U.S. TAX POLICIES DISTORTING ECONOMICS OF EXPLORATION, DEVELOPMENT VENTURES

Craig G. Goodman
Mitchell Energy Corp.
The Woodlands, Tex.

Since the Tax Reform Act of 1986, crude oil production in the United States has declined over 1.5 million b/d despite interim price increases of over 100%. Exploration and development in the U.S., measured by the drilling rig count, footage drilled, reserves replaced, and seismic crew activity, remain near record lows.

Two major factors determine the level of U.S. crude oil production: the price of crude oil and the expected return on investments to find and produce new reserves. This article discusses the impact of the U.S. take (tax and fiscal) system generally, and the alternative minimum tax (AMT) system specifically on new investments to find and produce crude oil in the U.S.

Over the last 20 years, important policy concerns have motivated U.S. tax reform. Yet its impact on the petroleum resource base of the country was never fully anticipated. The U.S. tax reform movement dramatically and adversely changed the time within which new oil and gas investments can be recovered. In the process, America's new capital recovery policies have produced both regressive and anticompetitive impacts. The charts presented in this article demonstrate these impacts as crude oil prices, revenues, or profitability decline and as the costs of production increase.

In sum, the percentage of a project's net revenues (social worth) taken by the U.S. take system increases, both absolutely and relatively as the investor's taxpaying position becomes less profitable. This regressive feature also causes the after-tax returns from new oil and gas investments to decline while it increases both the after-tax costs and risks of the investment, particularly for AMT taxpayers.

Importantly, firms in relatively similar competitive positions within the same industry but in different taxpaying positions have substantially different expected after-tax returns from the same drilling investments. As a result, current U.S. capital depletion and recovery policies reflected in the AMT distort economic decision making, resulting in potentially significant losses in wealth to U.S. society.

REFORM CONSIDERATIONS

Important policy considerations led to the Tax Reform Act of 1986.

Concepts like tax fairness, simplicity, and neutrality were cited. Abusive tax shelters and primarily tax-motivated transactions were inhibiting the efficient utilization of America's vast economic resources, Reducing marginal tax rates set an example for America's trading partners and further reduced the incentives for tax-motivated transactions.

Reducing marginal tax rates was an excellent first step, particularly for many low-capital and service-related industries. However, to pay for lower rates, a substantial portion of America's tax burden was shifted onto more capital-intensive industries. Predictably, the rate of U.S. expansion slowed. In turn, the slowdown in economic growth has exacerbated the slowdown in cost recoveries inherent in the new tax code. The real economic impact of U.S. tax reform and AMT capital depletion and recovery policies may now be higher than originally thought. However, there is real concern that because of the "political correctness" of tax reform, fine-tuning U.S. capital policies to meet the challenges of intense global competition may be very difficult, if not impossible.

COMPETING IN THE '90S

We have entered a new era.

The U.S. is competing for new capital, for new markets, and for its share of new opportunities in an increasingly globalized marketplace.

U.S. companies compete against foreign companies and governments. Competing countries are well experienced at integrating social and economic policies with tax policies. When business and government work together, the resulting competition can be overwhelming, and the impact on jobs, capital flows, trade balances, and standards of living cannot be ignored.

U.S. tax and economic policy must encourage Americans to compete in the new world market and bring home the wealth. U.S. social, economic, and tax policy must recognize that America's wealth lies not only with its environment and abundant resources but with the competitiveness of its people and its businesses.

Policies can create new wealth, new jobs, and new opportunities if they allow investments in the U.S. and its labor force to be a competitive use of capital.

America's AMT capital recovery policies are impacting a broad cross-section of U.S. industries. However, no industry is more negatively affected by AMT policy than the U.S. petroleum industry.

Virtually every major expenditure that keeps a U.S. petroleum company from liquidation is subject to alternative minimum taxes. Yet these policies were designed in response to OPEC embargoes, gas lines, shortages, and the price spikes of the early 1970s. Since then, the world crude oil market has changed dramatically.

TAX FAIRNESS

Fairness in government is described in many ways.

One theory is: To each according to need, from each according to ability. This apparently simple premise has prompted considerable debate as to how to interpret both "need" and "ability."

Clearly, an essential function of a successful government is to satisfy need yet nurture ability. Need is beyond the scope of this article; however, the ability to pay is fundamental to tax fairness.

A reasonably objective measure of the fairness of the U.S. take system is its operation as prices, revenues, and profits fall, or as the costs of production rise. A progressive system is considered fairer than a regressive system. Fig. 1 shows the impact of the tax and fiscal system as crude oil prices fall.

As shown, the level of financial claims taken from investments to find new crude oil reserves increases, and increases substantially as prices fall. As also shown, under government base price projections, some regular taxpayers still can make a profit. Yet taxpayers subject to the AMT cannot.

"Social worth," as used in these charts, is the value of the crude oil produced minus the costs of finding it, producing it, and getting it to market. In economic terms it is the actual wealth added or the net revenues generated by an investment, before multiplier effects. "Total claims" are the sum of all payments by the taxpayer to landowners and state and federal governments. Policies that take more than the social worth of an investment render that investment unprofitable and discourage substantial wealth creation.

The price of crude oil has doubled since the tax reform. So why aren't more people drilling for oil in this country? In short, the U.S. take (tax and fiscal) system renders a statistically average investment to find new crude oil reserves in this country a noncompetitive use of capital.

Fig. 2 shows one reason, Fig. 3 another. New microeconomic research (see acknowledgement) shows that the financial burdens placed on oil and gas investments by U.S. society increase substantially as field sizes (total revenues) decline. Fig. 3 shows the impact of the U.S. tax and fiscal system as well depths (costs of production) increase. Clearly, as reserves become harder to find and costlier to extract, the current U.S. system compounds the problem by taking a greater share of the social worth of the project.

Most of the firms in the domestic production industry are AMT taxpayers. At current price levels, average field sizes, and average well depths, the financial burdens imposed on these AMT taxpayers exceeds 100% of the total expected worth of new oil and gas investments.

U.S. energy producers are more likely than others to be subject to minimum taxes because minimum tax liability occurs when a producer invests money to find new oil and gas reserves and when existing deposits deplete beyond original finding costs.

Unlike the regular tax code, the AMT is structured to collect taxes on the capital invested to find new oil rather than on the income generated from the sale of that oil. By collecting tax revenues "upfront," before income is generated, both the money and its time value are lost to higher taxes. Consequently, both the cost of the investment and the amount of risk sustained by the investor are higher. Fig. 4 shows the difference in the timing of income tax liability between the regular system and the alternative minimum system.

It shows both the regular income tax liability and the added burden of the AMT on the statistically average U.S. geological prospect. AMT liability occurs during the first 2 years because the taxpayer is investing money in new drilling over this period.

For regular tax purposes, drilling costs are treated as an expense. However, for AMT purposes, a substantial portion of these investment dollars is treated as taxable income. As is also shown, it takes an AMT taxpayer approximately 11 years to recover the up-front AMT tax that results from a new drilling investment.

Contrary to the intent of the law, recovery of the up-front AMT payment is not guaranteed. Should the investor remain subject to AMT, the upfront drilling tax is not returned. Only if the taxpayer eventually becomes profitable enough to pay regular taxes is a credit provided to recover the up-front AMT tax on drilling capital.

Under this structure the taxpayer lends the government money, interest free, by paying income taxes before income is earned and gets paid back only if he is sufficiently profitable. Technically, if AMT credits are not available or are unusable, the AMT becomes a direct tax on the capital invested to maintain and replace America's depleting oil and gas reserves.

TAX NEUTRALITY

For a tax system to be neutral, it should operate in the same or similar manner on taxpayers in roughly the same position. It discourages purely tax-motivated transactions and attempts to equalize effective tax rates among taxpayers, industries, and different economic activities.

The purpose is to avoid allowing the tax code to determine how new investment will be made and instead urge taxpayers to rely on the underlying economic merit of the investment to determine whether it is a competitive use of capital.

In the abstract, these goals are both laudable and attainable. Tax reform was structured to eliminate tax shelters and multiple tax rates.

Yet today a regular taxpayer that explores for oil in this country can expect to profit in an amount that is almost identical to the expected loss of a competing AMT taxpayer on the same investment.

Fig. 5 compares the expected after-tax economics of an identical investment made by an AMT taxpayer and a regular taxpayer.

The revenues generated by this investment, if undertaken, would be split up in the manner shown in Fig. 6. In both Fig. 5 and Fig. 6, different taxpayers are treated differently. As a taxpayer moves from a regular tax position to an AMT position, this investment is rendered unprofitable because the government's share of the net revenues generated from the investment increases over a third, from 18% to 26%. As shown in the earlier charts, this added burden of the AMT also increases as prices or revenues decline or as costs go up. Yet none of these factors reasonably could be described as tax-motivated. If applied to individuals, these impacts would be considered regressive.

Proponents of tax neutrality argue that the underlying economics of a project should not be affected differentially by the tax code. However, under our new reformed system, after-tax economics do not approach similarity until investments become far more profitable. In essence, our system allows more-profitable taxpayers to make higher after-tax returns than less-profitable competitors, on the same investment. Many consider this to be anticompetitive.

TAXES AN CAPITAL

Disparity in treatment alone cannot reflect the true value of a project to society. The social worth of a project is a measure of its true value to society, before macroeconomic multiplier effects. As seen in Fig. 5, the expected social worth of the average oil and gas prospect is over 10 times greater than either its expected profit to the regular taxpayer or the cost to society of allowing the investment to break even for an AMT taxpayer.

Of equal or greater import, and not shown in these charts, is the total undiscounted value of the project to society and to both the federal and state treasuries. Tax monies are counted in undiscounted terms, and society does not share fully either the financial or geological risks of the average oil and gas prospect. Consequently, undiscounted numbers represent the real costs and benefits to society of policies that would render these investments marginally economic to an AMT taxpayer.

If U.S. tax policy rendered the average U.S. geological prospect marginally economic to an AMT taxpayer (75% of the domestic industry), the prospect would generate a total of over $12.5 million in "actual" new wealth to U.S. society, of which $2.5 million would go to the federal treasury and $1 million would go to the state treasury. Yet this does not occur because the investor faces an expected loss solely because of the impact of the AMT.

Revealing is that the federal government can improve expected economics at virtually no "real" cost. Since the AMT collects income taxes before the income is generated, a change that shifts the tax burden back to the income and off of the investment doesn't actually lower the total taxes that would be paid over the life of the project; it merely collects the tax when it's due, not "up-front".

As is also shown in Figs. 4 and 5, moving federal tax liability closer to the burden imposed by the regular tax system would eliminate the expected loss yet not lose a dollar in tax revenues. Each dollar in "up-front" AMT reduction would also mean an equal reduction in AMT credits, leaving the federal government with the same amount of taxes. Yet by moving the tax from the investment capital to the project's income, the project becomes marginally profitable.

As noted, this shift in capital recovery policy provides a direct gain to society from this one project of approximately $12.5 million in new wealth and over $3.5 million in new taxes. Current capital recovery policies do not generate new wealth or new taxes because the project remains unprofitable to over 75% of the domestic industry.

The costs and benefits of this change in policy are even more compelling when macroeconomic multiplier effects and the effects of new job creation are considered. Moreover, a dollar not spent to find new oil reserves in the U.S. will be exported to create new jobs and capital investments abroad. Improving the after-tax economics of investing in America and its people can pay large dividends.

Static macroeconomic analysis does not quantify the dynamic wealth creation effects of tax and fiscal policy changes. Quantitative microeconomic analyses can measure these effects very accurately and can be a useful tool in developing competitive tax and fiscal policies. Lowering marginal tax rates was an excellent first step. Improving capital depletion and recovery policies should be the next.

ACKNOWLEDGMENT

For detailed information on either the analysis presented here or the macroeconomic model and underlying assumptions used to compute the impacts presented in these charts, the reader is referred to a larger work, "U.S. Petroleum Income Taxation: 1890-1990."

The author appreciates the assistance provided by Jerry Youngblood and Dr. Richard G. Gordon on the technology used in these analyses.

Copyright 1991 Oil & Gas Journal. All Rights Reserved.