TAX LAWS FAVOR DRILLING OVER BUYING RESERVES

Changes in tax laws have made it more advantageous to drill for U.S. oil and gas than buy producing leases.

An analysis by Deloitte & Touche shows that producer incentives spelled out in the Energy Policy Act of 1992 and the Revenue Reconciliation Act of 1990 will take on added importance for oil and gas investors. That's especially true now that the top federal income tax rate has risen to 39.6% for individuals and 35% for corporations.

Because of "significant economic forces," operators preferred to buy producing leases rather than enter new ventures to drill for oil and gas in recent years, an official of the accounting firm points out.

But the tax landscape has changed in the past few years (Table 1). That requires a reexamination of tax benefits in drilling vs. acquisition of producing reserves.

Mark Edmunds, Dallas, presented Deloitte & Touche's tax analysis to the Independent Petroleum Association of America's midyear meeting last month in San Francisco. Edmunds is Deloitte & Touche's national tax director for energy and utilities.

TAX BREAKS

One of the greatest potential benefits for producers in the Revenue Reconciliation Act was liberalization of percentage depletion rules, Edmunds told IPAA's tax committee.

A prohibition of percentage depletion on transfers of proven leases was repealed for leases acquired after Oct. 11, 1990.

In addition, percentage depletion allowed on any one property was raised to 100% from 50% of taxable income from that property.

A new, higher percentage depletion rate - as much as 25% -also was established for marginal wells as the average price of crude falls to less than $20/bbl. For example, the average price of crude in 1992 was less than $16. So the 1993 percentage depletion rate on marginal properties was 19%.

However, due to the alternative minimum tax (AMT), the value of these benefits was substantially diluted.

Against long odds, Edmunds said, the Energy Policy Act included AMT relief for independent producers. The percentage depletion preference was repealed.

In addition, the intangible drilling cost (IDC) preference was repealed to the extent that the law does not result in a reduction of the taxpayer's AMT income by more than 40% (30% for taxable years beginning in 1993).

"Unfortunately," Edmunds said, "taxpayers will still have to compute the IDC preference to apply the 40% test."

Because the intangible drilling cost preference was only partially repealed, taxpayers will need to control the timing of their IDC outlays to avoid the AMT, Edmunds warned. To minimize their tax liability, taxpayers will need to balance current year IDC spending against projected taxable income and net income from oil and gas.

These incentives are especially apparent when comparing drilling ventures to acquisitions of producing reserves, Edmunds said. Deductibility of IDCs in the first year of a drilling venture and allowance of percentage depletion beyond a property's tax basis have become quite important tax benefits now that the AMT is somewhat neutralized.

AN EXAMPLE

To highlight tax effects, Edmunds compared a $20 million drilling program with a $20 million reserve purchase (Table 2). He assumed an equal amount of reserves (20 bcf) for the two alternatives and identical production profiles.

Under the acquisition, cost depletion exceeds percentage depletion in all years. Thus, total depletion deductions are limited to the $20 million investment. Because percentage depletion is not limited to the original investment, total deductions under the drilling venture exceed the $20 million investment by $9 million.

For an individual investor with a 42.2% effective federal and state income tax rate, the $9 million of additional percentage depletion deductions yields a $3.8 million greater tax benefit for the drilling venture than for the reserve acquisition.

What's more, because most of the tax benefits in a drilling venture will occur in the early years, on a net present value comparison the difference exceeds $5.1 million.

The tax benefits of a drilling venture can be substantial. However, there are still a number of tax traps for the unwary, Edmunds said.

For individuals, investments in drilling ventures through a limited partnership or some other entity that limits an investor's risk could be subject to the passive activity rules. If the drilling venture is construed as passive, the investor's deductions and losses from the drilling venture will be limited to the investor's passive income from all other sources.

In addition, "at risk" rules, limitations on prepayments, and certain tax shelter guidelines must be understood before investing, Edmunds said.