Oil Industry Tax Issues in the FY2010 Budget Proposal

Oil Industry Tax Issues in the

FY2010 Budget Proposal

name redacted

Specialist in Energy Economics

July 30, 2009

Congressional Research Service

7-....

www.crs.gov

R40715

CRS Report for Congress

Prepared for Members and Committees of Congress

Oil Industry Tax Issues in the FY2010 Budget Proposal

Summary

President Obama, in an Earth Day speech, addressed the linkage between the problems he

associated with U.S. reliance on imported oil and the importance of a future based more on

alternative energy sources. These problems could be partially addressed by reducing what the

Administration sees as favorable treatment of the oil and natural gas industries that were designed

to increase production of petroleum products.

The FY2010 budget proposal outlined a set of proposals, framed in terms of deficit reduction, or

the elimination of tax expenditures, that would potentially increase the taxes of the oil and natural

gas industries, especially the independent producers. These proposals included an excise tax on

Gulf of Mexico oil and natural gas production to limit previously granted royalty relief, repeal of

the enhanced oil recovery and marginal well tax credits, repeal of the expensing of intangible

drilling costs and the deduction for tertiary injectants, repeal of passive loss exceptions for

working interests in oil and natural gas properties, and the manufacturing tax deduction for oil

and natural gas companies, and the increasing amortization periods for certain expenses and the

repeal of the percentage depletion allowance for independent oil and natural gas producers.

It was estimated that these changes would provide $12.7 billion categorized by the Administration

as deficit reduction over the period 2010 to 2014. The changes, if enacted, also would reduce the

tax advantage enjoyed by independent oil and natural gas producers over the major integrated oil

companies. On what will likely be a small scale, the proposals also will make oil and natural gas

more expensive for U.S. consumers, with the effect of reducing consumption of those fuels.

Congressional Research Service

Oil Industry Tax Issues in the FY2010 Budget Proposal

Contents

Background ................................................................................................................................1

The Fiscal 2010 Budget Proposal ................................................................................................1

Excise Tax on Gulf of Mexico Oil and Gas............................................................................3

Repeal Enhanced Oil Recovery Credit...................................................................................3

Repeal Expensing of Intangible Drilling Costs ......................................................................4

Repeal Deduction for Tertiary Injectants................................................................................4

Repeal Marginal Well Tax Credit...........................................................................................5

Repeal Passive Loss Exception for Working Interests in Oil Properties ..................................5

Repeal Manufacturing Tax Deduction ...................................................................................5

Repeal Percentage Depletion Allowance................................................................................6

Increase Geological and Geophysical Amortization Period ....................................................6

Conclusion..................................................................................................................................7

Tables

Table 1. FY2010 Budget: Oil Industry Tax Proposals ..................................................................2

Contacts

Author Contact Information ........................................................................................................7

Congressional Research Service

Oil Industry Tax Issues in the FY2010 Budget Proposal

Background

In an Earth Day speech, President Obama linked the importance of winning the technological

race to develop clean energy sources with the economic problems associated with U.S.

dependence on oil. The President said that the federal deficit, the trade deficit, as well as global

warming, were all related to U.S. dependence on oil, especially imported oil. He also described a

fickle attitude held by American consumers, who typically are outraged by high gasoline prices or

shortages, while displaying apathy toward the issue of oil prices during periods of low prices. 1

In a market economy, the government can alter the behavior of consumers and producers through

tax and subsidy policies. If the government wants to discourage the consumption of a commodity,

it can raise the cost of the good to consumers by levying taxes at various stages of the production

process, or by levying a tax at the point of sale. Typically, the higher cost faced by the consumer

will lead to reduced consumption. If the government chooses to encourage the development of a

technology or a good, it can lower private costs through various types of subsidy, which may then

benefit consumers in the form of lower prices.

Given the President’s position, as reflected in his Earth Day speech, his FY2010 budget proposal

includes both subsidies for alternative energy sources and increased taxes on the oil industry. This

report analyzes the likely economic effects that might occur if the President’s proposed tax

increases on the oil industry are enacted by Congress.

During most of the 20th century the oil industry received favorable tax treatment in comparison

with other U.S. industries through tax provisions such as the percentage depletion allowance and

the expensing of intangible drilling expenses. Favorable tax treatment helped to keep petroleum

product costs low, and encouraged consumption. Low gasoline prices were a factor in both

residential and business location decisions, holiday travel, and other aspects of American life.

These decisions represent economic investments which might no longer be viable if the relative

price of gasoline and oil increase. For example, when the price of gasoline rose to more than $4

per gallon, based on oil prices that rose to over $145 per barrel, during the second half of 2008,

consumers shifted their spending away from sport utility vehicles and light trucks toward more

fuel efficient vehicles, reducing the sales and profitability of the U.S. automobile industry, and

accelerating the collapse of the industry. Shifting the energy consumption pattern from oil to

alternative fuels is unlikely to occur without adjustment costs to consumers and U.S. industry.

The Fiscal 2010 Budget Proposal

Under the pressure of an economic recession that began at the end of 2007 and continues in 2009,

a financial crisis which has required support of the banking system and financial markets, and the

costs of new policy initiatives in healthcare, carbon emissions, and other areas, the level of

projected federal deficit is a matter of concern.

The desire to shift the nation away from oil, and to try to control the federal deficit, has led to a

number of proposals to increase taxes on the oil industry. Many of these proposals represent the

1

Oil Daily, “Obama Says U.S. Must Win Clean Energy Race,” Vol. 59, No. 77, April 23, 2009.

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Oil Industry Tax Issues in the FY2010 Budget Proposal

elimination of tax expenditures.2 Table 1 identifies the proposed tax changes for the oil industry,

and the White House’s estimates of the revenues, or in its terms, deficit reduction, generated to

2014, if enacted by Congress. Many of these measures have the effect of equalizing the treatment

of the independent oil producers to that of the major oil companies. This equalization is

accomplished through eliminating preferential tax treatment of the independent companies

compared to that of the major oil companies. In some cases, for example, the expensing of

intangible drilling expenses, the major oil companies have been excluded from the benefits of the

tax provision while the benefit was still in effect for the independent oil producers.

Table 1. FY2010 Budget: Oil Industry Tax Proposals

(revenues in millions of dollars)

Total,

2010-2014

2010

2011

Excise Tax on Gulf of Mexico Oil and Gas

-

582

2,273

Repeal Enhanced Oil Recovery Credit

-

-

-

Repeal Expensing of Intangible Drilling Costs

-

347

1,863

Repeal Deduction for Tertiary Injectants

-

5

31

Repeal Marginal Well Tax Credit

-

-

-

Repeal Passive Loss Exception for Working Interests

in Oil Properties

-

2

19

Repeal Manufacturing Tax Deduction for Oil and

Natural Gas Companies

-

757

4,924

Repeal Percentage Depletion for Oil and Natural Gas

-

316

2,953

Increase Geological and Geophysical Amortization

Period for Independent Producers to Seven Years

-

41

668

Total

-

2,250

12,731

Source: Table S-6, A New Era of Responsibility, available at http://www.whitehouse.gov/omb.

Notes: (-) means program will have no effect.

As shown in Table 1, none of the proposed revenue changes are estimated to have a significant

effect in 2010. Almost 80% of the total proposed tax changes would come from only three of the

proposals. These three proposals are likely to increase total taxes on the oil industry: an excise tax

on Gulf of Mexico oil and natural gas production, the rescinding of the manufacturing tax

deduction for the oil industry, and the repeal of percentage depletion.

2

Tax expenditures are the losses to the U.S. Treasury as a result of granting deductions, exemptions, or tax credits to

specific categories of taxpayers. For additional analysis of energy tax expenditures, see United States Senate,

Committee on the Budget, Tax Expenditures, Compendium of Background Material on Individual Provisions,

December 2008, pp. 97-228. Available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=

110_cong_senate_committee_prints&docid=f:45728.pdf.

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Oil Industry Tax Issues in the FY2010 Budget Proposal

Excise Tax on Gulf of Mexico Oil and Gas

Oil and gas producers operating in federal waters in the Gulf of Mexico pay up to a 16.67%

royalty on revenue from existing production. New production, defined as production after March

2008, is subject to an 18.75% royalty rate. However, a program to encourage deep water drilling

allowed a zero royalty rate until a set level of production was attained. This production, which is

currently not paying any royalty, is what would be subject to the new royalty provisions of the

2010 budget. The new rate is not, then, a new excise tax on Gulf production, but could be

considered as the reversal of an earlier tax expenditure. 3

Under normal economic circumstances, an excise tax on the production of a good is likely to

reduce its production level and increase its price. However, the production of oil and natural gas

might not be goods subject to normal economic circumstances. The price of oil is determined on a

world market and over the past five years has generally been sufficiently high to cover even the

costs of relatively high cost producers. During the period from 2004 through 2009, prices have at

times reached record levels, resulting in record setting profits for the oil industry. Under these

circumstances, it is unlikely that the excise tax, especially one that “leveled the playing field”

between various Gulf producers, would result in higher consumer prices for petroleum products

or curtail output because the independent oil producers are not likely to have the market power to

pass the excise tax on to consumers.

While it is likely true that the existing exclusion from royalty payments may have acted as an

incentive for encouraging exploration and development, it does not necessarily follow that the

incentive should be left in place to keep the wells producing. As long as producing wells are

covering costs, it is likely that they will be kept in production with little or no reduction in output.

It might also be argued that the imposition of the excise tax reduces the incentive to invest and

expand domestic production in the affected exploration areas. However, this is unlikely to happen

unless the companies have alternative investment opportunities available in other areas that offer

lower government taxes and lower costs. A recent study by the Government Accountability Office

found that the total government take in the U.S. was low compared to what oil companies must

pay to other nations in production royalties and taxes.4 The implication is that even if effective

repeal of the royalty exclusion through the imposition of an excise tax might be a disincentive to

continued exploration and development, the oil companies might have a difficult time finding

better alternatives, yielding little change in investment activity.

Repeal Enhanced Oil Recovery Credit5

The enhanced oil recovery tax credit allows for a credit of 15% of allowable costs associated with

the use of oil recovery technologies, including the injection of carbon dioxide to supplement

natural well pressure, that enhance production of older wells. The credit is only available during

periods of low oil prices, determined by yearly guidance with respect to what constitutes a low

3

An excise tax is a tax levied on a specific product.

United States Government Accountability Office, Oil and Gas Royalties: A Comparison of the Share of Revenue

Received from Oil and Gas Production by the Federal Government and Other Resource Owners, GAO-07676R, May

1, 2007, p. 4. “Government take” refers to the total of taxes, royalties, fees, and other instruments used around the

world by nations to claim a portion of oil revenues generated by their domestic production from oil companies.

5

Tax credits are direct dollar-for-dollar offsets to the companies’ tax liability.

4

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price. The credit has not been in effect over the past several years. Elimination of this credit

would likely not have any effect on current oil supplies, unless the price of oil fell. Prices

generally fall in a market characterized by excess supply. During periods of excess supply, it is

unlikely that keeping older, high cost, low production rate wells producing is the optimal strategy,

based on the likely inability of the price of oil to cover the costs associated with operating these

wells.

Repeal Expensing of Intangible Drilling Costs

The expensing of intangible drilling costs has been part of the federal tax code since 1913.

Intangible drilling costs generally include cost items that have no salvage value, but are necessary

for the drilling of exploratory wells or the development of wells for production. The purpose of

allowing current year expensing of these costs is to attract capital into what has historically been a

highly risky investment. In recent years, however, the risk associated with finding oil has been

reduced, but not eliminated, by technology, including three-dimensional seismic analysis and

advanced horizontal drilling techniques. These advances make expensive “dry holes” less likely,

and expand the physical range of exploration and production available from drilling rigs, reducing

the cost of exploration of prospective oil fields.

Currently, the full expensing of intangible drilling expense provision is only available to

independent oil producers. According to White House estimates, elimination of this tax provision

is expected to contribute more than $1.8 billion in deficit reduction over the period 2010 to 2014,

and approximately $3 billion by 2019. The Independent Petroleum Association of America

(IPAA) estimates that revoking the expensing of intangible drilling costs provision might reduce

investment in U.S. oil development by about $3 billion in the future.6 The IPAA estimate of

reduced oil development appears to be based on an assumed dollar for dollar decline in

investment activity for every extra dollar of tax paid, with no empirical evidence to support this

assumption.

The actual decline in oil resource development as a result of eliminating this tax preference is

likely to depend on the price of oil. If the price of oil settles in the $40 per barrel range that

prevailed in December of 2008, the burden of additional tax expense could reduce drilling

activity. The combination of low price and additional taxes might not justify the development of

relatively high cost resources, especially in deep waters, as in the Gulf of Mexico. However, if the

price of oil exceeds $100 per barrel, as prevailed during the summer of 2008, the additional tax

expense is likely to have a smaller effect in reducing oil development activity.

Repeal Deduction for Tertiary Injectants

Tertiary injection expenses, including the injectant cost, can be deducted in the current tax year.

Supporters of the current favorable treatment of these expenses point to the importance of tertiary

recovery in maintaining the output of older wells, as well as the environmental advantages of

injecting carbon dioxide, a primary tertiary injectant, into wells. Repeal of the deduction or less

favorable tax treatment of the expenses would be likely to reduce output if the profit margin on

6

Independent Petroleum Association of America, New Natural Gas and Oil Taxes Would Crush America’s Clean

Energy and Energy Security, available at http://www.ipaa.org/news/docs/ObamasNewtaxes2009.pdf.

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Oil Industry Tax Issues in the FY2010 Budget Proposal

oil were low. In a high oil price environment, the repeal is likely to have a smaller effect on

production levels.

Repeal Marginal Well Tax Credit

The marginal well tax credit was implemented as the result of a recommendation by the National

Petroleum Council in 1994 to keep low production oil and natural gas wells in production during

periods of low prices for these fuels. This tax credit is designed to maximize U.S. production

levels even when volatile energy markets result in low prices. It is believed that up to 20% of

U.S. oil production, and 12% of natural gas production, is sourced from this category of well. The

credit was enacted in 2004, but has not been necessary because market prices have been high

enough since that time to justify production without the credit. The credit is not likely to be an

important factor if prices remain high, or if the United States is successful in transitioning to

alternative energy sources. The high cost wells that fall into the marginal well category are likely

to be some of the first to be eliminated on economic efficiency grounds if enhanced use of

alternative energy sources leads to a reduction in petroleum demand.

Repeal Passive Loss Exception for Working Interests in

Oil Properties

Repeal of the passive loss exception for working interests in oil and natural gas properties is a

relatively small item in terms of revenue contribution—$19 million from 2010 to 2014. The

provision exempts working interests in gas and oil exploration and development from being

categorized as “passive income (or loss)” with respect to the Tax Reform Act of 1986. This

categorization permits the deduction of losses in oil and gas projects against other active income

earned, which would not be permitted if the income (or loss) were considered to be passive. The

current provision is believed to act as an incentive to induce investors to finance oil and gas

projects, because losses incurred in oil exploration can be used as an offset against profits earned

in other investment activities.7

Repeal Manufacturing Tax Deduction

The most significant item in the proposed budget in terms of oil and natural gas industry tax

liabilities is the repeal of the manufacturing tax deduction. As shown in Table 1, the White House

estimates that repeal of this deduction would contribute approximately $4.9 billion in tax revenue

for the period 2010 to 2014. The total estimate might increase to $13 billion by 2019, according

to the Administration. This provision was enacted in 2004 as part of the American Jobs Creation

Act to encourage the expansion of American employment in manufacturing. The oil industry was

categorized as a manufacturing industry, and hence, eligible for the deduction, which was to be

phased in over several years, beginning at 3% in 2005 and rising to a maximum of 9% in 2010.

The base of the tax is net income from domestic manufacturing activities, capped by a company

payroll limitation.

7

See CRS Report RL30406, Energy Tax Policy: An Economic Analysis, by (name redacted), for a discussion of how

tax subsidy provisions for the oil and natural gas industries cause non-neutrality in the tax system.

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This tax deduction was intended to increase domestic employment in manufacturing at a time

when there was concern that manufacturing jobs were migrating overseas. By allowing a percent

deduction of net income, up to the payroll limitation, the effective cost of labor to the

manufacturer was reduced. The reduction in net labor cost was intended to expand employment,

increase output, and reduce prices, making domestic manufactured goods more competitive in the

world market.

Although the oil and natural gas industries are classified as manufacturing industries for national

data reporting purposes, they differ from traditional factory manufacturing in a number of ways.

Most importantly, the level of oil production is only indirectly related to the level of employment.

This implies that if wage costs go down, due to the tax deduction, there is less chance that the

industry will increase employment. Even if employment did increase, it would be expected to be

of a minor magnitude due to the capital intensive nature of the industry. The Bureau of Labor

Statistics reports that oil and natural gas extraction employed approximately 165,000 workers in

2009, of which fewer than 100,000 were classified as production workers.

The period since 2004, while difficult for American manufacturing as a whole, has been one of

record profit levels in the oil industry. The high price for oil prevailing since 2004 that has led to

record profit levels, is the critical factor in oil investment. Oil exploration tends to increase when

prices are expected to remain high, and decrease in times of falling prices. The variability in

actual and expected oil prices is likely to be a more important factor in determining capital

investment budgets in the oil industry than the elimination of a tax that is capped by a relatively

low wage bill.

Repeal Percentage Depletion Allowance

Percentage depletion is the practice of deducting from an oil company’s gross income a

percentage value, in the current law 15%, which represents, for accounting and tax purposes, the

total value of the oil deposit that was extracted in the tax year. Percentage depletion has a long

history in the tax treatment of the oil industry, dating back to 1926. The purpose of the percentage

depletion allowance is to provide an analog to depreciation for the oil industry, in effect, equating

oil deposits to capital equipment in more traditional manufacturing industries. In its current form,

the allowance is limited to American production, by independent producers, on the first 1,000

barrels per day of production, and is limited to 65% of the producer’s net income.

Percentage depletion was eliminated for the major oil companies in 1975. Although major oil

companies’ profits were likely affected by the tax change, their production of oil showed little

variation. Production of oil within the United States remains attractive for companies because

ownership of the oil is allowed in this country. In most areas of the world, ownership is vested in

the national oil company, as a proxy for the state. The result is a lower share of revenues for

companies producing outside the United States. The Administration projects that repeal of the

percentage depletion allowance would yield approximately $2.9 billion in deficit reduction over

the period 2010 to 2014, and more than $8 billion by 2019.

Increase Geological and Geophysical Amortization Period

Geological and geophysical expenses are necessarily incurred during the process of oil and

natural gas resource development. The most favorable tax treatment of these costs is to allow

them to be deducted in the year they are incurred. Requiring these costs to be amortized, or

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Oil Industry Tax Issues in the FY2010 Budget Proposal

spread out, over several years is less favorable. The longer the amortization period, the less

favorable the tax treatment, because a smaller amount is deducted in each year, and it requires

several years to recover the entire cost. As a result, it is possible that the cost of capital may be

increased, and the level of investment reduced.

Currently, the major integrated oil companies amortize geological and geophysical costs over a

period of seven years. In the Obama budget proposal, independent producers that benefit from a

shorter amortization period would have their amortization period extended to seven years,

equalizing treatment with the integrated oil companies. The extended amortization period for

independent producers is projected by the Administration to contribute almost $1.2 billion in

deficit reduction over the period 2010 to 2019. The IPAA estimates that independent producers

would likely reduce exploration and development activities on a one-to-one dollar basis as a

result of lengthening the amortization period. However, it seems unlikely that oil producers would

reduce exploration investment to this extent if the spread of market price over full cost of

exploration and development remains strong, as it generally has been in the period of high oil

prices since 2004. Additionally, if prices decline to a level near the cost of exploration and

development, investment is likely to be curtailed even with more favorable tax treatment of

geological and geophysical expenses. If the industry were experiencing a time of stagnant oil

prices that were near the cost of production, relatively small changes in tax expense might affect

investment and production activities. However, in a time of high and volatile oil prices, small

changes in tax expense are overshadowed by price variations.

Conclusion

On the one hand, the deficit reduction proposed items in Table 1 can be considered to be effective

tax increases on the oil and natural gas industries that could have the effect of decreasing

exploration, development, and production while increasing prices and increasing our foreign oil

dependence. These same proposals, from an alternate point of view, can also be considered to be

the elimination of tax preferences that have favored the oil and natural gas industries over other

energy sources, and made oil and gas products artificially inexpensive, with consumer costs held

below true cost of consumption, when the costs associated with climate change and energy

dependence, among other effects, are included.

Whichever view is adopted, the real effects of these proposals on oil production, consumption,

and imports are likely to be small relative to both the federal deficit and the revenues of the oil

industry.

Author Contact Information

(name redacted)

Specialist in Energy Economics

/redacted/@crs.loc.gov, 7-....

Congressional Research Service

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