The U.S. oil and gas industry would emerge from the first tax reform since 1986 relatively unaffected, though time will change some dynamics—for good and ill—and a few prized deductions are going away.
Oil and gas companies stand to lose some tax provisions, including $1.3 billion in annual domestic production deductions. The highly leveraged E&P sector may also eventually see new caps on interest expenses as financially stifling—especially as commodity prices rise.
The industry is also losing some tax credits, mostly those that kick in at low commodity prices such as EOR credits that will have little impact. And the big headline, reduction in corporate rates to 20% from 35%, is more likely to benefit refiners since few E&Ps generate positive net income.
“Corporate income tax matters less for energy than just about any other sector of the U.S. economy,” Pavel Molchanov, an analyst at Raymond James, said in a Nov. 6 report.
The U.S. House of Representatives was reportedly set to vote on the “Tax Cuts and Jobs Act” on Nov. 16 while the Senate continues work on its own legislation.
The message from the oil and gas industry: so far, so good. Intangible drilling costs (IDCs)—arguably the most important tax deduction for oil and gas producers—have so far been untouched, though until a bill is on the president’s desk nothing is certain.
“We are pleased that the House version of the tax bill left intangible drilling costs and percentage depletion untouched, which has been the primary focus,” Ed Longanecker, president of the Texas Independent Producers and Royalty Owners Association told Hart Energy on Nov. 9. “The House Ways and Means Committee is marking up the bill this week and if successful will likely go to the floor prior to Thanksgiving. We hope the Senate version of the bill protects IDCs and percentage depletion, but we will have to see how those negotiations go.”
The U.S. government doesn’t subsidize fossil fuel production, according to a 2015 report by the U.S. Department of the Treasury. However, the industry can take advantage of 11 federal fossil fuel production tax provisions totaling $4.7 billion in annual revenue costs based on revenue over a 10-year period.
“Each of the energy sectors will have winners and losers depending on level of taxable income, structure, leverage and jurisdictions in which they operate, said Michael Terracina, a partner and national tax sector leader for energy and natural resources at KPMG.
“No tax reform bill will ever be perfect and no bill will likely ever be able to accomplish everything Congress wants to do,” he told Hart Energy. “But if they are able to reduce the tax rate dramatically, that will still be reform and will be a victory for Congress.”
A look at several key elements to tax reform and the potential effect on oil and gas companies based on how the legislation is currently crafted.
Intangible drilling costs—staying put
IDCs have been around a long time—they date back to the Revenue Act of 1913 and were used to help promote the risky business of finding oil.
The U.S. Treasury Department estimates that oil and gas IDCs annually cost about $1.5 billion in federal revenue. For operators, they cover anywhere from 60% to 80% of the costs associated with wells.
“Independent E&P companies have long benefited from a series of favorable business-specific provisions in the tax code, the most important—from the standpoint of drilling activity—being write-offs for intangible drilling costs and percentage depletion,” Molchanov said.
Under current tax rules, operators and working interest owners may elect to expense or capitalize IDCs. IDCs cover all expenses by an operator, including wages, fuel, repairs, hauling, supplies and other costs, according to the bipartisan Joint Committee on Financing (JCT).
“The current deductibility of IDCs is important for encouraging development of oil and gas reserves and is consistent with the expensing provisions in the overall framework of the bill,” Terracina said.
The House tax bill does not change either of the provisions and removal of IDCs could be disastrous, according to the American Petroleum Institute (API).
The bipartisan Joint Committee on Taxation (JCT) reported in 2015 that all industries $5.5 billion in tax expenditures for the expensing of R&D by all qualifying industries. However, while other manufacturers can deductive 9% of their net income, U.S. oil and gas industry deductions are capped at 6%. Repealing IDCs could also reduce domestic production by 3.8 million barrels of oil equivalent per day (boe/d), according to a 2013 study by Wood MacKenzie.
Terracina noted that integrated oil companies are still subject amortizing 30% of their IDCs over a 60-month period. “Further, all oil companies must still capitalize their exploration costs and amortize them over 24 months,” he said.
Corporate tax cuts—largely neutral
The E&P sector won’t feel any immediate impact from a corporate tax cut since most companies paid little to no cash income tax even during the oil boom, Molchanov said.
“To clarify, income statements generally showed an income tax provision during the profitable era, but virtually all of it was deferred,” he said.
For Midstream MLPs, the lower corprorate rate “is a slight-to-moderate negative” as their relative tax advantage over C-corps will be squeezed.
“Let’s recall that the potential for MLPs to convert to C-corps had been a big topic around last year’s election,” he said. “With the tax-advantage gap set to narrow, and with the benefit of a larger investor base for C-corps, we think this may re-enter investor discourse.”
Refiners stand to benefit the most, Molchanov said.
“With our refining coverage universe currently paying corporate tax at, or close to, the statutory rate of 35%, the cut to 20% should be very beneficial,” he said.
Tax credits eliminated—some hurt more than others
Terracina said the lower tax rate is somewhat offset by the repeal of deductions and credits the oil and gas industry currently receives, such as the loss of manufacturing deductions, “proposed repeal of certain energy credits that have been available to upstream companies in the current commodity price environment including the enhanced oil recovery credit and credit for producing oil and gas from marginal wells,” he said.
Oil and gas companies, like other manufacturers, can deduct income attributable to domestic production activities—though at a lower rate than other industries.
In 2013, API noted that most U.S. manufacturers may deduction 9% of their net income derived from qualified domestic production activities. Legislation around that time curtailed the oil and gas industry by “freezing them at 6%.”
In 2015, the production tax break for oil and gas and coal companies totaled $1.3 billion, according to the Treasury Department.
More recently, API said the deduction may not be need if other pro-growth tax reform positions are implemented.
The EOR credit offers a tax credit equal to 15% of EOR costs when prices fall below a certain threshold. but it has largely gone unused. The JCT estimates that the repeal of the EOR credit will save the federal government less than $50 million in annual cost savings from 2019 through 2023.
A repeal of tax credits for marginal wells will have no revenue effect.
Interest and losses—potential worries
Provisions that limit the carryback and use of net operating losses from an “immediate cash flow perspective” have the greatest potential to affect the oil and gas industry and E&Ps in particular, Terracina said.
“Volatility in commodity prices has historically caused significant swings in taxable income from year to year,” he said. “The ability to carryback net operating losses has been beneficial as it allowed recovery of prior taxes paid in recent years.”
The proposed limitation on carryback as well as the ability to offset only 90% of taxable income will result in a longer time needed to recoup those previously paid taxes from profitable years, he said.
The House legislation proposes a cap on interest expense equal to 30% of EBITDA.
“Limitations on interest expense could have a negative impact on highly leveraged upstream oil and gas companies,” Terracina said. “The repeal of the Alternative Minimum Tax could be a benefit to many independent producers.”
None of the C-corps. Covered by Raymond James currently pay federal income tax, so the deductibility interest expense “is unlikely to become relevant over the next decade-plus,” Molchanov said.
API said in June that should net interest expense no longer be deductible, it does not have a position on how to address the transition of existing debt.
“However, the final rules must permit options to accommodate past taxpayer decisions or else historical business decisions would be unfairly compromised,” the trade association said.
Darren Barbee can be reached at firstname.lastname@example.org.