Over a Barrel: How we ended up on the hook to oil and gas producers to the tune of $294 million

NOTE: This week, Oklahomans learned the state was on the hook to pay oil and gas producers $294 million over the next three years in deferred tax rebates for horizontal and deep well drilling in 2010 and 2011, an amount almost $150 million more than initially anticipated. The deferred payments came about as a result of legislation, HB 2432, passed in 2010 that provided several concessions to the oil and gas industry in how horizontal and deep well drilling is taxed. Here is the blog post we ran at that time explaining HB 2432 and expressing our concern about the potential costs of tax breaks to the industry. It has been edited to revise errors in the initial post and to link to an updated fact sheet.

In their efforts to find additional revenues for the upcoming budget year, legislative leaders and Governor Henry took some strong and politically risky steps to suspend tax credits for various forms of economic activity. But when it came to tax incentives for the oil and gas industry, expected to amount to some $150 million in FY ’11 and FY ’12, it was the industry that seemed to have the upper hand. HB 2432, which passed in the final days of session, allowed the state temporarily to defer incentive payments to oil and gas producers – but only in return for some permanent and questionable concessions to the industry.

Under HB 2432, approved as part of the FY ’11 budget agreement, payment of the rebates owed for horizontally drilled and deep wells produced in Fiscal Years 2010 and 2011 will be deferred until July 1, 2012 and then paid out in monthly installments over the next 36 months. The state will be assessed interest at nine percent on any payment that is not made by the end of the month it is due. This does not involve a moratorium or suspension of these tax rebates – just a deferral in payments. This procedure made available an additional $85 million for appropriation in FY ’11 that would otherwise have been paid out in rebates.

In return for this one-time deferral of their rebates, the oil and gas industry extracted three significant changes to the system of tax breaks for production (see this fact sheet for a detailed explanation of the current system). First, beginning in FY ’12, drilling incentives for horizontally drilled and deep wells will be paid out as front-end credits, rather than as rebates that are applied for and refunded after the end of the year. This switch will involve a one-time cost to the state in the crossover years from back-end to front-end payments that is projected by the Tax Commission to be $65 million. It also precludes any future attempt to defer incentive payments.

Secondly, the law changes how horizontally drilled and deep wells are taxed. Under HB 2432, beginning in 2011, deep wells drilled below 15,000 feet will be taxed at 4 percent (compared to 1 percent currently), but the current cap limiting total incentives for deep well drilling to $25 million per year will be abolished. For horizontally drilled wells, HB 2432 strikes the language in current law that makes producers eligible for incentives only until project payback has been completed.

Finally, for other forms of drilling, in which incentives are subject to a price trigger, HB 2432 indexes the trigger to an annual inflation-based increase. Currently, incentives can be claimed for oil production only in years when the average price is below $30 per barrel or for gas production in years when the average price is below $5.00 per MCF; this floor will rise based on the Consumer Price Index.

We fully appreciate the important of the energy industry for Oklahoma’s economy. But this deal leaves us with a pair of troubling questions. The first is, at a time when budgets for almost all government functions are sustaining deep and enduring cuts, does it make sense to extend additional tax breaks for oil and gas producers? While the switch in how deep well drilling is taxed is purported to be revenue-neutral, the lifting of the project payback limit on rebates for horizontally drilled wells is expected to reduce taxes by an additional $13 million. This is on top of the approximately $60 million in gross production tax breaks already going to horizontal drilling, along with oil and gas depletion allowances and other tax benefits. Rather than provide unlimited credits, we should be looking to limit the state’s fiscal exposure and provide greater budget certainty by establishing reasonable caps on the total amounts of credits that can be claimed by producers.

The second question relates to how HB 2432 exacerbates a system where certain forms of production, dominated by large producers, are subsidized regardless of the price of oil and gas. When natural gas is at $3.50 per MCF, tax rebates or credits may, perhaps, make the difference in the decision to drill a well. But should production be fully exempted (in the case of horizontally drilled wells) or partially exempted (in the case of deep well) even  from gross production taxes when gas is at $8.00 per MCF? What about $15.00 per MCF?  The additional concessions granted to these producers by HB 2432 only strengthens the perception that when it comes to the subsidy system for oil and gas drilling, policies are being driven not by geology or economics, but rather politics.