Pennsylvania governor's proposed gas severance tax is hardly a surprise

If anyone still wonders whether the general economic recession will affect the oil and gas industry, they need look no further than Pennsylvania where Gov. Edward G. Rendell proposed a natural gas severance tax on Feb. 4 in his annual budget message.

"We have a Pennsylvania gold rush going on in the form of drilling for natural gas along what is known as the Marcellus Shale. Scientists now estimate that if we can extract just 10% of the gas that exists below ground in the Marcellus, it would be enough to supply the natural gas needs of the entire United States for two years," he told legislators.

Rendell called for the levy as the Keystone State faces a current projected budget deficit of $2.3 billion as a direct result of the national economic recession. "It is a staggering number, and despite the fact that our problems are largely not of our own making, we nevertheless have to act now to put our financial house in order," he said.

He proposed a tax of 5% at the wellhead, plus 4.7 cents per thousand cubic feet of production, an approach identical to neighboring West Virginia's. Pennsylvania gas producers would pay the tax to the state's Department of Revenue monthly beginning Oct. 1. State officials projected that it would raise an estimated $1.82 billion over five years, starting with $107.2 million in the 2009-10 time period and climbing to $631.9 million in 2013-14.

"Some have suggested that exacting such a tax would hinder development of this important resource. However, I spoke personally with West Virginia Gov. [Joe] Manchin who told me that their approach did not inhibit gas extraction and that it is continuing at a record pace, and it's reaping critically needed revenues so the state can provide services to its citizens," Rendell said.

Low-yielding, marginally economic

Oil and gas industry associations in the state warn that it could seriously hurt existing producers who also would have to pay the tax. "Although Pennsylvania has been the third most active drilling state in the US over the last five years, the Commonwealth ranks a distant 15th in production among states. The conventional wells in
Pennsylvania are low-yielding and marginally economic. Only with careful cost control and minimal operating expense can these wells attract any investment. The average gas well in Pennsylvania yields a profit averaging 15% of investment, which is net of operating expense and royalties," said Lou D'Amico, executive director of the Independent Oil and Gas Association of Pennsylvania in a Feb. 5 statement.

"A 5% severance tax on gross production would amount to a full one-third income tax of each well's average cash flow, and is in addition to other taxes already imposed on the industry. No other industry in Pennsylvania will be asked for such a sacrifice. No other extraction industry faces the same challenge. No industry can survive such a burden, even in good economic times," he continued.

"Royalty owners will be forced to share the same pain, effectively raising their state income taxes on this revenue stream from 3.07% to over 8%, which is in addition to their federal income taxes on this same production. Many farmers in Pennsylvania find that their royalty check is the difference between keeping or losing the family farm," D'Amico said.

Stephen W. Rhoads, president of the Pennsylvania Oil and Gas Association (POGAM), told me in a Feb. 13 telephone conversation that the proposed tax has an effective rate of 6.25%. "It's a very regressive tax because of the volumetric component. When gas prices are low, the effective tax rate escalates. When the price is below $2, it's about 7.5%. When the price reaches $7.50 to $8, it's below 6%," he said.

POGAM also tried to determine the proposed levy's impact on a shallow gas producer's bottom line by evaluating it against a typical shallow gas well over a 20-year life span. "These wells are very marginal. Their net income is only about $73,000. When you put an effective 6.25% tax against the gross income to the working interest, drilling costs and operating expenses, it takes about 30-35% of the net income away," Rhoads said.

'We can't afford it'

"This has some very serious implications for shallow gas producers in Pennsylvania. It can't stand. We can't afford it," he added.

In a fact sheet on the proposed tax, state officials cited a Pennsylvania State University estimate that the Marcellus Shale holds $1 trillion of economic value. Rhoads conceded that the formation has significant production potential, but added that there's not enough of it yet to tax. "Not enough wells have been drilled to define the scope of the play and what we can expect. We don't know enough about it yet. The governor shouldn't be levying a tax against a totally speculative commodity," he told me.

He also said that he recognizes that Pennsylvania is facing a difficult budget year and the governor is looking everywhere he can to fill holes. Rhoads said that Rendell also is welcoming alternative proposals, and that POGAM has one.

"We think it would be more practical to lease state forest lands which lie within the Marcellus Shale fairway for production and development. The Department of Conservation and Natural Resources, which is the state's land manager, held a lease sale in September for just this purpose. It earned, on average, about $2,500/acre or about $90 million," he explained.

"If you assume Marcellus production rates based on what's going on in the Barnett and other shale plays and assume a lease sale of 100,000 acres annually for four years and lease signing bonuses similar to last year, we believe the governor could raise $1 billion from the lease sales themselves and royalties, based on the department's standard 16.5% rate, in the $800 million range over five years," Rhoads said. That would be close to the $1.82 billion the state projects to receive from the proposed tax, he noted.

'A rational basis'

This approach would give Pennsylvania the chance to develop its part of the Marcellus Shale without additional government encumbrances while finding out what's actually in the ground, according to Rhoads. "If the government wants to revisit the idea of a severance tax in another 5-7 years, it would have a rational basis for considering it. In the meantime, the state would be contributing to development of a major shale gas play and making money in the process," he said.

The proposed severance tax, on the other hand, potentially could hurt profits to the extent that the larger out-of-state producers who primarily would drill the deep wells in Pennsylvania's part of the Marcellus might consider other domestic shale plays instead, Rhoads warned.

D'Amico said that in an October 2008 study, the Pennsylvania Economy League reported that more than 26,500 Pennsylvanians owe their jobs to the state's traditional oil and gas industry. "Nearly $1 billion are paid to these employees and for each of these dollars, $1.88 in additional spending is generated. $842 million in proprietors' income for small business and self-employment are also generated. Rents, royalties and dividends contribute another $1.9 billion in investor and property owner income," he said.

Gas prices also have fallen dramatically, yielding profits less than half those of a year ago, he continued. "Leasing costs, service company costs and the cost of regulatory burdens have increased from one year ago as a result of land acquisition and regulatory concerns fueled by the hype surrounding the potential of Marcellus Shale development," D'Amico said.

He also noted that the Marcellus Shale has great potential, but that its development is still in its infancy. He said that while IOGA-Pa. represents the oil and gas industry in the state, it also opposes the proposed severance tax on behalf of thousands of Pennsylvanians who depend on the industry for jobs and royalties. "This tax will destroy the existing conventional well development in Pennsylvania and severely hamper and delay the exploration and development of Marcellus Shale in the commonwealth," he maintained.

Drilling permit fees

Pennsylvania's legislature will decide whether to adopt the proposed tax in the next few weeks. In the meantime, the state's Department of Environmental Protection published its proposal on Feb. 14 to replace the current $100 per well drilling permit fee, which has been in place since 1984, with a sliding scale based on well depth and type. The state's Environmental Quality Board approved the DEP's request to impose new drilling permit fees on Dec. 16. Public comments will be accepted until March 14.

The DEP said that the proposed fee sets the base permit cost for vertical wells up to 2,000 feet deep at $250, with increase of $50 for every 500 feet of depth from 2,000 to 5,000 feet. An additional $100 charge would be levied for every 500 feet of well drilled beyond 500 feet. Horizontal wells up to 1,500 feet long would have a $900 base permit cost, with an additional $100 for every 500 feet of well bore drilled past 1,500 feet. Permit applications for vertical wells with bores 1,500 feet or less for home use would have a flat cost of $200.

"Pennsylvania's oil and natural gas industry is booming with a record 7,924 permits issued and nearly 4,200 new wells drilled in the past year, yet the cost of a drilling permit has not changed in a quarter century. Our goal is to establish a new permit fee that better reflects the true cost of providing timely review of new permits and inspecting well sites and drilling activities. This proposed new permit fee structure will allow DEP to hire the staff to help balance this historic opportunity with our responsibility to closely monitor this activity to protect our land and water resources," DEP Acting Secretary John Hanger said.

He said that the fee increase would also allow the department to hire additional staff in Meadville, Pittsburgh and Williamsport to process permits and monitor drilling activities in the north-central and northeastern regions of Pennsylvania. "Our goal is to establish a new permit fee that better reflects the true cost of providing timely review of new permits and inspecting well sites and drilling activities," he said.

DEP said that the proposal is currently before the Pennsylvania House and Senate Environmental Resources and Energy committees for review and approval, and will be considered by the Independent Regulatory Review Commission at its March 19 meeting.

Contact Nick Snow at nicks@pennwell.com