In recent years there has been a tremendous growth of horizontal drilling for oil and gas across the United States. In Oklahoma, this has led to growing concern that the state’s tax breaks for horizontal drilling are growing out of control at the expense of adequate funding for our schools and other critical services.
Oklahoma taxes traditional production at 7 percent but provides for a lower tax rate to support certain kinds of production seen as especially risky or costly. As the result of a tax break first enacted in the 1990’s, horizontal production is taxed at only 1 percent for the first four years of production. The state is now forsaking some $250 million in revenue from this tax break.
Some proponents of the tax break for horizontal drilling claim that it is working just as it supposed to by encouraging drilling activity that benefits that state’s economy and treasury. They assert that state tax policy is an important factor in determining where energy companies chose to invest. If that were true, we’d expect that states with the lowest tax rates would see more growth in horizontal drilling while states with the highest tax rates would see less. Instead, no such correlation seems to exist.
The graph below compares two variables for Oklahoma and six peer producing states:
(1) The effective state tax rate on horizontal production for oil. This is based on a study by Headwater Economics that calculated the tax rate on an unconventional oil well over the first ten years of production;
(2) The growth in the number of spudded horizontal oil wells between 2009 and 2013.
The chart shows that:
- The biggest growth in horizontal drilling between 2009 and 2013 – an 1,872 percent increase – occurred in Wyoming, which also has the highest effective tax rate, 11.7 percent.
- Oklahoma, which has the lowest effective rate at 3.3 percent, saw the second lowest growth – 360 percent;
- Growth in five states whose effective tax rates varied all the way from 3.3 percent to 11.5 percent – Montana, New Mexico, North Dakota, Oklahoma and Texas – all saw horizontal drilling increase by roughly the same amount, tripling or quadrupling during this period.
Nowhere can we find evidence that a high tax rate is deterring producers from drilling in areas where there are large reserves of oil and gas, or that lower tax rates are leading to especially active production.
Rather than being necessary to encourage production, a recent national report on state severance taxes singled out Oklahoma for providing excessive subsidies that fail to generate adequate revenue. Jennifer Carr writes:
Oklahoma’s policy of exempting production from horizontal wells for up to four years goes way beyond encouraging innovations and reducing investment costs and exempts wells that oil and gas producers would drill and develop even without the exemption. Although horizontal wells cost far more to drill, even in states such as North Dakota, where tax rates are fairly high, the severance tax doesn’t seem to hamper growth. The length of Oklahoma’s exemption is unjustified.
Carr suggests that “a good starting place would be to reduce the exemption for horizontal drilling to between 12 and 18 months.” That would put Oklahoma’s effective tax rate more in line with other states, while continuing to allow Oklahoma producers to operate profitably and competitively.