Shale Gas and the Severance Tax

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The U.S. hydrocarbon era began in 1859, when Colonel Edwin Drake (who wasn't really a colonel of anything) drilled the first successful oil well at Titusville, Pennsylvania.

What is happening these days in the state capital of Harrisburg may one day loom as a watershed moment of equal importance. This time, however, the subject is natural gas.

I was in Harrisburg Saturday to address the annual convention of the Pennsylvania AP Broadcasters Association, the statewide professional TV and radio organization. My topic was off-the-radar news stories about drilling in the Marcellus Shale – the unconventional shale gas basin emerging as likely to be a main new source of natural gas, especially in the energy-dependent Northeast.

The prospect of a major local source capable of fulfilling energy needs for the next couple of centuries was enthralling for the journalists in the room. But how to report on the developments as they accelerate over the next decade (and more) is becoming a daunting task, to say the least.

There are a number of major ongoing concerns, but one that is central to the entire basin expansion involves taxes. And it's this concern – and what happens next – that will inform the future of unconventional drilling around the world.

Battleground: Marcellus

This is all about whether the state is going to tax the production at the wellhead – that is, when the gas comes out of the ground.Usually called a "severance tax," the device or something acting like it is already used in every other state with significant gas production. But in Pennsylvania, it is becoming a battleground over a rising budget deficit.

The tax story is one of those stories that broadcasters throughout the state have been covering, because it pits recently-elected Governor Tom Corbett's campaign pledge (for no new taxes) against a state budget in desperate need of revenue. The incoming administration has already signaled its intention to cut expenditures. Hit so far are public university and public school block grants. Up next on the chopping block are healthcare and entitlement programs.

On the other side of the pro-drilling argument are those who suggest that not taxing the companies would provide enticements to drill, added employment, and tax revenues from the traditional levies on profits and permits. In fact, the move to provide tax cuts and incentives to prompt additional drilling is already a subject of political contests in other states (see "The 'Oil Battle' in Alaska is Spreading," April 4).

Those opposed to a severance tax point to an American Petroleum Institute (API) study released last summer indicating $24 billion added to the state economy, along with 280,000 jobs and $6 billion in revenues through 2020. Yet those figures have themselves been a matter of some dispute. For example, my graduate students at Duquesne have concluded the data used in the study cannot be replicated to be verified.

But even if there is a tangible positive result from the drilling (and environmental concerns can be satisfied), other problems loom large.

Budget Cuts, Revenue Shortfalls

There are currently some 1,650 wells drilled in the state, with as many as 120,000 coming before the rush is over, sometime next decade. That means some fundamental questions need answering before the development curve spikes.

Without additional revenue, the Department of Environmental Protection, the Pennsylvania office that issues the licensing permits, will have a hard time putting enough inspectors in the field to meet the avalanche of new drilling on its way. This is a big problem, given the budget cuts resulting from the state deficit.

Other departments face similar additional expenses resulting from drilling and are under the same constraints. These include wildlife and fisheries, timber, rivers and streams, parklands, and conservation services.

Funding the additional expenses in these categories will be hard enough without a severance tax (which is why all other states have one). However, that's not the only difficulty here.

I think a major issue is being ignored – not just in Pennsylvania, but elsewhere in the U.S. and Canada, where unconventional gas and oil drilling are revving up.

This is not about the normal budgetary debate between the spenders and the cutters; it's s about the impacts of a game-changing energy play in ways people aren't even talking about yet.

Local Adverse Economic Indicators Are Mounting

We have indications in Pennsylvania that significant rises are forming in what I call "local adverse economic indicators," which involve the following, just for starters:

  • Damage to local infrastructure (especially roads).
  • Additional demands on local services resulting from labor mobility (schools, assistance programs, hospitals, police, and fire).
  • Decline in property values from contiguous drilling.
  • Localized inflation (already seen in housing and dual-usage equipment/supplies).
  • Imbalances in local sector employment patterns.
  • Water supply problems (hydrofracking for shale gas requires large volumes of water, putting it in competition with agricultural, industrial, municipal, and recreational uses).

Now, any primary revision in an economy will cause ancillary negatives. In this case, those negatives will primarily hit the communities in which drilling takes place. Despite the companies spending more in those communities, prior experience in Texas and Arkansas indicates that these negative effects will hang on long after the drilling money stops.

This is what Harrisburg must understand, and why what is happening in Pennsylvania will be an important lesson for other U.S., Canadian, and foreign locations where shale gas production is intensifying. Unless there is a genuine way to balance the increasing local problems with sources of revenue to meet them, you end up with an unfunded mandate – the state sets down policy, but the localities have to figure out how to pay for it.

It would be the cruelest of ironies if the shale gas opportunity was lost. Yet it may well come down to that, because behind the debate on the severance tax lies a fundamental concern over something else: The quality of life of the people who were there before the drilling started, and who will be there long after it ends.

Disclosure: None

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