Confusion over energy subsidies festers in the 2017 federal budget proposed last month in Canada. In a pattern familiar in the US during the administration of President Barack Obama, the Liberal government cites international agreements about consumption subsidies to explain tax changes related to production.
"Canada has made a commitment with its partners in the G20 and Asia-Pacific Economic Cooperation to phase out inefficient fossil-fuel subsidies," notes a budget document. "Such subsidies can encourage wasteful consumption, impede investment in clean energy sources, and undermine efforts to combat the threat of climate change."
The budget measure addresses none of that. It changes a timing preference related to production. The G20 and APEC targets are consumption subsidies.
What changes
Canadian operators now can deduct costs of exploratory drilling in the year of incurrence. They must book costs of development drilling as assets to be charged to expense over time. Small producers can treat development outlays applicable to flow-through investors the same as exploration costs. The budget proposal disallows current-year expensing for exploratory drilling associated with discoveries and removes the development-cost preference of small operators.
"The success rates for exploratory drilling have increased substantially since the 1990s, and, in a majority of cases, discovery wells now lead to production, which makes the well an asset of enduring value," the budget document says. In fact, not all discovery wells become producers. And exploration is still exploration, whatever the success rate. Reserves still deplete. Companies still must drill for and find hydrocarbons continuously to replace production. The independent operators that drill most wells especially need the ability to recover funds promptly for reinvestment. Immediate expensing helps them do so.
Characterization of a discovery well as "an asset of lasting value" invokes an accounting principle asserting that expenses should coincide with revenues to the extent possible. With oil and gas drilling and production, the alignment never can be perfect. In the US, moreover, the principle itself soon might give way to tax reform, one proposal for which is to allow immediate expensing of all investment. If that happens and the measure applies to US oil and gas investment, Canadian drilling capital will feel a strong pull southward.
The government of Liberal Prime Minister Justin Trudeau might find nothing to regret in the constriction of oil and gas drilling already hurt by depressed commodity prices. His preference, as Obama's was, is for carbon-free energy. For political reasons, he can't afford to act with Obama's unabashed hostility toward oil and gas. Canadian producers, though, should see no friendly intent in his budget's treatment of drilling.
The government can't rationalize its move as a revenue-enhancer. If the change didn't affect drilling, disqualifying costs from immediate expensing wouldn't affect government receipts over time. But it would deny affected taxpayers the time value of money, which is more important to them than the government. So it would affect drilling, inevitably diminishing activity relative to what the level would have been without the change. That would lower government revenue.
Errant context
Placing the change in the errant context of a campaign against consumption subsidies represents a disservice to the oil and gas producing industry. It perpetuates the myth that producers enjoy lavish transfers of money from taxpayers. Timing options that benefit the taxpayer, such as current-year expensing, do not transfer money from the public to producers over time. They are not tax credits or grants. Tax credits and other forms of relief indeed are available on both sides of the border. But they're limited to narrowly defined activities or regions where governments want to stimulate work. They have nothing to do with consumption subsidies.
When a government changes tax policy in ways that punish taxpayers and explains itself with irrelevant claims, the suspicion must be high that its true motive is to discourage the underlying activity. If Ottawa wants to discourage oil and gas drilling, changes under discussion in Washington, DC, certainly would help it succeed.
