The US government needs to stop giving subsidies to Big Oil! This is such a common rallying cry that few stop to consider what it really means.
The idea appears simple: Oil companies make so much money the government should not support them. But is the government giving oil companies money? How does the system really work?
Breaking Energy recently spoke with some leading tax code experts at Ernst & Young who work with the energy industry to get some clarification.
“The government is not giving companies money to go out and produce oil,” and they do not get subsidies; It is more a matter of when a company can receive a tax deduction, said Deborah Byers, Ernst & Young’s America’s Oil and Gas Tax leader.
The issue extends back to the early 1900’s when companies began drilling for oil and gas before federal tax codes were written. As tax issues arose, they were settled by the Supreme Court and the codes in effect today were written based on these early court rulings. “That is the logic we have used and it has not changed,” said Susan Thibodeaux, Ernst & Young’s Executive Director of the Federal Energy Tax Center, which works with clients on tax returns and tax planning.
Dry Holes: Risk Mitigation and Capital Management
Intangible drilling costs are one of the main issues that relate to oil companies with regard to tax treatment. It takes several years and millions, if not billions of dollars, for companies to drill the exploration and production wells that eventually extract petroleum and generate revenue.
These costs are intangible, meaning a company cannot know how much it will cost to develop a prospect until they drill the holes. For tax purposes these costs are expensed as “cash out of pocket costs.”
Many companies do this. Farmers have intangible costs and so do design and construction companies, the E&Y representatives explained. Companies either expense intangible costs or amortize and deduct them – they all get deducted, it’s just a matter of timing.
It also has to do with risk. There is no guarantee a company will produce oil when it drills exploration wells that routinely run into the millions of dollars. This is what the industry calls “dry holes.” Part of the rationale behind offering tax incentives is to encourage companies to operate in the US – they are not available when operating overseas. The timing helps keep companies drilling and spending money, said Thibodeaux.
The risk factor is also one of the reasons unconventional oil and gas development became so popular in the US. Originally considered “resource plays”, these projects were attractive because they involved drilling fewer dry holes. Many of the shale deposits being targeted were already well-delineated and once technology helped unlock the petroleum resources, drilling risk significantly decreased.
Tax code reform will continue to be a major issue in 2013 across the entire energy complex – not just oil and gas – so keep reading Breaking Energy for additional coverage of how tax code changes will impact the sector.