“You Don’t Even Know What a Write-Off Is!”

I’m a tad sensitive about people who tell me things about my business in an authoritative tone, when they don’t know the first thing that they’re talking about.

Last year, I was trying to explain to my MIL’s friend Ernie, a Western Electric retiree, why gasoline prices were so high. I mentioned that among the costs that oil companies must cover is the cost of the dry holes we drill – the non-productive wells drilled on the prospects that don’t work out.

“But that’s a write-off!” Ernie exclaimed with authority.

Well, yeah, in a sense, it’s a write-off. Dry holes are a legitimate business expense for tax purposes, and always have been. But it’s not as if dry holes don’t cost money. Maybe the best analogy is gambling losses – they can offset gambling income, but nobody makes money by intentionally losing money. A loss is still a loss.

In Ernie’s Western Electric days, “write-offs” for the Ma Bell subsidiary just got rolled into the rate base, and “write-offs” just magically became somebody else’s problem. As a monopoly, AT&T’s return was guaranteed, on top of whatever write-offs they accumulated.

Ernie reminded me of one of my favorite Seinfeld episodes, the one where Kramer didn’t give a second thought to making a false claim on postal insurance. After all, he told Jerry, “It’s a write-off!”

To which Seinfeld replied, “You don’t even know what a write-off is!”

Trouble is, by all appearances we now have Kramer and Ernie setting energy policy in this country.

For the oil and gas industry, two of the biggest turds in the Obama Budget punchbowl are labeled as “loophole” closings, “loophole” being essentially synonymous with “write-off”. Liberal think-tankers with no industry experience and with industry in their righteous cross-hairs have all the influence in the Obama Administration. They have targeted “Percentage Depletion”1 and “Expensing of IDCs”2 as the loopholes they’d most like to close (i.e., the ones that will generate the most IRS revenue).

Oil and gas is a historically tax-advantaged business. There’s no point in debating the justification of those tax advantages; they are an ingrained part of energy economics that an operator considers before committing to drill a well. For the last hundred years or so, the folks that set tax policy, the Congress, were persuaded that a domestic energy supply was of such a strategic importance that it made sense to cushion the risks inherent in energy exploration by creating special tax advantages for taking the risk. And the level of drilling activity now (off 40% or so from 2008 highs) reflects the relative attractiveness of the industry as perceived by the investment community. If oil and gas were easy money, capital would be beating our doors down, but it’s not.

Since Percentage Depletion only benefits Independents (it was taken away from the Majors years ago), the tax measure targets the very industry segment that is most likely to finance its investment out of cash flow. Keep in mind that Independents drill 90% of domestic gas wells. By taking these tax advantages away, the government directly and punitively decreases an important incentive to drill for oil and gas. You can bet that fewer wells will be drilled. Domestic exploration will suffer.

Almost by law of nature, we’ll see oil and gas prices rise, while taking two steps back from the national goal of energy security.

1 – Percentage Depletion is analogous to depreciation in most businesses. It is common in extractive businesses, and relates to the expense associated with depletion of a natural resource. Large integrated oil companies have been ineligible for percentage depletion for several years; Obama’s proposal would mainly affect smaller “independents”. Percentage depletion first hit the tax books in 1926.

2 – Intangible Drilling Costs (IDCs) are costs associated with the drilling of a well such as labor or services, as opposed to “tangible costs”, such as the cost of pipe. Under current tax law, tangible costs are capitalized and written off over time, while IDCs are written off in the year incurred. So, the debate is not whether IDCs represent a legitimate write-off, it is over the time frame of the write-off. Faster is better. The current tax treatment of IDCs started in 1913.