production in the Gulf of Mexico and the extension of the period of geological and geophysical amortisation [the process of increasing or accounting for an amount over a period of time]. Here we take a more extensive look at each measure of the proposal to fully comprehend its overall potential impact on the US oil and gas sector.
A taxing proposition for the Gulf of Mexico
There seems little doubt that the new excise tax on production in the Gulf of Mexico will have a negative impact on the oil companies operating in the region. It is primarily aimed at ensuring payments from deepwater leases issued in the 1990s – which originally provided royal waivers as a way of making development of resources in the region economical. However, these leases did not contain any clauses which would stop the incentive during high oil prices.
The proposed tax will therefore target those leases which contain royalty free production as the government believes the plan will allow for tax credits against the royalties paid. The budget proposes the new tax from 2011 and estimates that it could bring in $5.3bn by 2019.
However, concern has been raised by the US oil and gas industry, which believes that the timing of the taxes during low oil prices is repressive and would ultimately lead to lower revenues for oil and gas companies. It also believes this will lead to lower investment in the region, which could compromise future energy supplies.
The counterproductive nature of tax deductions and repeals
Elsewhere, the proposed budget aims to repeal the provision for manufacturing deduction on domestic manufacturing income for oil and gas companies. Such a provision was originally enacted in 2004 to encourage the development of US jobs and has provided capital for US-based independent producers to fund their investments in new production. The budget estimates that the repeal of the manufacturing deduction would bring in excess of $13bn of federal revenues by 2019.
Similarly, the budget proposes to eliminate the tax incentive on intangible drilling and development costs (IDC), which it estimates will raise about $3.4bn. This move would eliminate the ability of companies to write off certain business expenses as intangible drilling costs. IDC includes the costs incurred on recovering oil from the toughest areas of a reservoir.
With this in mind, some industry experts believe the elimination of IDC would affect the independent producers and reduce their ability to invest in new production.
A percentage depletion income tax deduction also features in the proposal, which could raise an estimated $8.2bn. All natural resources would be eligible for such a percentage depletion tax deduction and it would allow for the recovery of capital investment over a period of time – subject to various conditions.
One such condition is that the percentage depletion allowance may only be taken by independent producers and royalty owners and not by integrated oil companies.
Depletion also may only be claimed on specific daily domestic production levels of up to 1,000 barrels of oil or 6,000mcf of natural gas.
Another catch is that the deduction is limited to 65% of net taxable income while the net income limitation requires percentage depletion to be calculated on a property-by-property basis. In addition, it prohibits percentage depletion to the extent that it exceeds the net income from a particular property.
So while the percentage depletion tax deduction could provide capital for smaller independent companies, the repeal of the percentage depletion tax deduction will at the same time mainly affect the smaller independent companies – thus proving the measure counterproductive.
The effects of geological and geophysical amortisation
By extending the period of geological and geophysical amortisation for independent producers to seven years, the Obama administration hopes to raise about $1.1bn. With the introduction of 3D technology, the industry’s ability to locate and identify areas with the potential to produce commercial quantities of oil and natural gas as well as determine the optimal location of the exploration and development wells has significantly improved.
Compared to 2D technology, the newer technology offers geological and geophysical (G&G) surveys with enhanced finding rates, reduced environmental impact and more detailed information. Yet, such technological development comes at a cost – which some experts estimate to be around five to six times the cost of older technology.
With the Obama administration extending the period for G&G surveys to seven years – after it was only recently extended from a period of two years in 2005 – there are fears this would be a setback for the smaller producers; which could fail to see the incentive for investing in new exploration and production activity.
While the energy policy set out by the Obama administration clearly aims to rid the US economy of its current oil addiction through a sharp focus on renewable energy, many are questioning the timing of a proposed increase in taxes on oil and gas companies.
Overall, the industry and its experts seem to fear that the increase in taxes will put additional pressure on the cash flows of oil and gas companies, which will consequently lead to lower investments and an overall reduction in production.
In the long term this could even contradict the basic purpose of the Obama administration’s energy independence, as it could spark an increase in the US importation of oil and gas.
Equally as counter-productive is the possibility that an increase in revenue losses of smaller companies could lead to a greater level of consolidation in the US oil and gas industry – enforced by bankruptcies.
There is concern also that the change to renewable energy sources will not happen fast enough to offset the reduction of oil and gas production predicted for the next two to three years.
With the tax increases likely to strip the oil and gas companies of the much-needed capital required to weather the downturn in the economy, some have even gone as far as to question whether the Obama administration’s energy policy will mark the end of the US domestic oil and gas industry.