Limiting oil and gas tax exemptions would help bring budget balance

In recent months, with the state confronting historic budget shortfalls for the coming fiscal year and critical services facing massive cuts, there has been growing attention paid to the vast array of exemptions, credits, deductions, and rebates known collectively as tax expenditures. According to data compiled from the most recent report by the Oklahoma Tax Commission, the state’s tax expenditure budget in FY ’08 consisted of over 450 tax preferences with a fiscal impact of at least $5.6 billion – an amount that exceeds the state revenue available for appropriation for next year’s budget ($5.4 billion).

Much of the discussion of late has focused on the wisdom and likelihood of reining in certain income tax credits whose costs have snowballed with little, if any, apparent economic benefit. However, this may also be the appropriate moment to look again at the tax preferences granted for oil and gas production in Oklahoma.

As we discussed in detail in this 2009 fact sheet, Oklahoma currently provides tax exemptions for seven types of drilling: horizontally drilled wells, re-established production (inactive wells), production enhancement (workovers and recompletions), deep wells, new discovery wells, and economically at-risk wells. The tax exemptions take the form of rebates that lower the gross production tax rate from 7 percent to 1 percent. These exemptions, however, are limited in three ways:

• By price – most drilling exemptions apply only when the average annual index price of oil or gas is below a floor or $5.00 per MCF of gas or $30.00 per barrel of oil. The only exemptions not subject to a price trigger are those for enhanced recovery projects, horizontally drilled wells, and deep wells below 15,000 feet spudded after July 1, 2005.
• By duration – all oil and gas exemptions can be claimed only for a set length of time following a project’s initiation or completion. The duration is typically 28 months but extends to 48 or 60 months for certain drilling;
• By amount – For deep wells of 15,000 feet and greater, the total amount of exemptions claimed is capped at $25 million per fiscal year as of FY ‘09.

Overall, the most generous exemption is for horizontally drilled wells, which can be claimed in an unlimited amount regardless of the price of oil and gas and for a duration of 48 months. The next most generous credit is for deep wells below 15,000 feet, which is also issued irrespective of price and for a duration of 48 to 60 months. However, the cap on the total amount of credits limits the state’s exposure on deep well drilling.

Some research has called into question the importance of incentives to the decision by producers to drill, compared to price and other factors. However, even assuming, for the sake of political reality, that incentives for the oil and gas industry will remain in place, the current incentives system can be challenged in at least two ways.

The first is that the absence of a price trigger for deep wells and horizontally drilled wells distorts the market and creates an unfair advantage for the mostly larger energy producers who are able to engage in those forms of drilling, compared to the mostly smaller, independent producers who are likeliest to participate in the less advantaged drilling methods. We see from the table below that nearly 75 percent of all rebates from FY ’04 – FY ’08, and 97.5 percent in FY ’08 alone, were claimed for horizontally drilled and deep wells. (The Tax Commission is unable to provide a breakdown by type of drilling for FY ’09).

The second concern is that the lack of an overall cap on gross production exemptions, plus the existence of an uncapped exemption for horizontally drilled well regardless of the price of oil and gas, creates great fiscal uncertainty for the state. The state paid out over $35 million in rebates just for horizontally drilled wells in FY ’08 at a time when historically high prices should have made drilling profitable without incentives. Now, when lower natural gas prices are expected to keep the price triggers off, the cost of incentives is expected to blow through the roof. For FY ’11, the Tax Commission is projecting total natural gas rebates of $121 million, along with $28 million in oil rebates. This would equate to 50 percent more incentives than in any other recent year at a time when budget shortfalls are threatening the provision of key public services.

Creating a more consistent set of rules across all forms of drilling would create greater equity for all kinds of producers and production while limiting the state’s fiscal exposure. This could involve two components:

1. Setting a global rebate cap for all forms of production, or separate caps for each form of production, as is currently done for deep well drilling. The cap could vary based on the price of oil and gas so as to subsidize production when prices are low;
2. Standardizing the price triggers for all the rebates, rather than removing the exemption when prices are high for some forms of drilling but not others, as is now the case.

This year in particular, we are compelled to acknowledge that dollars being used to subsidize oil and gas production are dollars unavailable, to limit the number of teachers being laid off from public schools, for example, or to limit the extent of rate reductions for domestic violence treatment programs or group homes. Faced with these stark trade-offs, developing fair caps on the availability of drilling incentives should be part of a balanced approach to the budget.

Update: Wayne Greene wrote a Sunday Tulsa World column on this subject that echoed  our arguments and cited our data while making a strong case for the waste and inefficiency of oil and gas subsidies.