Oil and Natural Gas Industry Tax Issues in the FY2012 Budget Proposal

Oil and Natural Gas Industry Tax Issues in the

FY2012 Budget Proposal

name redacted

Specialist in Energy Economics

March 3, 2011

Congressional Research Service

7-....

www.crs.gov

R41669

CRS Report for Congress

Prepared for Members and Committees of Congress

Oil and Natural Gas Industry Tax Issues in the FY2012 Budget Proposal

Summary

The Obama Administration, in the FY2012 budget proposal, seeks to eliminate certain tax

expenditures that benefit the oil and natural gas industries. Supporters of these tax provisions see

them as comparable to those affecting other industries and supporting the production of domestic

oil and natural gas resources. Opponents of the provisions see these tax provisions as subsidies

for a profitable industry the government can ill afford, and impediments to the development of

clean energy alternatives.

The FY2012 budget proposal outlines a set of proposals, framed in terms of deficit reduction, or

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

industries, especially those of the independent producers. These proposals include repeal of the

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

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

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

deduction for oil and natural gas companies, increasing the amortization period for certain

exploration expenses, and repeal of the percentage depletion allowance for independent oil and

natural gas producers. In addition, a variety of increased inspection fees and other charges that

generate more revenue for the Department of the Interior are included in the budget proposal.

The Administration estimates that the tax changes outlined in the budget proposal would provide

$22.8 billion in revenues over the period 2012 to 2016, and over $43.6 billion from 2012 to 2021.

These changes, if enacted by Congress, also would reduce the tax advantage enjoyed by

independent oil and natural gas companies over the major 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 and likely increase foreign dependence.

This report will be updated as events warrant.

Congressional Research Service

Oil and Natural Gas Industry Tax Issues in the FY2012 Budget Proposal

Contents

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

The FY2012 Budget Proposal .....................................................................................................1

Repeal Enhanced Oil Recovery Credit...................................................................................2

Repeal Credit for Oil and Gas from Marginal Wells...............................................................3

Repeal Expensing of Intangible Drilling Costs ......................................................................3

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

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

Repeal Percentage Depletion Allowance................................................................................4

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

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

Other Tax Policies.......................................................................................................................6

LIFO.....................................................................................................................................7

Superfund .............................................................................................................................7

Oil Spill Liability Trust Fund ................................................................................................7

Dual Capacity Rule ...............................................................................................................7

Department of the Interior Budget .........................................................................................8

Conclusion..................................................................................................................................8

Tables

Table 1. FY2012 Oil/Gas Industry Tax Proposal Revenue Estimates ............................................2

Contacts

Author Contact Information ........................................................................................................9

Congressional Research Service

Oil and Natural Gas Industry Tax Issues in the FY2012 Budget Proposal

Background

The Obama Administration, in the FY2012 budget proposal, has proposed eliminating a variety of

federal tax deductions and credits available to the oil and natural gas industries. This year’s

proposals are similar to those sent to Congress in conjunction with the FY2010 and FY2011

budget requests. New revenue estimates for the 2012 proposed tax changes are $43.6 billion over

the next decade, contrasted with estimates of $31 billion and $36 billion in 2010 and 2011,

respectively, for essentially the same proposed changes. Although these proposals have failed to

be implemented by Congress in FY2010 and FY2011, the current atmosphere of high deficits and

high earnings by the major oil companies, coupled with a price of gasoline over $3 per gallon,

might reduce resistance to increasing taxes on the industry.

The Administration characterizes the deductions and credits slated for elimination as tax

preferences, or oil and gas subsidies, that are costly to U.S. taxpayers and do little to either

provide incentives for increased production or reduce prices to consumers. 1 A contrasting

description is provided by the American Petroleum Institute (API), which describes the tax

provisions slated for elimination as “cost-recovery methods that are similar to cost-recovery

methods for many other types of taxpayers.”2

The Administration characterizes repealing these tax preferences as eliminating market

distortions, and links them to providing resources for investments in clean, renewable, and more

efficient energy resources.

The FY2012 Budget Proposal

The Administration’s proposals to shift the nation away from oil and to try to control the federal

deficit have led to eight proposed changes for the oil and natural gas industries. Table 1 identifies

the proposed tax changes and the Administration’s estimates of the revenue gains for 2012, the

five-year period, 2012-2016, and the 10-year period 2012-2021.

Many of these proposed tax changes have the effect of equalizing the tax treatment of

independent oil producers to that of the major oil companies. Equalization is accomplished by

eliminating preferential tax treatment of the independent companies not available to the major oil

companies.3 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 for years, while the

independent companies continued to receive the benefit.

1

FY2012 federal budget request, Terminations, Reductions, and Savings, Dept. of Energy, p. 52.

Petroleum Intelligence Weekly, “Obama Targets Oil Industry Tax Breaks,” Vol. L, No. 7, February 21, 2011, p. 3.

3

Independent oil companies are generally defined to mean non-integrated companies. They might, for example, work

in exploration and production, but not in refining and marketing.

2

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Oil and Natural Gas Industry Tax Issues in the FY2012 Budget Proposal

Table 1. FY2012 Oil/Gas Industry Tax Proposal Revenue Estimates

(in millions of dollars)

Proposed Change

2012

2012-2016

2012-2021

Repeal Enhanced Oil Recovery Credit

0

0

0

Repeal Credit for Oil and Gas from Marginal Wells

0

0

0

1,875

8,883

12,447

Repeal Deduction for Tertiary Injectants

6

46

92

Repeal Passive Loss Exception for Working

Interests in Oil Properties

23

117

203

Repeal Percentage Depletion for Oil and Natural

Gas Wells

607

4,977

11,202

Repeal the Domestic Manufacturing Deduction for

Oil and Natural Gas Companies

902

7,704

18,260

Increase Geological and Geophysical Amortization

Periods

59

1,140

1,408

3,472

22,867

43,612

Repeal Expensing of Intangible Drilling Costs

Totals

Source: FY2012 federal budget request, Dept. of Energy, Terminations, Reductions, and Savings, p. 52.

Notes: A zero implies no revenue effect under current and forecasted conditions in oil markets.

As shown in Table 1, the proposed tax changes would have the effect of raising almost $3.5

billion in 2012. Almost all (96%) of the revenues from the proposed tax preference repeal from

2012-2021 would come from only three of the proposals. The repeal of the expensing of

intangible drilling expenses, the repeal of percentage depletion, and the repeal of the

manufacturing tax deduction for the oil industry would increase the industry’s estimated tax

payments by $41.9 billion through 2021.

Repeal Enhanced Oil Recovery Credit4

The enhanced oil recovery tax credit provides 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 can enhance the production from 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, or expected oil production, as oil prices

are generally expected to remain high. Periods of low oil prices are usually associated with excess

supply in the market. During periods of excess supply, it is unlikely that keeping older, higher

cost, low production wells producing is an effective strategy for oil companies. Revenues from

these wells are unlikely to cover operating costs in periods of weak demand, and the credit could

provide the margin that keeps the wells in production.

4

Tax credits are direct offsets to the company’s tax liability and are generally considered to be preferred to deductions.

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Oil and Natural Gas Industry Tax Issues in the FY2012 Budget Proposal

Repeal Credit for Oil and Gas from Marginal Wells

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

Petroleum Council in 1994. The purpose was to keep low-production oil and natural gas wells in

production during periods of low prices for those fuels. The tax credit is designed to maximize

U.S. production levels even when world energy market balances 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

wells of this category. The credit was enacted in 2004, but has not been necessary because market

prices have been high enough since that time to justify production on economic grounds 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 experienced.

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. Intangible

drilling costs cover a wide range of activities and things, including ground clearing, draining, and

surveying, to wages, repairs, supplies, drilling mud, chemicals, and cement necessary to

commence drilling, or to prepare for development of a well. The purpose of allowing current year

expensing of these costs is to attract capital to what has historically been a highly risky

investment. Current expensing allows for a quicker return of invested funds through reduced tax

payments.

In recent years, the risk associated with finding oil has been reduced, but not eliminated, through

the use of advanced technology, including three-dimensional seismic analysis and advanced

horizontal drilling techniques, among others. 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 and natural gas fields.

In the current tax law, the full expensing of intangible drilling cost is available to independent oil

producers. Since 1986 major integrated oil companies have had to capitalize 30% of intangible

drilling expenses over a 60-month period, rather than expense these costs in the current year.

Administration estimates are that repeal of the expensing of intangible drilling costs provision

will yield $8.883 billion by 2016. In response to a similar tax proposal in the FY2010 federal

budget proposal the Independent Petroleum Association of America (IPAA) estimated that the tax

change would result in a reduction in investment in U.S. oil development of about $3 billion in

the future.5 The IPAA’s estimated reduction in oil development implied an almost-dollar for-dollar

relationship between higher taxes and reduced investment. Little empirical evidence for the

estimate was provided. The effect of the elimination of the expensing of intangible drilling cost

5

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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this year was estimated by the IPAA to result in an immediate one-third reduction in drilling

budgets.6

Actual reductions in drilling budgets are likely to be determined by the price of oil. If the price of

oil settles in the $40 per barrel range that prevailed in December 2008, the burden of additional

tax expense on the independent firms could reduce drilling activity. The combination of low oil

prices and additional taxes might not justify the development of relatively high-cost resources,

especially in deep waters, as in the Gulf of Mexico. However, with the current price of oil near

$100 per barrel, supported by political unrest in the Middle East, the additional tax expense is

likely to have a smaller effect in reducing oil development activity.7

Repeal Tertiary Injectants Deduction

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

year. Supporters of the favorable current treatment of these expenses point to the importance of

tertiary recovery methods 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 oil output

from older producing fields during periods when the profit margin, and price of oil, was low.

During a period of high oil prices, the repeal is likely to have a smaller effect on production

levels.

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 tax revenues, $117 million from 2012 to 2016. The provision

exempts working interests, investments, 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 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 the tax treatment of capital equipment in more traditional manufacturing industries.

The analogy is based on the observation that both capital equipment in traditional manufacturing

as well as an oil deposit, are “wasting resources” in the sense that they both require capital

investment to generate an income stream, and that both will eventually become non-productive

6

Independent Petroleum Association of America, “Increasing Taxes on America’s Independent Natural Gas and Oil

Producers—A Bad Idea,” available at http://www.ipaa.org.

7

On February 22, 2011 the observed price of West Texas Intermediate on the NYMEX was $94.55 per barrel.

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Oil and Natural Gas Industry Tax Issues in the FY2012 Budget Proposal

through obsolescence or through wearing out. Depreciation allowances are applied against the

investment in capital equipment and depletion allowances are applied to oil deposits as a way to

recover the initial investment.

In its current form, the allowance is limited to domestic U.S. production, by independent

producers, on the first one thousand barrels per day per well 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 $5 billion over the period 2012 to

2016, and over $11 billion through 2021.

Repeal Manufacturing Tax Deduction

A provision in the proposed budget that affects both independent and the majors’ oil and natural

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

Administration estimates that the repeal of this deduction for the oil and natural gas industries

would contribute $7.7 billion in revenue for the period 2012 to 2016. The total revenue might

increase to $18.2 billion by 2021, 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 limitation related to the

size of the company’s payroll. Section 1999(d)(9) of the Tax Code limits the rate available to the

oil and natural gas industries to 6%.

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 U.S. and world markets.

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

reporting and tax purposes, they differ from traditional factory manufacturing in a number of

ways. For example, the production of petroleum products at a refinery is only indirectly related to

the level of employment.8 This implies that if wage costs go down due to the tax deduction, there

is less chance that the result will be increased output due to higher employment. Even if

employment did increase, it would have little effect on national employment levels due to the

8

The refinery can attain different utilization rates with only minor variations in labor utilization.

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Oil and Natural Gas Industry Tax Issues in the FY2012 Budget Proposal

capital intensive nature of the industry. The Bureau of Labor Statistics reports that oil and natural

gas extraction industries 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 profits for the oil industry. The generally high prices for oil prevailing since 2004 that have

helped generate the record profits are seen as the critical factor in oil investment. Oil exploration

tends to increase when prices are increasing, and expected to remain high, and decrease in times

of falling prices that are likely to remain low. The variability, and level of, expected oil and

natural gas prices is likely to be a more important factor in determining capital investment

budgets, and hence exploration and production development budgets, than the repeal of a tax

benefit that is capped by a relatively low wage bill.

Increase Geological and Geophysical Amortization Period

Geological and geophysical expenses are 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 for tax

purposes, 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 more time is

required to recover the entire cost.

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

period of seven years. In the FY2012 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 yield $1.1 billion in revenue over the

period 2012 to 2016. The Independent Petroleum Association of America estimated in 2010 that a

similar proposal in the FY2011 budget 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 the full cost of oil 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

expenses 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.

Other Tax Policies

The American Petroleum Institute (API), in responding to President Obama’s FY2012 budget

proposal, identifies a number of other proposed tax changes which would affect the oil industry.

These changes include the repeal of the last-in-first-out (LIFO) accounting method, reinstating

Superfund taxes, and modifying the Dual Capacity Rule.

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Oil and Natural Gas Industry Tax Issues in the FY2012 Budget Proposal

LIFO

LIFO, as described by the API is not a tax loophole, but a well-established accounting

methodology to determine taxable earnings. 9 LIFO accounting procedures assume that the last

goods a company acquires are the first goods they sell. In periods of inflation, or periods when

the expected cost of acquiring inventories is rising, LIFO is beneficial in reducing taxes by

allowing the deduction as a cost of the most recent (expensive) goods, independently of which

goods were actually sold out of inventory.

The general upward movement of oil prices since 2004 has, with the exception of the period

when the recession drove oil prices down (September 2008 to January 2009), been a favorable

period for the oil industry to be using LIFO. To the extent that political unrest in oil producing

regions might keep the price of oil rising, keeping LIFO would be a tax advantage for the oil

industry. API states that companies might have to redirect cash or sell assets to cover the tax

payment, driving some firms to bankruptcy. API estimates that repealing LIFO will result in

additional tax liabilities of $22.5 billion for the oil industry.10

Superfund

Reinstating Superfund taxes was judged by API to unfairly impose higher taxes on oil production

and the sale of petroleum products. API’s position is that the oil industry does not account for

substantial amounts of the Superfund liability, yet would result in additional tax liabilities for the

industry of $11.2 billion. From an environmental point of view, the API points out that reinstating

the taxes would not ensure that remediation or cleanup will happen more quickly.11

Oil Spill Liability Trust Fund

The budget proposal also proposes to increase the Oil Spill Liability Trust Fund by raising the tax

on domestic and imported oil to 9 cents per barrel after 2011 and 10 cents per barrel after 2016.

The current plan is to raise the tax to 8 cents per barrel after 2011 and 9 cents per barrel after

2016. These proposed increases are likely a response to the Deepwater Horizon oil spill in the

Gulf of Mexico. 12

Dual Capacity Rule

The credit for foreign income tax, upon which the Dual Capacity Rule is based, dates back to

1918. Since that time corporations have been able to deduct from their U.S. income taxes tax

payments made to foreign governments. The period from the end of World War II to 1950 saw a

new interpretation of this tax rule develop with respect to the oil industry. Before that time, oil

9

American Petroleum Institute, “Significant Industry Tax Issues Contained in President Obama’s FY 2012 Budget,”

February 2011, available at http://www.api.org.

10

Ibid.

11

For more detail on the Superfund, see CRS Report R41039, Comprehensive Environmental Response, Compensation,

and Liability Act: A Summary of Superfund Cleanup Authorities and Related Provisions of the Act, by (name red

acted).

12

See National Pollution Trust Fund Center, U.S. Coast Guard, for details on the Oil Spill Liability Trust Fund.

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producing countries like Saudi Arabia charged the oil companies operating in their countries

royalties, based on the resources extracted, as well as other taxes. For U.S. tax purposes, the

royalties were treated as costs of doing business, hence not a direct credit against U.S. taxes. In

1950, Saudi Arabia and the U.S.-owned oil companies began negotiations to transform royalty

payments into income taxes which had the effect of allowing the companies to increase after tax

earnings while, in effect, transferring funds from the U.S. Treasury to the Saudi government.13

Proposed modification of the dual capacity rules would restrict companies from claiming the full

amount of foreign income taxes as a credit against U.S. taxes. Instead they would only be allowed

to credit amounts equal to the general corporate tax rate applicable to other industries. Additional

taxes would be classified as an operating expense. The effect of the change in dual capacity rules

would be to reduce after-tax revenues and returns from overseas investments. This could lead to

U.S. firms choosing to invest in fewer marginal overseas projects.

Department of the Interior Budget

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

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

The FY2012 budget proposal includes provisions to transfer both the cost of both onshore and

offshore drilling inspection fees to the companies, as well as the cost of oil and gas permit fees.

Additionally, fees would be established for new non-producing oil and gas leases to encourage

development and production. Royalty rate adjustment and terminating the royalty-in-kind

program would also be ended.

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

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

suggested by opponents of the proposals, the effects are likely to be small, as these fees represent

only a fraction of a percent of the 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, might 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 external costs associated with environmental costs and energy

dependence, among other effects, are included.

13

Daniel Yergin, The Prize, Simon & Shuster, New York, 1991, p. 446.

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Whichever view is adopted, the real effects of these proposals on oil and natural gas production,

consumption, and import are likely to be small relative to both the federal deficit and the revenues

of the oil and natural gas industries.

Author Contact Information

(name redacted)

Specialist in Energy Economics

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

Congressional Research Service

9

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