Consequences of a Tax Hike for Oil and Gas Companies

Includes: OIL, UNG, USO
by: Bill Francis
I want to look at what kind of consequences the oil and gas industry might have to look forward to as the President and Congress both have moved forward with bills that would remove certain accounting deductions directed at the industry. Around $2 billion of the $3-4 billion (0.0026% of 2011 deficit) in annual revenue the federal government will generate from eliminating the current tax deductions comes from just two provisions out of the eight targeted. One is referred to as Intangible Drilling Costs (IDC) and the other is called the Domestic Production Activities Deduction or Series 199.
Intangible Drilling Cost
The IDC provision has been in our country’s tax code and promoted companies reinvesting into domestic energy production since 1913. To this day, the IDC deduction is still doing what its original authors had intended, and that is to incentivize our domestic companies to produce more oil and gas. This of course makes prices cheaper than if the provision had not been in place. When drilling a regular O&G well, usually 60-80% of the expenses are deemed IDC and are able to be deducted in the year that they are incurred. IDC are those expenses related to drilling a well that cannot be recovered, such as labor, drilling mud, and contracted services. Expenses involving the extraction of goods are deducted in almost every other industry, and are generally viewed upon by industry insiders as a research and development expense as the words "research and exploration" are synonymous and just as risky of investments.
100% of R&D expenses are usually deducted from companies in sectors such as pharmaceuticals and computer technology. American O&G companies utilize it in order to further their risky investments in research and development of the underlying geology of our country. Stating otherwise would prove that you lack understanding of the scientific breadth and technological know how that our O&G industry uses and experiments with in the field every day.
Domestic Production Activities Deduction (Series 199)
The Series 199 is a completely different accounting incentive enacted by Congress in 2004. The Series 199 is directed at any domestic tax payer engaged in the production or manufacturing of goods. This was not some loophole designed by the heads of oil and gas companies, but a leveling of the playing field for America’s industrial complex to compete with foreign manufacturers. This was due to the fact that the US already has the highest corporate tax rate in the developed world, and is driving our domestic businesses to overseas tax shelters (see Transocean (NYSE:RIG)). When enacted in 2004, it stated that all income resulting from the production of goods or materials should receive a 3% deduction. This would then rise to 9% in 2010. However, the oil and gas industry deduction rate was singled out and capped at 6% instead of the 9% deduction that everyone else got to enjoy.
After looking at the potential outcomes from raising the taxes on just oil and gas companies, I’ve concluded that Washington’s actions will end up causing the following consequences:
  1. Repealing the tax deductions would lower domestic oil production and move gasoline prices higher than what they’d be if the deductions were not in place.
  2. Repealing the tax deduction would blatantly misinform the public about the disadvantageous operating environment O&G companies already work in.
  3. Repealing the tax deductions will deter natural gas exploration and production exponentially more than oil, even at a time when an equivalent amount of natural gas is five times cheaper and 1/3 cleaner.
  4. Repealing the tax deductions will disproportionately affect small businesses (the median independent producer employs 11 people) who make up the majority of the industry and will provide most of the job growth.
First Consequence
Whenever you raise taxes on a business, that means it will have less capital to put to use in future investments. With less capital to spend on replenishing a company’s production, the company will clearly not be able to spend as much on infrastructure and exploratory and development wells directed at O&G. The fewer wells and amount of capital deployed ultimately leads to the conclusion that the future level of O&G produced domestically will be lower than if the tax hikes were not in affect. With less supply and capacity in the market, one only has to go to one's high school economics textbook to determine that gasoline prices will remain at levels above that in which the industry’s taxes were left alone.
The argument that we should go after the companies that are scrambling to bring more supply onto the market is absurd. If we let market forces play out and not meddle in private industries' conduct, they will contract more rigs to drill more oil, build more horsepower to complete more productive horizontal wells, and expand the oil shale development, which has lagged behind the natural gas shale development by at least three years. Killing these deductions will also kill jobs and raise, not lower, gasoline prices.
Second Consequence
Large integrated oil companies that made big headlines with “windfall profits” this earnings season have politicians naively advocating that O&G companies should be paying their fair share in taxes. However, this is already the case. One only needs to look at how the industry compares with its peers in other sectors to see that it's more than paying its fair share in taxes.
The O&G industry’s profits are being taxed an extra 20 percentage points on every dollar of profit it makes than the average American manufacturer. If you take away the Series 199, then it's paying twice the income tax rate of the S&P 500 average. While almost half of what the O&G companies earn is taken from them by Washington, the top five American financial companies (JPMorgan (NYSE:JPM), Wells Fargo (NYSE:WFC), Citi (NYSE:C), Bank of America (NYSE:BAC), and Goldman (NYSE:GS)), who were the primary cause of the biggest wealth destruction scheme in American history, are only paying on average 29.26%.
One might then want to compare tax rates with other energy companies. The top five profitable American coal companies based on market cap (Peabody (NYSE:BTU), Consol (NYSE:CNX), Walter (NYSE:WLT), Alpha (ANR), and Arch (NYSE:ACI)) are taxed at a rate of less than 2/5 of what O&G companies will be charged without the Series 199. This at a time when the coal industry has the largest carbon and environmental footprint of any of the fossil fuels and is actually more expensive than natural gas on an equivalency basis.
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Another good measure of comparison between sectors is the amount of profit a company makes for every dollar it brings in, or its profit margin. As you can see below, O&G companies are nowhere near being one of the top business sectors where it is the easiest to make money. Repealing these tax code provisions would only lower the Big Five oil companies’ (ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), ConocoPhillips (NYSE:COP), Marathon (NYSE:MRO), and Occidental (NYSE:OXY)) margins, and hurt investors like the American retirement system, which through Pension Funds, IRAs and mutual funds own over 70% of Big Oil according to Energy Tomorrow.
I would say these two metrics are probably the best for determining if a company or sector should be taxed more or less, and clearly O&G companies are paying a much larger proportion of taxes on harder to generate profits than most everyone else out there.
Third Consequence
According to a Wood Mackenzie study, taking away the IDC and Section 199 deductions would make 88 out of the 230 (38%) fields that currently produce or contain reserves of O&G uneconomic to explore and develop. The report goes on to state that out of the 88 fields that will probably not receive investment, 90% of the fields are those directed at producing natural gas. This just as the President is openly admitting that we should be developing these huge natural gas shales, not oil reserves. Natural gas is the cheapest, cleanest, and most efficient fossil fuel by everyone’s measure. Yet he now wants to enact legislation that will actually encourage limiting the development of natural gas, while the oil producers get a slap on the wrist.
Wood Mackenzie predicts 5% of future natural gas production is to be lost in just the first year the IDC is repealed, as opposed to only 1% of oil production. These deductions in their current form are incentivizing the production of the cleaner resource over the dirtier one. The fact is that at a time when natural gas prices are low, repealing incentives on O&G companies removes the investment from the marginal wells, which are almost all natural gas right now. The President needs to realize that natural gas and oil can no longer be piled into the same punching bag. They are significantly different products that are currently priced different, burned by dissimilar consumers, and resulting in variant outputs (CO2).
Fourth Consequence
The Obama administration is proclaiming this new legislation will curb “subsidies” for the Big Five oil companies and prevent them from making obscene profits at the expense of Main Street. However, the IDC overwhelmingly helps smaller companies more than the integrated majors. Even informed people in favor of these measures like Jerry Taylor and Peter Van Doren of Forbes openly admitted this fact in their piece on May 3. Independent producers drill 90% of American wells and in the past have put as much as 150% of their cash flow back into American O&G plays, according to John S. Herold Inc. analysis. The sheer nature of reserve declines will not allow any O&G CEO to sit on capital for an extended period of time, like our financial institutions did with the carry trade once they were bailed out.
Small companies have a smaller reserve base and therefore have to drill feverishly to replenish last year’s production. The smaller the company, usually the higher the percentage last year’s production depleted your overall reserves. Small companies don’t just hit big wells and sit back and collect dividends. Once they hit those wells, the pressure they are under to go out and produce more just multiplies, as does the capital they invest in new production and jobs. So companies that are producing and will have to replace a high percentage of volume compared to their reserves (10% or higher) and whose reserves are made up almost solely of natural gas will be the ones taking the biggest hit. Prime examples would be well-run small- and mid-cap companies like PetroQuest Energy (NYSE:PQ), Comstock Resources (NYSE:CRK) Rosetta Resources (NASDAQ:ROSE) and Bill Barrett Corp (BBG).
Drilling extremely expensive and risky wells like those offshore in the Gulf of Mexico will also be hit disproportionately hard by these measures, as half of those wells turn out to be dry holes. Good companies like McMoRan Exploration (NYSE:MMR), which spend a large chunk of their capital on a smaller amount of very expensive wells that they might have to write off over a long period of time when no revenue is generated, could slow exploration significantly.
The integrated majors currently do not benefit as much from deducting their IDC as their smaller counterparts. For instance, they are only allowed to count 70% of the expense in the year it occurred, as opposed to the smaller independent producers, who are able to expense the full amount. Smaller companies are also able to benefit more from the current tax code by the sheer fact that their main purpose is to grow.
So while the Big Five will distribute cash through dividends, you will rarely see a small company give up any significant portion of that precious cash saved from taxation to its investors. Rather, you will see them leverage that money into investments for future production growth. So while the integrated majors are contempt to sit back and just replace its reserves that were lost to production that year, you will see the smaller guys attempting to grow as fast as possible, usually by exploring new, riskier plays.
According to Wood Mackenzie, we risk losing 58,800 jobs the year the federal government repeals the IDC deductions, most of which will come from small business canceling plans to expand their drilling schedules.
We need to realize that the small independent producers are the ones that are willing to go out and attempt to innovate with new techniques, ideas and equipment in the field. They were the ones who unlocked the secret to producing oil and natural gas from shales through technological breakthroughs. It was not Chevron or Exxon drilling in the Barnett shale for decades before they finally figured out the code to produce shale gas. It was a small company called Mitchell Energy (acquired by Devon (NYSE:DVN) in 2001) that would tinker in its lab (Natural Gas Rig) with each new well it drilled for 18 years until it had the field mastered and had sparked what is clearly the biggest and most widespread land rush in O&G history. I am willing to bet that George Mitchell wouldn’t have gone near experimenting with those subpar wells if he couldn’t expense his IDC, as most of them weren’t economic to begin with.
A mere $3 billion a year is half of what we spend to subsidize the unpopular ethanol industry, but pales in comparison to the amount our independent O&G companies would not be able to invest, which some are conservatively claiming to be $12 billion in lost domestic capital expenditures. Without even tinkering with the Laffer Curve argument, these tax hikes will almost surely have consequences that will be felt by investors in future production guidance, consumers at the pump, and the government in future rents, royalties, and state severance tax payments.
Disclosure: I am long COP.