TAX INCENTIVES SPUR DEVELOPMENT OF COALBED METHANE

Peet M. Soot
Northwest Fuel Development Inc.
Portland, Ore.

With new wells continually being put on-line, estimates show that the nonconventional fuel tax credit is attaining the role which Congress had intended in encouraging unconventional gas production.

A large number of wells have been drilled to produce coalbed methane in various coal basins in the U.S. The highest activity has been in the Black Warrior and San Juan basins.

Each of these basins has reports of over 1,000 wells in production as of November 1990.1 2

A comprehensive computer-based analysis has been made to project the future production from these wells. In the Black Warrior basin, 1,364 wells were analyzed. It was projected that the average well would produce 220 MMcf in a 10-year period. The field would produce 300 bcf in 10 years.

Using the projected 1991 value of the tax credit of $0.90/MMBTU, Black Warrior production would be eligible for $270 million in tax credits (assuming coalbed methane has a nominal heating value of 1,000 BTU/scf).

A similar evaluation of 1,204 Rocky Mountain coalbed methane wells indicates a tax incentive of $860 million in 10 years.

This tax credit (Section 29 Credit) was second only to the alternative minimum tax relief segment of the 1990 Revenue Reconciliation Act in providing support for domestic fuel production.3

INCENTIVE PROGRAM

An incentive for production of nonconventional fuels was provided by the Crude Oil Windfall Profit Act of 1980 (tax act). This incentive was a production tax credit intended for times when low oil prices would limit the competitiveness of unconventional gases.

When the tax act was passed by Congress, oil prices were high and the tax credit was not available. The current market place has the low energy prices which allow the implementation of the tax credit.

The tax credit has been revised several times since its initial passage. Legislation in 1984, 1985, and 1986 modified aspects such as the tax credit applicability with alternative minimum tax considerations and sales of qualified fuels between affiliated corporations.

The tax credit has been extended on two different occasions. In 1989, legislation allowed a 1-year extension for qualifying fuels. An additional 2-year extension was provided in the Omnibus Budget Reconciliation Act of 1990.

Production of fuels other than coalbed methane are also eligible for the tax credit. The list of qualified fuels includes:

Oil produced from shale or tar sands
Gas produced from biomass, geopressurized brine, Devonian shale, and some tight formations
Some processed wood fuels
Steam produced from some agricultural by-products.

Some of these other fuels have specific rules governing their use of the tax credit. One should refer to the latest Internal Revenue Service (IRS) regulations for a full presentation of the rules.

DEFINITION

The tax credit formula for coalbed methane can be expressed in algebraic form as follows:

TC = ($3 -- BOE) x IAF x PH

where:

TC = Tax credit in $/MMBTU

BOE = Barrel of oil equivalent, 5.8 MMBTU

IAF = Inflation adjustment factor (based on GNP implicit price deflator)

PH = Phaseout factor (PH < 1)

PH is based on domestic crude oil prices at the well-head, as follows:

PH = 1 - (Domestic oil price $23.50/bbl x IAF) ($6/bbl x IAF)

The value of the tax credit for a given year cannot be calculated until March or April of the following year. At that time the IRS presents values for the IAF and the reference domestic oil price. These values are published in the Federal Register.

This year, they were found in the Apr. 1, 1991, issue.

Using the IRS values, the formulas presented above can be used to calculate the tax credit and to determine whether the phaseout is applicable. The phaseout factor has not been applied since the first 2 years of the tax credit, 1980 and 1981.

In 1980, the domestic oil prices were high enough to phase out totally the tax credit. In the following year, the tax credit was partially phased out. In subsequent years, the tax credit has been unaffected by the phaseout factor.

The history of the tax credit can be reviewed in a prior publication .4

Fig. 1 presents a graph showing the current and projected values of the tax credit. Coalbed methane production during 1990 can receive a tax credit of $0.865/MMBTU.

This year's and the near-term future values of the tax credit are not difficult to predict. One only needs a forecast of the GNP implicit price deflator.

This is a commonly predicted variable. Predicasts Forecasts provides a quarterly projection of this value as estimated by several sources.4

Long-term future values are obviously less predictable. The projection in Fig. 1 assumes that inflation is maintained at the current annual rate of 4%. At that rate, the tax credit will climb to $1.385 in 2002.

Numerical values for the annual tax credit are presented in Table 1. The domestic oil prices required for partial or total tax credit phaseout are also listed in Table 1.

The values for 1991 and beyond are based on the same 4% inflation rate as was used for calculating the tax credit. Wellhead oil prices would have to rise to an annual average of $40.89/bbl before the tax credit would even be partially phased out in 1991.

Last year's domestic oil reference price was $20.03/bbl. If oil prices were to increase linearly through the year from last year's value, that would mean that oil prices would have to end at over $60/bbl before partial tax credit phase out took place.

Total tax credit phaseout would only occur if 1991 oil prices averaged over $49.35/bbl. Phaseout oil prices are plotted in Fig. 2.

The actual reference price is published with the IAF in the Federal Register. Because this does not occur until the following year, a current source for reference prices would be valuable. Such a source is the Monthly Energy Review published by the U.S. Department of Energy's Energy Information Administration (EIA).

Since 1981, the domestic oil reference price used in the tax credit calculation has been the same as the EIA value for "average domestic first purchase price."

By reviewing the crude oil price summary table in the Monthly Energy Review, one can calculate the moving average for the current year. By the time the Monthly Energy Review is available, those values may be several months old, but it is still better than having to wait until the following year.

Knowing the spot prices for domestic oil will provide a semiquantitative indication of the reference oil price.

APPLICABILITY

The tax credit is only applicable for production of coalbed methane from new wells on new property as defined by the tax act. Wells must have been drilled after Dec. 31, 1979, and before Jan. 1, 1993. There are no definitions in the tax act as to what is meant by "drilled."

The wells cannot be drilled into reservoirs where commercial coalbed methane was produced prior to 1980 or else they will not be eligible. Again, there is no definition of "reservoir" in the tax act.

This tax credit differs from other tax credits which have been allowed under the U.S. Tax Code. This tax credit is associated with production of a fuel.

The tax credit must be taken in the year of production and has only limited capability for carry forward and carry back. However, once it is taken it is not subject to recapture, as are investment tax credits.

There are limitations if the owner of the coalbed methane is subject to the alternative minimum tax. If this is the case, the owner should make an attempt at reorganizing the project so the tax credit flows to another entity which has a significant tax liability.

The following items need to also be considered in particular instances:

The producer claiming the tax credit must sell the coalbed methane to an unrelated party. (Affiliated corporations are not considered related parties for the purpose of this act.)

Any grants or subsidies received from the federal or state governments for a given project must be deducted from the tax credit.

Only domestic production of coalbed methane and other qualifying fuel is eligible for the tax credit.

INTERPRETATION

There are no regulations in force regarding this tax credit. No court rulings have been located addressing the credit.

The only interpretive sources which one can reference are IRS letter rulings, revenue rulings, and general counsel memoranda.

Even though letter rulings cannot be cited as precedence for nonoriginating cases, they do provide an indication of the IRS' current stance regarding some specific issues relating to the tax credit.

More than 15 letter rulings are on record relating to this tax credit. They cover issues such as noneligibility of coal/water slurries, validation of spud dates for well drilling, allocation of the credit among partnerships, assignment of the tax credit into the year in which production payments were received by cash-basis taxpayers, and other issues.

All of the rulings and published memoranda should be studied if one is interested in a complete understanding of the tax credit.

REFERENCES

Rocky Mountain Coalbed Methane Report, Petroleum Information Corp., Denver, March 1991.
Southeastern U.S. Coalbed Methane Report, Petroleum Information Corp., Denver, March 1991.
Mandelker, Philip, "Vehicles can be structured to take advantage of E&P investment opportunities in the '90 tax act," OGJ, Feb. 18, 1991, pp. 60-63.
Soot, Peet M., Non-Conventional Fuel tax credit, in Geology and Coal-Bed Methane Resources of the Northern San Juan Basin, Colorado and New Mexico, Rocky Mountain Association of Geologists, 1988, pp. 253-256.
Cratcha, George, ed., 1991 Predicasts Forecasts: Predicasts Inc., Cleveland.