Oil Industry Tax Issues in the FY2011 Budget Proposal

Oil Industry Tax Issues in the

FY2011 Budget Proposal

name redacted

Specialist in Energy Economics

March 24, 2010

Congressional Research Service

7-....

www.crs.gov

R41139

CRS Report for Congress

Prepared for Members and Committees of Congress

Oil Industry Tax Issues in the FY2011 Budget Proposal

Summary

President Obama, in a speech on April 22, 2009 (Earth Day), addressed the linkage between the

problems he associated with U.S. reliance on oil, especially imported oil, and the importance of a

future based more on alternative energy sources. To move in the direction of accomplishing these

goals, the Administration, in the FY2011 budget proposal, proposes that certain tax expenditures

designed to increase domestic production of oil and natural gas be revised, thus reducing what the

Administration sees as favorable treatment of the oil and natural gas industries.

The FY2011 budget proposal outlined a set of proposals, framed in terms of deficit reduction, or

termination of tax preferences, that would potentially increase the taxes of the oil and natural gas

industries, especially the independent producers. These proposals included repeal of the enhanced

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

repeal of the deduction for tertiary injectants, repeal of passive loss exceptions for working

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

and natural gas companies, increase of the amortization periods for certain expenses, and repeal

of the percentage depletion allowance for independent oil and natural gas producers. In addition,

a variety of inspection fee increases and a per-acre fee on unused leases were proposed to

generate revenue for the Department of the Interior (DOI).

The Administration estimates that the tax changes would provide $18.2 billion in deficit

reduction, or new revenues, over the period 2011 to 2015. 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 would likely be a small scale, the proposals also would make

oil and natural gas more expensive for U.S. consumers, likely achieving the intended effect of

reducing consumption of those fuels.

This report will be updated as events warrant.

Congressional Research Service

Oil Industry Tax Issues in the FY2011 Budget Proposal

Contents

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

The FY2011 Budget Proposal .......................................................................................................... 2

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

Repeal Deduction for Tertiary Injectants ................................................................................... 3

Repeal Marginal Well Tax Credit .............................................................................................. 3

Repeal Passive Loss Exception for Working Interests in Oil Properties ................................... 4

Repeal Manufacturing Tax Deduction ....................................................................................... 4

Increase Geological and Geophysical Amortization Period ...................................................... 5

Repeal Percentage Depletion Allowance ................................................................................... 5

Department of the Interior Budget ................................................................................................... 6

Conclusion ....................................................................................................................................... 6

Tables

Table 1. FY2011 Oil Industry Tax Changes..................................................................................... 2

Contacts

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

Congressional Research Service

Oil Industry Tax Issues in the FY2011 Budget Proposal

Background

In a speech on April 22, 2009 (Earth Day), 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 an oil-based society. The President said that the federal deficit and 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, governments can, and do, 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 direct 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, or consumption, of a good, it can lower the price consumers face through subsidies,

typically applied to the producers of the good, who then may pass the benefit of reduced costs on

to consumers in the form of lower prices.

Given the President’s position on shifting U.S. energy consumption patterns toward renewable

energy sources, his FY2011 budget proposal includes both subsidies for alternative energy

sources and increased taxes on the oil and natural gas industries. 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 enjoyed favorable tax treatment in comparison

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

the write-off of intangible drilling expenses. These benefits helped to keep petroleum product

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

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

Many of these decisions represent economic investments that might no longer be viable if the

relative price of gasoline and oil increases. For example, when the price of gasoline rose to over

$4 per gallon, based on oil prices that rose to over $145 per barrel in 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, accelerating the

collapse of the industry. Shifting the U.S. energy consumption pattern from oil to alternative fuels

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

In addition, available technology makes it unlikely that rapid large-scale transformations of usage

patterns can be achieved. Although hybrid fueled automobiles are becoming popular, gasolinepowered vehicles promise to dominate the U.S. auto stock for some time. Over two-thirds of U.S.

oil consumption is in the transportation sector, and it is unclear how renewable fuels can be

utilized to substantially alter that pattern.

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 FY2011 Budget Proposal

The FY2011 Budget Proposal

Under the pressure of an economic recession, which began at the end of 2007 and continues to

affect the United States in 2010, a financial crisis that has required federal support for the banking

system and financial markets, and the costs of new policy initiatives in health care, carbon

emissions, and other areas, the level of projected federal revenues and deficits is a matter of

concern in terms of achieving a structural change in preferences for petroleum products and

alternative energy.

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. Table 1 identifies the proposed tax

changes for the oil industry, and the White House’s estimates of the impact of each on projected

deficit effects to 2015, if enacted. Many of these measures also 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.

Although the White House prefers to call these proposals deficit reductions, or the elimination of

tax preferences, they, for the most part, eliminate tax expenditures and would actually, or

potentially, under certain market conditions, increase tax revenues.

Table 1. FY2011 Oil Industry Tax Changes

(deficit reductions in millions of dollars)

2011

Repeal Enhanced Oil Recovery Credit

Total, 2011-2015

-

-

1,202

5,635

Repeal Deduction for Tertiary Injectants

5

38

Repeal Marginal Well Tax Credit

-

-

Repeal Passive Loss Exception for Working Interests in Oil Properties

20

98

Repeal Manufacturing Tax Deduction for Oil and Natural Gas

Companies

851

7,272

Repeal Percentage Depletion for Oil and Natural Gas

522

4,328

Increase Geological and Geophysical Amortization Period for

Independent Producers to Seven Years

44

858

2,644

18,229

Repeal Expensing of Intangible Drilling Costs

Total

Source: FY2011 federal budget request, Dept. of Energy, Terminations, Reductions, Savings, p. 39.

Note: (-) means program will have no deficit effect.

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Oil Industry Tax Issues in the FY2011 Budget Proposal

Compared to the FY2010 federal budget request, the 2011 document differs in that it eliminates

the excise tax provisions on Gulf of Mexico oil and gas production. This tax provision was

intended to equalize the royalty rate on certain deepwater drilling projects that were allowed to

pay a zero royalty rate until specified production targets had been reached.2

As shown in Table 1, the proposed revenue changes would have immediate effects in 2011 of

raising over $2.6 billion. Over half of the total proposed deficit reduction from 2011 to 2015

would come from only two of the proposals. These two proposals could increase taxes on the oil

industry, and influence its behavior. The repeal of the expensing of intangible drilling expenses,

and the rescinding of the manufacturing tax deduction for the oil industry, would increase the

industry’s tax payments by $25 billion through 2020.

Repeal Enhanced Oil Recovery Credit3

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

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 is low, a market

period usually associated with excess supply in the market. 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 inability of the price of oil to cover the costs associated with operating

these wells.

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

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

2

For a more complete analysis of this provision, see CRS Report R40715, Oil Industry Tax Issues in the FY2010

Budget Proposal, by (name redacted), p. 3.

3

Tax credits are direct offsets to the company’s tax liability.

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Oil Industry Tax Issues in the FY2011 Budget Proposal

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 a reduction in

petroleum demand is achieved.

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 deficit reduction contribution—$98 million from 2011 to 2015.

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, and is believed to act as an incentive to induce investors to finance oil and gas projects.

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 $7.3 billion in federal

deficit reduction for the period 2011 to 2015. The total tax revenue might increase to $17.3 billion

by 2020, according to the budget proposal.

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 payroll limitation.

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 domestically 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.

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Oil Industry Tax Issues in the FY2011 Budget Proposal

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 prices for oil prevailing since 2004 that have led

to the record profit levels are seen as 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.

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

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.

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 $0.8 billion in

deficit reduction over the period 2011 to 2015. The Independent Petroleum Association of

America estimates that independent producers would likely reduce exploration and development

activities on a one-to-one dollar basis as a result of altering this tax provision. 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 high, 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.

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

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Oil Industry Tax Issues in the FY2011 Budget Proposal

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 $4.3 billion in deficit reduction over

the period 2011 to 2015, and over $10 billion through 2020.

Department of the Interior Budget

The Department of Interior (DOI) budget proposal contains several changes in fees and other

revenue-generating items that would affect the oil and natural gas industries.

The 2011 budget proposal includes provisions to transfer part of the cost of both onshore and

offshore drilling inspection fees to involved companies. However, the costs to industry are

relatively minor. The onshore fee expected to generate $10 million in revenues, or 25% of the

cost of inspections. The offshore inspection fee is to be doubled from the current level; it is

expected to generate $10 million in revenues. In addition, the budget proposal includes a $4-peracre fee on nonproducing leases. This fee is expected to yield $2.5 million in receipts.

The budget proposal also seeks congressional repeal of Section 365 of the Energy Policy Act of

2005 (P.L. 109-58). Section 365 prohibits the Bureau of Land Management from charging

producers for processing onshore drilling permit applications.4

Although these fees and charges would increase the cost of exploring, developing, and operating

oil and natural gas facilities under DOI’s management and hence are likely to reduce those

activities, as suggested by opponents of the proposals, the effects are likely to be minor, as these

fees represent only a fraction of a percent of revenues, profits, or other taxes and fees paid to the

government. Supporters of these fees might make the argument that they represent “user charges”

consistent with environmentally sound management of resources on federal lands.

Conclusion

On the one hand, the tax changes proposed in Table 1 would increase tax collections from the oil

and natural gas industries and may have the effect of decreasing exploration, development, and

production, while increasing prices and increasing the nation’s 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 the 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

and natural gas industries.

4

Oil & Gas Journal, Week of February 8, 2010. pp. 26-27.

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Oil Industry Tax Issues in the FY2011 Budget Proposal

Author Contact Information

(name redacted)

Specialist in Energy Economics

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

Congressional Research Service

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