The President’s proposed 2011 Budget has tax-raising bulls-eye squarely on every demagogue’s favorite target, “BIG OIL”.  Nobody likes Big Oil, right? They’re the Shells, the Exxons and the BPs who keep jacking up gasoline prices, right?  WRONG. Regardless of what you think about Big Oil, those companies will hardly notice this tax increase. No, this baby will fall squarely on the backs of smaller, non-integrated domestic producers. The direct cost of this inept policy will be:

• Loss of American jobs,
• Loss of American GDP,
• Increased oil imports, and
• Reduced energy security.

The current tax system has been in place for many decades. It has been successful at doing what it was designed to do: making it easier to raise money for the risky hydrocarbon exploration business, and providing an incentive for marginal producers to keep their low-volume domestic “stripper wells” on line.

Obama proposes to change that.

Obama takes aim at drilling incentives – Upstream Online

The move has been strongly condemned by oil and gas companies, which argue that abolishing the tax breaks would reduce domestic drilling, cost jobs and increase US reliance on foreign energy suppliers. … The White House said ending the subsidies would not have much of a financial impact on energy companies, as $36.5 billion represents about 1% of expected domestic oil and gas revenues over the coming decade.

That last comment really grates me. It shows how oblivious the current Administration is when it comes to energy policy. The reason this tax increase will affect small companies disproportionately is that the big companies lost many of their tax breaks long ago!

The small companies are represented by industry organizations (with some overlap in membership): the Independent Petroleum Association of America (IPAA, of which I am a member), and the National Stripper Well Association (NSWA, of which I am not).

I’ve plead IPAA’s case in these pages before. At the end of this diary, I’ll post the text of their description of each of the Admistration’s proposed changes and let that speak for itself. Independents drill 90% of America’s gas wells. Natural gas is a plentiful, clean and almost completely domestic fuel. Changing these particular tax laws will make it more difficult for independents to finance their drilling projects.

If IPAA represents the small producer, NSWA represents the marginal producer. The 80/20 rule applies in oil and gas – 20% of the wells produce 80% of the fossil fuel. “Stripper wells” are the other 80% – a high cost, low volume, largely mom ‘n’ pop activity. A stripper well, by definition, makes less than 10 barrels a day or less than 60,000 cubic feet of gas a day.

Altogether, 400,000 stripper wells make 800,000 barrels of crude oil a day – 28% of total U.S. crude oil production.

The problem with stripper wells is that their operation is so marginal. They barely cover the cost of operation to begin with. If a stripper well is plugged, that’s it. It’s history.

And these proposed tax law changes will mean that many of those 400,000 can no longer be produced at a profit. The loss in production might take several expensive deepwater developments, or even an ANWR to replace. The jobs, they’ll be gone for good.

If all marginal wells were abandoned the lost output would be $61 billion while the lost earnings would be $12.5 billion. In addition, 292,374 individuals would lose their jobs. In the oil and gas industry alone, the effect of abandonments is $5.3 billion in lost worker earnings and 83,000 potential jobs lost.

What follows is IPAA’s response to the Adminstration Proposal to “Eliminate Funding for Inefficient Fossil Fuel Subsidies”, in its entirety. I have highlighted portions as they relate to the disproportionate impact on small and marginal producers.

Intangible Drilling and Development Costs (IDC) – IDC tax treatment is designed to attract capital to the high risk business of natural gas and oil production. Expensing IDC has been part of the tax code since 1913. IDC generally include any cost incurred that has no salvage value and is necessary for the drilling of wells or the preparation of wells for the production of natural gas or oil. Only independent producers can fully expense IDC on American production. Eliminating IDC expensing would remove capital that would have been invested in new American production – such as the emerging shale gas resources throughout the country.

Percentage Depletion – All natural resources minerals [e.g. coal, gypsum, sand, limestone, etc. - ed.] are eligible for a percentage depletion income tax deduction. Percentage depletion for natural gas and oil has been in the tax code since 1926. Unlike percentage depletion for all other resources, natural gas and oil percentage depletion is highly limited. It is available only for American production, only available to independent producers, only available for the first 1000 barrels per day of production, limited to the net income of a property and limited to 65 percent of the producer’s net income. Percentage depletion provides capital primarily for smaller independents and is particularly important for marginal well operators. Eliminating percentage depletion would remove capital that would have been invested in maintaining and developing American production.

Passive Loss Exception for Working Interests in Oil and Gas Properties – The Tax Reform Act of 1986 divided investment income/expense into two baskets – active and passive. The Act exempted working interests in natural gas and oil from being part of the passive income basket and, if a loss resulted, it was deemed to be an active loss that could be used to offset active income as long as the investor’s liabilities were not limited. Most natural gas and oil producers in the United States are Small Business Owners. Natural gas and oil development require large sums of capital and producers frequently join together to diversify risk. To qualify for the exception, the producer must have liability exposure and definitely be at risk for any losses. If income/loss, arising from natural gas and oil working interests, is treated as passive income/loss, the primary income tax incentive for taxpayers to risk an investment in oil and natural gas development would be significantly diminished.

Geological and Geophysical (G&G) Amortization – G&G costs are associated with developing new American natural gas and oil resources. For decades, they were expensed until a tax court case concluded that they should be amortized over the life of the well. In 2005 Congress set the amortization period at two years. Later, Congress extended the amortization period to five years for large major integrated oil companies and then extended the period to seven years. Early recovery of G&G costs allows for more investment in finding new resources. Extending the amortization period would remove capital from efforts to find and develop new American production.

Marginal Well Tax Credit – This countercyclical tax credit was recommended by the National Petroleum Council in 1994 to create a safety net for marginal wells during periods of low prices. These wells – that account for 20 percent of American oil and 12 percent of American natural gas – are the most vulnerable to shutting down forever when prices fall to low levels. Enacted in 2004, the marginal well tax credit has not been needed, but it remains a key element of support for American production – and American energy security.

Enhanced Oil Recovery (EOR) Tax Credit - The EOR credit is designed to encourage oil production using costly technologies that are required after a well passes through its initial phase of production. For example, one of the technologies is the use of carbon dioxide as an injectant. Given the increased interest in carbon capture and sequestration, carbon dioxide EOR offers the potential to sequester the carbon dioxide while increasing American oil production. Currently, the oil price threshold for the EOR tax credit has been exceeded and the oil value is considered adequate to justify the EOR efforts. However, at lower prices EOR becomes uneconomic and these costly wells would be shutdown.

Manufacturing Tax Deduction -Congress enacted this provision in 2004 to encourage the development of American jobs. All US manufacturers benefitted from the deduction until 2008 when the oil and natural gas industry was restricted to a six percent deduction while other manufacturers will grow to a nine percent deduction. While many producers’ deductions are capped by the payroll limitation in the law, it is another tax provision that provides capital to America’s independent producers to invest in new production.

Cross-posted to VladEnBlog.