Pennsylvania’s Natural Gas Industry Challenged by Regulatory Changes
While a number of regulatory changes could slow Pennsylvania’s oil and gas expansion, its resource deposits will continue to attract steady growth. Pennsylvania Governor Tom Wolf’s proposed natural gas severance tax would significantly increase the effective tax rate for shale gas producers in the state, and ongoing revisions to oil and gas regulations that aim to increase environmental oversight would increase costs of compliance for natural gas producers. However, investments in Pennsylvania are unlikely to decline due to the built-in advantages of the Marcellus shale formation – namely, its thickness, shallow depth, resource abundance, and proximity to large East Coast markets. Ongoing natural gas pipeline expansion projects in the Northeast will eventually improve market access, help alleviate supply bottlenecks, and stabilize prices. In addition, the Bureau of Land Management’s (BLM) latest regulations governing hydraulic fracturing on federal and tribal lands are unlikely to have direct impact on Pennsylvania’s oil and gas industry due to limited federal mineral rights in the state. They could ultimately help shape the state’s oil and gas surface regulations that are being amended to strengthen environmental protections.
Pennsylvania’s Proposed Natural Gas Severance Tax to Address Budget Deficit
On February 11, 2015, Pennsylvania Governor Tom Wolf proposed the Pennsylvania Education Reinvestment Act, which would impose a severance tax on natural gas extraction to fund the state’s public education in the face of a $2.3B budget deficit. The legislation – modeled after West Virginia’s severance tax plan – would enact a 5 percent tax on gross value and an additional volumetric fee of $0.047 per thousand cubic feet.
Pennsylvania is the only major oil and natural gas producing state that does not levy a severance tax on its producers. Texas, Wyoming, North Dakota, and Alaska rely on oil and gas production taxes to fill significant portions of their state coffers. Though the global oil and gas industry was born in Pennsylvania in the 1860s, the state only reemerged as a significant hydrocarbon producer when horizontal drilling and hydraulic fracturing were implemented over the past decade. In that time, Pennsylvania natural gas production has surged from 200 bcf in 2008 to 3.2 tcf in 2013 (Figure 1). Natural gas production companies such as Range Resources and Chesapeake Energy have leveraged the geological parameters of the Marcellus shale formation with the state’s limited taxes and regulations to build their businesses.
Governor Wolf’s proposal would replace the existing shale gas well impact fee and continue payments made to drilling-impacted communities that are currently funded by the impact fee. It would include exemptions for gas given away free, gas from low-producing wells, and wells resuming production after failing to produce marketable quantities. Governor Wolf’s tax proposal assumes consistent increases in natural gas prices and that production will increase as follows:
- 2015: 4,915.0 bcf
- 2016: 4,978.2 bcf
- 2017: 5,065.3 bcf
- 2018: 5,114.0 bcf
- 2019: 5,186.2 bcf
- 2020: 5,265.5 bcf
Existing Shale Gas Well Impact Development Fee has Generated $630M since 2012
The existing tax regime in Pennsylvania is considerably less burdensome than those of other major oil and natural gas producing states, and has aided in attracting huge investments to the Marcellus shale. Former Pennsylvania Governor Tim Corbett signed Act 13 into law in February 2012, amending Title 58 of the Pennsylvania Consolidated Statutes, which regulates oil and gas activity. The Act authorized Pennsylvania counties to levy an impact fee on unconventional gas well development to address local drilling impacts, in addition to putting in place a new set of environmental regulations. The impact fee has generated approximately $630M since 2012 (Figure 2). The Pennsylvania Independent Fiscal Office estimates that the existing impact fees are equal to a 2.1 percent effective tax rate on shale gas production. It provides significant benefits for counties directly affected by natural gas drilling while providing a minimum annual allocation to all counties for certain environmental initiatives through the Marcellus Legacy Fund. The Pennsylvania Public Utility Commission (PUC) administers fee collection and disbursement, with annual adjustments based on natural gas prices and Consumer Price Index. It allots funds to state agencies, the Marcellus Legacy Fund, Unconventional Gas Well Fund, and specific purposes set forth in the Act.
Effective Tax Rate of Proposed Severance Tax Higher with Current Natural Gas Prices
The proposed severance tax would significantly raise the effective tax rates that natural gas production companies pay in Pennsylvania and generate hundreds of millions of dollars in additional tax revenues. The effective tax rate would increase considerably if natural gas production continues to rise, as forecasted, and prices remain at their current levels. A clause in the proposed tax sets a minimum taxable level of $2.97/MMBtu on natural gas production – irrespective of actual sale price. While natural gas prices in the Marcellus region have hovered around $2/MMBtu in recent months, producers would be taxed as though the price stood at $2.97/MMBtu. Pennsylvania produced 3.259 tcf of natural gas in 2013. Under Governor Wolf’s proposal, the state would have generated $483,967,737 from the 5 percent severance tax, and an additional $152,174,974 from the volumetric fee. In 2013 alone, Pennsylvania would have raised more than the $630 million that the existing impact fee has generated since it was implemented in 2012. In this scenario, natural gas producers in Pennsylvania would have paid an effective tax rate on their production of approximately 6.5 percent in 2013.
While natural gas producers in the state have increased their production to 1.9 tcf in the first half of 2014, there is reason to believe that prices in the region will not increase dramatically over the next year. Spot prices at the key trading hubs in the Marcellus region – Leidy and Tennessee Zone 4, Dominion (North and South), and TCO Pool – have fallen below the national benchmark at Henry Hub due to the limited capacity of regional pipeline networks and storage facilities to process the skyrocketing output of shale gas in the state.
Several major natural gas pipeline projects that are under construction, including the Constitution Pipeline project (FERC docket number CP13-499), will eventually alleviate some of the downward pressure on Marcellus natural gas prices. According to Moody’s, natural gas pipeline projects in advanced stages will increase the national capacity by 2018. Of those projects, 88 percent are located in the East Coast, where Marcellus shale gas production has grown to account for 40 percent of the national total. However, these pipeline projects face regulatory scrutiny and, in some cases, public opposition. Moreover, their construction timelines mean that natural gas prices in the region are not likely to experience dramatic increases in the short to medium-term. Assuming that natural gas production reaches 4.978 tcf and average natural gas prices average $2.50/MMBtu, Pennsylvania would generate $973,238,100 from Governor Wolf’s severance tax proposal in 2016 ($739,262,700 from 5 percent tax and $152,174,974 from $.047 volumetric fee). As a result, the effective tax rate of the proposal would increase to 8 percent.
Republican-Controlled State Legislature, Local Governments and Natural Gas Industry Oppose Tax in Current Form
Republicans in the state legislature, regional interests, and the natural gas industry will provide stern resistance to Governor Wolf’s proposed tax. State Republicans are adamant that other deficit-focused legislation, including privatization of liquor sales and pension reforms, must be addressed before the severance tax moves forward. Municipal governments in the areas with the greatest levels of natural gas production – the Northeast and Southwest regions of the state – are also opposed to the severance tax because it would replace the impact fees that are distributed locally. The natural gas industry argues that the severance tax would significantly decrease investment in the sector. Furthermore, the price floor built into the tax limits natural gas companies’ abilities to forecast their tax bills due to the volatility of natural gas prices in the region. Governor Wolf will find less resistance to his severance tax proposal if he is able to accommodate on liquor sales and pensions with the state legislature and lowers, or removes, the floor price of $2.97/MMBtu.
Pennsylvania Department of Environmental Protection Issues New Shale Gas Regulations
In addition to proposing a severance tax, Governor Wolf has also moved to bolster environmental regulations on the shale gas industry, potentially reducing natural gas producers’ profit margins further. On March 9, Pennsylvania’s Department of Environmental Protection (DEP) released draft amendments to its Environmental Protection Standards at Oil and Gas Well Sites. The revisions would update requirements related to surface activities at oil and gas well sites and implement Act 13 which strengthened environmental protection measures for well pads, freshwater and wastewater impoundments, gathering pipelines, and borrow pits at oil and gas sites.
Among the key components, the revisions would create additional standards for noise control and mitigation and wastewater storage. The revisions would require operators to expand the review of drilling impacts to include public resources, such as schools and playgrounds. They include separate regulatory chapters to differentiate conventional and unconventional well development. The draft will be open for a 30-day comment period from April 4. Industry groups, including the Marcellus Shale Coalition (MSC) and the Pennsylvania Independent Oil and Gas Association, have leveled criticism towards the new regulations. At a public DEP hearing on March 20, Jim Welty, the vice president for government affairs of the MSC, said, “In our view, [these regulations] are designed to increase costs and threaten continued development of this industry.”
Federal Hydraulic Fracturing Regulations are Unlikely to Directly Impact Pennsylvania Industry
Finally, newly released Bureau of Land Management (BLM) regulations pertaining to hydraulic fracturing on federal and tribal lands are unlikely to have a significant impact on Pennsylvania due to limited federal mineral rights in the state. The BLM’s final rules, released on March 20, establishes new requirements to enhance chemical disclosure, ensure well-bore integrity, and protect water quality. Approximately 100,000 oil and gas wells are located on federal lands, of which more than 90 percent use hydraulic fracturing. Among the key provisions, the rule requires companies to publicly disclose hydraulic fracturing chemicals through the FracFocus website; sets higher standards for interim storage; and outlines measures to protect groundwater supplies and lower the risk of cross-well contamination. States and tribes may request variances from provisions if they have equal or more protective regulations, thereby avoiding duplication. Based on the Energy Information Administration’s (EIA) average per well cost of $5.4M, the BLM estimates the rule to cost less than one-fourth of one percent of well-drilling costs.
Federal acreage in oil and gas producing areas in Pennsylvania is not significant. According to the U.S. Department of Agriculture’s 2007 Land and Resource Management Plan for the Allegheny National Forest, the federal government has seven percent mineral rights in the Allegheny National Forest – Pennsylvania’s largest swath of federal land – representing approximately 35,000 acres. Of this total acreage, 16,254 acres (46 percent) have been withdrawn from leasing and an additional 7,315 are not available for leasing – including lands inundated by the Allegheny Reservoir. Currently, 870 acres have been leased for drilling and no active drilling has occurred in recent years. However, the BLM hydraulic fracturing regulations for federal lands could influence the ongoing review of state level regulations.
Shale Gas Producers Can Afford Proposed Severance Tax
Although Governor Wolf’s severance tax and the DEP’s new shale gas regulations will prove costly for the industry, particularly while natural gas prices remain low, it is highly unlikely that natural gas producers in Pennsylvania will shift their focus to other states. Depressed natural gas prices in the region have already lead companies like EQT Resources to cut their capital budgets for 2015 and the severance tax could lead to marginally larger cuts. However, EQT Resources estimates that after tax internal rates of return for its southwestern Pennsylvania shale gas wells stands at 18 percent when natural gas prices are at $2.50/MMBtu. When natural gas prices reach $4/MMBtu, the after tax internal rate of return is boosted to 109 percent. A study conducted by Bentek Energy found that internal rates of return were significantly higher in other shale gas formations, including the Barnett, Haynesville and Fayetteville. While profit margins would be tightened and drilling programs reduced, natural gas producers active in Pennsylvania’s Marcellus shale can afford Governor Wolf’s proposed severance tax.
Originally published by EnerKnol.
EnerKnol provides U.S. energy policy research and data services to support investment decisions across all sectors of the energy industry. Headquartered in New York City, EnerKnol is proud to be a NYC ACRE company.
