Oklahoma’s taxes on unconventional production of oil and gas, or horizontal drilling, are among the nation’s lowest and would remain relatively low even if the state eliminated the tax breaks currently benefiting horizontal drilling, according to a new study from Headwater Economics, in conjunction with Oklahoma Policy Institute.
The study applies state tax policies to average production yields for typical unconventional oil and natural gas wells to determine comparable effective tax rates over a ten-year period. It finds:
- Oklahoma’s effective tax rate on unconventional oil production is 3.3 percent, the lowest of seven peer oil-producing states (Wyoming, North Dakota, Montana, New Mexico, Texas, Colorado);
- Oklahoma’s effective tax rate on unconventional natural gas is 2.6 percent, ranking fifth lowest of seven peer natural gas-producing states;
- If Oklahoma eliminated its tax break benefiting unconventional production, its effective production tax rate on oil would ranks sixth among seven peer producing states and third (along with Texas) among seven natural-gas producing states.
Oklahoma currently taxes production from horizontal wells at only 1 percent for the first 48 months of production, compared to 7 percent for conventional (vertical) wells. This tax break has an especially large impact because unconventional wells have very steep decline curves compared to conventional production. For a typical oil well, nearly two-thirds (64 percent) of cumulative production over the first ten years will come in the first 48 months after a well is completed, the study shows. The decline curve for natural gas is even steeper.
Using data from a typical unconventional oil well, the study shows that cumulative gross production tax revenue over ten years will be $620,000, which is less than half of what the state would collect ($1.4 million) without the tax break.
As we discussed in a recent issue brief, with an increasing share of total oil and gas production in Oklahoma comes from horizontal wells, the total cost to the state from the tax break for horizontal drilling has risen dramatically. This past year, state tax credits for horizontal wells totaled $148 million, according to the Office of Management and Enterprise Services. In addition, the state paid out $102.6 million in rebates and refunds for horizontal production in prior years that were deferred as part of an agreement made with the energy industry in 2010 to help address budget shortfalls during the recession. Without legislative action to curb this tax break, the cost could quickly reach $400 million or more annually, squeezing out critical funding that otherwise could be directed to help meet the state’s education, public safety, infrastructure and health care needs.
The new Headwater study confirms not only that Oklahoma’s tax holiday for horizontal drilling is increasingly unaffordable, but that it is also unnecessary. Even if one assumes that state taxes influence the decision of where to drill, Oklahoma is providing subsidies that are far more generous than what is needed to compete. Previous research has shown that state oil and gas tax preferences do not significantly affect the decision to drill or determine a well’s profitability.
It is encouraging that state leaders, including Finance Secretary Preston Doerflinger and Treasurer Ken Miller, have acknowledged the urgent need to revisit the taxation of oil and gas production, even if no clear consensus has yet emerged on the right reforms to enact. As Secretary Doerflinger has stated, “any fiscally responsible policymaker needs to seriously consider at what level government should incentivize something that is now standard practice.” Policymakers should proceed with considering reforms confident that curbing the current tax preferences for horizontal drilling will only bring us closer in line to the tax treatment in other energy-producing states.