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War Has Been Declared on U.S. Energy
On Thursday, the White House released its federal budget proposal--declaring war on United States energy producers. Though somewhat anticipated, there are a number of tax incentives for the oil industry that may be repealed. At first glance, it appears that independent producers who primarily operate within the U.S. stand to be hurt the most.As it pertains to the budget, the biggest tickets items include the repeal of the Gulf of Mexico royalty relief, the expensing of intangible drilling costs (IDCs), the manufacturing tax deduction, and the percentage of depletion method for oil and natural gas. The Gulf of Mexico Royalty relief calls for lower royalties when commodity prices are below certain thresholds. Given the long investment cycle, large investment, and geological risk associated with offshore drilling, producers claim the royalty relief is necessary to reduce capital impairment risk. The budget also provides for a fee on nonproducing leases on federal lands (primarily offshore)--basically a "use it or lose it" clause. Players that stand to be impacted by this change include the majors: ExxonMobil, Chevron, ConocoPhillips, and large independents like Anadarkoand Devon. Portfolio diversity will insulate the largest producers from these higher taxes to some degree. Perhaps of greater importance is the repeal of the IDC deduction. IDCs (roughly 80%-90% of the well cost) are tax-deductible, allowing producers to defer taxes. An especially active producer that increases its drilling budget every year can effectively avoid paying cash taxes for years. Given the heavy capital requirements for early- to mid-stage producers, the IDC tax deduction is a critical component of a firm's financing strategy. Small to medium-sized E&Ps that are still rapidly growing stand to be impacted the most from this change: Chesapeake Energy CHK, Range Resources RRC, Ultra Petroleum UPL, XTO XTO, and Southwestern Energy SWN, among others. Because natural gas is primarily a regionally traded commodity, we believe this places a governor on the pace at which domestic natural gas production can grow, putting upward pressure on prices in the longer term. Producers with clean balance sheets who aren't as reliant on IDC tax credits as part of their financing strategy stand to benefit. The manufacturing tax credit is pretty straightforward and was enacted with the 2004 American Jobs Creation Act. In 2008, it represented a 6% tax credit on manufacturing activities. The budget calls for oil companies to be ineligible for this deduction. The percentage of depletion clause is a little more complicated and only pertains to nonintegrated producers. It is essentially a form of accelerated depreciation, which defers tax payments. Bottom line, cash taxes appear to be headed higher, which points to higher oil and natural gas prices in the longer term. With a higher cost structure, we wouldn't expect U.S. producers' profits to move in lock step. Posted by: Fred 2009-02-28 |
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