Replies to This Discussion

Permalink Reply by Bobi Carr ("parker") on May 6, 2009 at 4:33

Found this comment from Keith (makes sense to me):

KB,

I don't understand the logic of penalizing independents while investing billions to unproven alternative energy sources like hybrids, ethanol plants, wind. I would think that the government would prefer to find a way to ride the successes of domestic production to fuel future energy sources rather than making them go into hiding until its "safe" to come out. Domestic producers employ us and make this nation move right now - obviously a huge tax base. BTW, where do you see party rhetoric?

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Permalink Reply by Todd M. Baker on May 6, 2009 at 4:50

I am a small independent & I pay a bushel full of taxes. Maybe I should get in touch with your sources.

Todd M. Baker

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Permalink Reply by Joel on May 6, 2009 at 5:50

Hi KB,

O&G accountants probably disdain words like 'virtually' and use numbers. :)

Seriously, the numbers are pretty simple. Percentage depletion lets operators deduct 15% of the revenues from the well as a proxy for the effect of reduction in pressure. (In reality the reduction in pressure is much greater in the first years than in subsequent years but they had to use some number.) Hard to get to 'virtually income tax free' from that.

So 'real life' well example - well revenues of $1M -> depletion expense of $150K. How does that make it tax free? Ask your O&G accountant.

Best,

Joel

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Permalink Reply by Joel on May 6, 2009 at 9:31

Hi KB,

I'm not sure what you're driving at. I take it you're not a business person.

In ways other than percentage depletion, the deductions are like any other business. If the expenses of running the well are low compared to the income, there's a profit. If the well had a lot of other expenses, profits would be lower. I guess if the well operating costs were outrageously high then the well would run at a loss. (If that happened a lot, though, who would risk their money drilling?)

So to run this out, say there were $100K of other expenses and no other income. $1M revenues minus the $100K of other expenses and the $150K depletion =$750K taxable income. Whip out the checkbook and pay Uncle Sam.

I hope your O&G accountant isn't saying that typical wells always run at a loss after depletion? If so, there wouldn't be much an industry to employ O&G accountants! :)

If it's not too much trouble, invite your O&G accountant to chime in directly. I'd be interested in hearing from him/her.

Best,

Joel

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Permalink Reply by Joel on May 6, 2009 at 9:45

No fiction involved. It is a reduction in the value of what is in the ground. Gas plus no pressure is less valuable than gas plus pressure. Pretty simple.

As I understand it, anyone who participates in the expense of running the well is allowed the depletion so there's no restriction against mineral owners if they are participating in expenses. Land/mineral owners usually do leases for royalties, which shield them from exposure to all expenses including depletion.

Best,

Joel

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Permalink Reply by Joel on May 6, 2009 at 13:24

Hi KB,

You can't mix expenses and credits. I don't know that it's possible to explain this to someone who is not an accountant. You will end up having to rely on someone you trust who understands taxes, the O&G industry, and is not snowed by partisan nonsense and just take their word for it. We don't know one another and you have no reason to trust me. But the facts are, depletion is as real as wearing out a machine tool in a factory. The right to depreciate the tool goes to the person who paid for it -same goes for depletion. Congress in their infinite wisdom took the right to deduct depletion away from 'integrated' producers years ago, leaving it intact only to 'independent' producers as a swipe at 'bg oil'.

The only reason to take it away from independents, too, is politics. The results of doing so are clear - marginally profitable wells would be be plugged, and the independent operators will earn lower profit, leaving less to reinvest in new wells, and some riskier prospects may go undrilled. So some impact increasing taxes, lower profits for producers, and lower output.

So, if you're for higher taxes, lower activity and O/G output, and more dollars going to Washington from Shreveport, then this is just the thing! :)

Best
Joel

Permalink Reply by Joel on May 6, 2009 at 18:03

Since you're not an accountant, it's not a good idea to use terms like allowance and credit.

Depletion like depreciation is not out of pocket at the time it's expensed but it was factored into the price paid when the interests were acquired. The whole idea of 'allowables' being set by the conservation department is to maximize the value of the depletable asset.

Also, not sure what you mean about brochures and geting WIOs to invest.

The marginal well numbers are red herrings - it doesn't matter how much oil/gas comes from them and they're not the main point on depletion anyway. But let's go there for a bit.

It's in society's best interest not to cap them when they could keep producing with little or no effort. Benefit to the nation from keeping marginal wells open is more supply and thus (econ 101) lower prices.
These wells are no different to look at than any other wells - no better or worse environmentally. May be better, in the sense they usually don't have much happening, so fewer risks of 'oopses'.

There isn't a lot of investment being done on the marginal wells - they limp along on depleted (there's that term again) pressures, until the day that operating costs outweigh the production revenues consistently enough that they get P&Aed.

Given your use of terms 'pad the pockets of a few' etc. I am guessing maybe you already have your mind made up? But if the O&G independents give up and get another line of work, sure I hope you like burning logs to heat your home! :)

Best,

Joel

Permalink Reply by Todd M. Baker on May 6, 2009 at 8:16

KB:

Back in the mid-70's when these tax credits were instituted, the average oil well in the middle east would produce in the neighborhood of 10,000 barrels of oil per day while the average oil well in the US would barely produce 10 barrels of oil per day. Without the incentives to drill more wells to deeper, riskier zones, there would be no oil and gas industry today. We would be totally dependent on the middle east for oil. I wish we didn't have them, but hindsight says they have produced an incredible amount of jobs, led to many other scientific discoveries and helped keep the US somewhat energy independent. Let's us drive bigass cars & trucks, hunt & fish using 4-wheelers, etc. Without it, we would all be driving Yugos.

I don't like tax credits for any industry. I don't like quotas. I don't like earned income tax credits for anybody. I don't like welfare. We have over regulated and over taxed ourselves to satisfy every hand and every complaint that goes out to Washington. Some good, most of them bad. But they have become part of the American fabric, like them or not.

I can't plant peanuts if I want to. Can't plant sugar cane if I want to. Some farmers get paid for NOT raising hogs or not planting crops (crp land). Now you want to talk about a bunch of junk-getting paid not to do something.

We don't teach men to fish any longer in this country. We give them fish. At least in the oil and gas business, you must do something before you get any kind of tax break. I know there are other industries that are the same, but I know the oil and gas industry the best.

Todd M. Baker

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Permalink Reply by Bobi Carr ("parker") on May 6, 2009 at 15:48

Here is Dion Warr's comments:

Penalties placed upon domestic production as proposed will disproportionately affect mid-size and smaller independents, as well as 'mom and pop' operators who work in the local submarkets, older fields, and stripper well fields precisely because of the use of current exemptions and offsets, lower overhead and tolerance for smaller profit margins. Many wells that such operators produce could not be economically redrilled or replaced if they were P&A'ed. Such reserves would simply be lost.

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Permalink Reply by Bobi Carr ("parker") on May 7, 2009 at 3:16

Jay and Jim,

These are complex issues for those of us outside of the business. I have the utmost respect for both of your opinions. That is why I asked you both to comment on the discussion.

Many are quick to point fingers at politicians and say "do something". I am amazed that more people have not signed this petition. I can understand that some will think, "what good will it do". Well my response to them would be, "it'll do more good than DOING NOTHING does".

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Permalink Reply by Joel on May 7, 2009 at 3:59

Hi KB,

The depletion allowance isn't limited to stripper/marginal wells. There are some limits on amount but if I recall the upper limit on amounts is pretty high. The IRS link Jim Krow provided has most of the nuts and bolts - I think it's 1000 barrels of oil/day or the BTU equiv of NG. Also note that there are limits as to how much of the well's income can be reduced by depletion expense.

I'm not a promoter or investor so can't speak directly on the brochure angles. If you want a look at how promoters attract investors, you might see if your library has a copy of the book 'money in the ground' - a good read for anyone with an interest in this 'play'. If I understand the book correctly, tax aspects play a role in O&G investing (as in all investing) but not a dominant one, after Reagan tightened the tax shelter rules in 1986.

A side excursion on philosophy. Any industry exists by providing service or product of greater value to its customers than what the customers pay for it- or they wouldn't buy it. The amount they pay is hopefully larger than the cost to the supplier, and if so the supplier make a profit. If the profit is good enough, they expand. Meanwhile other companies get wind and enter the business if they can - that reduces the profits and things stabilize. When you load external costs (taxes) on an industry, they produce less and/or charge more for it. How much less domestic O/G do we want? (side comment - If you think the O/G companies are going to make good profits - buy some stock and 'line your own pockets' :) I note CHK is up somewhat now that NG price has stopped its freefall.

Now, you may believe removing the depletion deduction is not loading costs. But it is. Ask the accountants where you work if they depreciate their property plant and equipment. They will look at you funny and say 'of course.' If someone in Washington decided that your industry was out of favor and decided to change the rules so they couldn't deduct depreciation, that would load more cost onto them and their profits would drop. And maybe they could raise prices and maybe they couldn't. And maybe if they raised prices their sales would drop. So maybe they would have to cut costs instead. Personnel costs, possibly.

So things have consequences. That's all I'm saying.

Best,

Joel

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Permalink Reply by Noel on May 7, 2009 at 6:13

According to the IRS article, posted earlier, the royalty owner will be losing an opportunity for a depletion allowance too.

http://www.irs.gov/publications/p535/ch09.html

The following site states some of these tax credits have been on the books since 1926. This site also states there may be upwards of 20,000 jobs at risk in Illinois if these credits are removed. So if jobs from independent producers with marginal wells in Illinois are at risk then Louisiana and Arkansas are at risk for losing jobs too.

http://www.ioga.com/tax%20resource%20page.htm

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