Buried within President Obama's 2009 budget proposal are nine provisions intended to eliminate $31.5 billion of "oil and gas company preferences" over the next decade. Most are repeals of existing tax breaks, while a new excise tax on Gulf of Mexico production is thrown in for good measure.
These budget measures are a pretty clear shot at Big Oil, which remains a political target despite the sudden shrinkage of those wicked windfall profits. I'm afraid, however, that our country's independent energy producers will disproportionately bear the brunt of these proposed changes, which could lead to less domestic production.
Give me a break
Consider the repeal of the manufacturing tax deduction. This deduction is straightforward enough: produce stuff domestically, score a tax break. If you take this benefit away from globally diversified ExxonMobil (NYSE:XOM), maybe it drills a few more wells in Thailand or Turkey instead of Texas. No biggie.
Strip a domestic producer like Southwestern Energy of these savings, though, and the money to pay the higher taxes will predictably come right out of the capital budget. The impact gets multiplied as it translates to reduced demand for the services of Dawson Geophysical (NASDAQ:DWSN), Nabors Industries (NYSE:NBR), and the rest of the oil patch's service providers.
Maybe politicians aren't paying attention to what's happening in the oil patch these days, but we energy-focused Fools are following the company implosions, collapsing rig count, and asset fire sales with great concern. This is a heck of a time to put the brakes on productive activity in the energy sector.
A more tangible example
Let me flesh out this next example a bit more. Another line item in the Obama budget proposes the repeal of intangible drilling cost (IDC) expensing. Sounds boring, I know, but the numbers here (crunched by research associate Lisa Fancy of Ross Smith Energy Group) should grab your attention.
When it comes to drilling and completing a well, IDCs represent anywhere from 60% to 90% of the total cost. Basically, the more complex the job, the higher the proportion represented by IDCs like site surveys and fracture jobs. Integrated oil companies are already required to capitalize a portion of these costs, so once again independents are the ones getting hit hardest here.
Wait a tick. Isn't capitalization versus expensing just an accounting choice, leading to non-cash discrepancies between firms such as Devon Energy (NYSE:DVN) and Anadarko Petroleum? Not when we're talking about tax reporting. Take away the ability to expense IDCs, and you accelerate the payment of cash taxes.
Capitalization, on the other hand, doesn't usher in an increase in taxes, but rather a shuffle. Still, the temporal shift is enough to seriously ding the net present value of a drilling operation. In a hypothetical case in which an E&P spends the same amount year after year, Fancy calculates a 13% hit to the firm's net asset value (NAV). Of course, given the depleting nature of oil and gas assets, spending usually rises each year (when the economy's not paralyzed, at least). In the case of a 10% annual bump in capital expenditures, the hypothetical hit to NAV rises to 20%.
The most costly and complex natural gas wells being drilled onshore today are in the Haynesville shale play in Louisiana and east Texas. Consequently, single-well economics in the Haynesville appear hardest hit by a loss of IDC expensing, perhaps to the tune of 18% of net present value. This would be pretty bad news for folks such as Petrohawk Energy (NYSE:HK), though I suspect that particular outfit would keep plowing ahead in any case.
Drilling our domestic producers
I see the same problem recurring across these various oil-industry tax proposals. Global firms such as ConocoPhillips (NYSE:COP) get encouraged to shift business abroad, while small fries lacking the scale to move activity outside of the country simply do less drilling. In both cases, we see less domestic energy production (not to mention fewer jobs). I don't see how this helps us "reduce dependence on foreign oil," a stated goal of the budget.
Through these line items, we are effectively kicking our independent producers while they're down. And they produce 82% of U.S. natural gas!
As the head of StatoilHydro (NYSE:STO) recently pointed out in a letter to shareholders, "despite the best of intentions, it is a fundamental energy reality that the world is decades away from a low-carbon society." These measures, which we can expect to drive up the marginal cost of natural gas, promise to make the ensuing decades just that much more uncomfortable as we continue to rely on fossil fuels for the majority of our energy needs.
