In the final days of the 2010 session, when legislative leaders were faced with historic revenue shortfalls and were desperate for ways to balance the budget, a deal was struck with representatives of the energy industry on oil and gas drilling incentives. The industry agreed to defer payment of credits on horizontal and deep well drilling for twenty-four months, until July 2012, and then to pay out over the next three years the credits that accrued during this period. In return, the legislature adopted several changes to how drilling is taxed that were sought by the industry .

At the time, it was anticipated that deferring the payment of credits on horizontal and deep well drilling for two years would put the state on the hook for $150 million. Instead, when oil and gas companies submitted their claims in late 2011, the price tag turned out to be nearly double: $297 million. The state now must pay out close to $100 million annually between 2013 – 2015 for credits accrued in 2010 and 2011, leaving less money than expected for state appropriations. These back payments are in addition to credits that are accruing for current production

The announcement that tax breaks for horizontal and deep well drilling amounted to nearly $150 million per year in 2010 and 2011  should serve as a wake up  call to Oklahoma policymakers and the public. All evidence points to horizontal drilling accounting for a substantially greater share of Oklahoma oil and gas production in the years ahead.  The generous tax treatment we provide this form of drilling threatens to compound our budget woes and hamper our efforts to provide adequate funding of core public services.

To understand how these oil and gas tax breaks work, we need to briefly look at how gross production is taxed in Oklahoma. The normal tax rate for oil and gas production in Oklahoma is seven per cent, except when the price falls below a certain floor. However, the state sets a lower tax rate for certain kinds of drilling.  The most favored treatment is provided for horizontally drilled wells, which are taxed at 1 percent regardless of the price of oil and gas for a duration of 48 months from initial production. Deep wells are taxed at 4 percent for a period of 48 to 60 months regardless of price.

Between FY 2004 and FY 2009, gross production tax breaks for all forms of drilling – which then took the form of  rebates paid on claims submitted to the Oklahoma Tax Commission – averaged $86 million per year. In 2005 and 2006, deep well drilling rebates alone totaled $106 million; the legislature responded by setting a $15 million to $25 million annual cap on deep well rebates. In the three years after the deep well tax incentives were capped (FY 2007 – FY 2009), all gross production tax rebates together averaged a relatively modest $56 million.

But this was prior to the current explosion in horizontal drilling that is creating a profound transformation in Oklahoma’s oil and gas industry. The graph below (based on monthly production data compiled from the U.S. Energy Information Administration (EIA) and IHS, a private energy data company), shows the steep and continuous growth of horizontal production in recent years.  Between 2006 and 2011, the share of total gas production in Oklahoma from horizontal wells has grown more than six-fold, from 5 percent to over 30 percent. Oil production has followed a similar pattern: horizontal drilling accounted for just 2 percent of oil production in 2006 but exceeded 20 percent  by 2011. And the trend towards horizontal dominance shows no signs of abating: according to the Baker-Hughes weekly rig count from mid-March, 57 of 58 new gas rigs and 124 out of 149 new oil rigs in Oklahoma are drilling horizontally. This trend has led some industry experts to predict that within a few years, up to 60 percent of total production in Oklahoma could be derived from horizontal wells.

Data compiled from EIA and IHS

The fiscal impact of the shift to horizontal production is already being felt. In FY 2010, the state paid out $83 million in rebates for horizontal drilling that had occurred in prior years. Of the $297 million of deferred credits that were accrued for drilling in 2010 and 2011, $245 million was from horizontal drilling. But this amount may represent only a fraction of the tax breaks’ future costs if horizontal drilling continues to grow as anticipated. If total oil and gas production remains steady at current levels, and horizontal drilling reaches 50 percent of total production, the state could soon be providing $400 million annually in horizontal drilling credits (1). If prices and production continue to rise, the revenue losses could be considerably higher. The cost of oil and gas credits will constrain not only funding available for education, public safety, and infrastructure, but also make it more difficult to justify and pay for the tax cuts that many legislators seek to enact.

As resources to fund basic and essential state services remain scarce, allocating hundreds of millions of dollars annually to subsidize horizontal drilling becomes increasingly difficult to defend.  Most  horizontal drilling in Oklahoma is conducted by a small number of large and profitable energy companies, and there is little or no evidence that state tax breaks have a major impact on the decision to drill. Although current low natural gas prices pose genuine concern for profitability, state law already lowers the tax rate for all forms of drilling when gas prices fall below $2.10 per MCF.

If eliminating oil and gas tax breaks are off the table, the state could at least limit its exposure by capping credits or by allowing them to be claimed only when the commodity price falls below a floor price. If legislators choose instead to do nothing, they should at least not act surprised when the skyrocketing cost of oil and gas tax subsidies drills a huge hole in the state budget.

(1): Calculated based on annual oil production of 58,000 barrels of oil at $100 per barrel and 1.887 TCF of oil at $4.00 per MCF