Markets, Not Govt., Will Improve Energy Security

Senator Edward J. Markey provided the Institute for Energy Research (IER) with questions for the record after the hearing he held on “U.S. Security Implications of International Energy and Climate Policies and Issues” on July 22, 2014. Below are IER’s responses to those questions:

I have responded to each of the questions from Senator Markey below. I would like to make it clear at the outset that I am in favor of all energy technologies. However, I believe that the energy marketplace should determine the market penetration of each technology, not government policies that distort the economics of the technologies and end up costing the American public more than necessary to pay for the power that they need.

Further, I would note that some of the policies that Senator Markey seems to advocate in his questions below would reduce U.S. energy production, increase oil imports and our trade deficit, and have the effect of reducing U.S. energy security. Senator Markey should understand the implications of ending the tax deductions mentioned below, which is essentially a tax increase on the oil and gas industry resulting in a reduction in domestic energy production, which would result in an increase of oil from overseas suppliers. That said, in regard to tax policy, I believe that all industries should be treated the same, irrespective of the product that the industry produces.

There are those who complain about the earnings of the oil and gas companies without understanding the nature of the business, which is the most capital-intensive in the world. The oil and natural gas industry must make large investments in new technology, new production, and environmental and product quality improvements to meet future U.S. energy needs. These investments are not only in the oil and gas sector but in alternate forms of energy (e.g. biofuels). For example, an Ernst & Young study shows the five major oil companies had $765 billion of new investment between 1992 and 2006, compared to net income of $662 billion during the same period. The 57 largest U.S. oil and natural gas companieshad new investments of $1.25 trillion over the same period, compared to net income of $900 billion and cash flows of $1.77 trillion. In another Ernst and Young report, the 50 largest oil and gas companies spent over $106 billion in exploration and development costs in 2011, an increase of 38 percent over those capital investments in 2010. Without these investments, the U.S. oil and gas industry would not have been able to make the strides in increased oil and gas production that they have made and continue to make in this country.[i] Earnings allow companies to reinvest in facilities, infrastructure and new technologies, and when those investments are in the United States, it means many more jobs, directly and indirectly. It also means more revenues for federal, state and local governments.

Question: Ukraine’s reliance on Russian natural gas to meet half of its domestic needs has left it vulnerable to predatory Russian practices in terms of energy supply manipulation. Yet Ukraine has vast untapped domestic natural gas supplies and it is also the second least energy efficient country in the world. I have introduced legislation—S. 2433—that aims to double U.S. government-wide energy assistance to Ukraine to help them increase efficiency, develop their own resources, and get off Russian gas. Do you support this legislation? Please provide any thoughts or technical feedback about this legislation.

Response: For years, the United States experienced declining natural gas production and was constructing terminals for liquefied natural gas (LNG) imports to ensure that the United States had an adequate supply of natural gas in the future. The reason the United States now produces the most natural gas in the world and no longer needs to rely on LNG imports is not because of government programs, but because of technological improvements in the market place, private property rights, and prudent regulations by state regulators. Policymakers should promote these proven avenues that have led to natural gas energy independence and growing market power for the United States. If Senator Markey believes that Ukraine is vulnerable to hostile governments because it has not fully tapped its domestic gas supplies, Senator Markey should agree that the United States government should not commit a similar mistake by hampering the development of American oil and gas supplies, as the Obama Administration is currently doing.

If it is the case that Ukrainian government is hampering the development of its own domestic gas resources, then Ukrainian people would be served by eliminating such obstacles. However, the U.S. government does not need to assist Ukrainian government in implementing a policy that makes Ukrainians wealthier and more strategically secure. Furthermore, S. 2433 contains provisions for the U.S. government to provide “loan, lease, and bond guarantees” to financial institutions to facilitate the goals of the proposed legislation.[ii] Such guarantees place U.S. taxpayers on the hook in the event of a default. There is no economic rationale for U.S. taxpayers to effectively subsidize Ukrainians to do what it is in their own best interest.

Question: You made your critical views on the Cape Wind offshore wind project, and government support for it, very clear during the hearing. What are your views on the $8.3 billion loan guarantee, most of which has been finalized, to construct nuclear reactors?

Response: The Energy Information Administration (EIA) estimates the levelized cost of new generating technologies as part of its Annual Energy Outlook. The average cost of offshore wind in the agency’s 2014 outlook is 20.4 cents per kilowatt hour while the levelized cost for advanced nuclear is 9.6 cents per kilowatt hour, or less than half the cost of offshore wind.[iii] Given that EIA also expects advanced nuclear to have a 90 percent capacity factor while offshore wind has only a 37 percent capacity factor on average, the amount of generation from nuclear power compared to wind power would be 2.4 times more for the same amount of generating capacity. Further, wind is an intermittent technology and cannot be relied on continuously to supply power when Americans need it most. It generates power only when the wind blows which is more prevalent at night when we need it the least. Because Cape Wind will drive up the cost of energy for Americans based on its contract specifications, I do not support it.

Compared to offshore wind, which is an intermittent, inefficient and expensive technology, nuclear power is reliable, efficient and more affordable as the numbers from EIA above demonstrate.

That said, I believe it is a bad idea for taxpayers to support either technology (or any technology for that matter).  The federal government has demonstrated time and time again with companies like Solyndra that it is ill-suited to pick winners in the marketplace.  The reason that the government supports specific technologies is the belief that consumers will not willingly pay for those technologies.  When elected officials impose their choice of technologies on consumers and taxpayers, other technologies that could have made it in the marketplace on their own are locked out–and the consumers who would have preferred those technologies–suffer.

Question: Thanks to an oil company court challenge to a 1995 law, oil companies are able to drill on many leases in the Gulf of Mexico without paying any royalties to the American taxpayers. Currently, oil companies are paying zero royalties to taxpayers for one quarter of all offshore oil production in the United States. Incentivizing companies to renegotiate these leases in order to pay a fair return to the public could save taxpayers $15.5 billion over 10 years according to the Department of the Interior. The Government Accountability Office has estimated that taxpayers could lose up to $53 billion over the life of these faulty leases. Would you support legislation to correct this problem, which the Congressional Research Service has found is within Congress’s legal authority and would not abrogate contracts between oil companies and the federal government?

Response: I am grateful for the opportunity to set the record straight on the deepwater royalty relief program. Oil is being produced in the deep water federal Gulf of Mexico, where production just increased during fiscal year 2013 for the first time since the moratorium on drilling was imposed by the Obama Administration in 2010, because of the royalty relief program. The program originally provided royalty relief for operators to develop fields in water depths greater than 200 meters (656 feet). The suspension of Federal royalty payments for new leases was limited to a certain level of production based on water depth. The original terms and conditions expired in November 2000, and since that time, a revised incentive plan was adopted that is no longer based on volumes determined by water-depth intervals. Instead, the Department of Interior assigns a lease-specific volume of royalty suspension based on how the determined suspension amount may affect the economics of various development scenarios with the most economically risky projects receiving the most relief, while others may receive no relief. For example, a deep-water field might not receive any relief if it is adjacent to an existing gathering system. On the other hand, a similar field may receive a great deal of relief if it is located far beyond the current pipeline infrastructure.[iv]

If the royalty relief program did not exist, the technology would not have been developed to produce oil and natural gas in the deep water Gulf of Mexico and domestic oil production would be much lower—clearly reducing America’s energy security and making the United States more dependent on foreign imports. This is consistent with the points made by the Honorable Hazel O’Leary, Secretary of Energy during the Clinton Administration.

In a letter on page H11872 of the Congressional Record in support of the legislation at the time,[v] the Secretary said, “Comparing this loss (foregone royalties) with the gain from the bonus bids on a net present value basis, the Federal government would be ahead by $200 million. It is important to note that affected OCS projects would still pay a substantial upfront bonus and then be required to pay a royalty when and if production exceeds their royalty-free period. A royalty-free period, such as that proposed in S. 395, would help enable marginally viable OCS projects to be developed, thus providing additional energy, jobs and other important benefits to the nation.”

On the matter of national security, she went on to add, “The ability to lower costs of domestic production in the central and western Gulf of Mexico by providing appropriate fiscal incentives will lead to an expansion of domestic energy resources, enhance national energy security, and reduce the deficit.”

Clearly, President Clinton and his Administration studied this matter and saw it as a significant national security benefit to the United States, and a benefit, not a loss, to the U.S. Treasury. Besides providing the American public with more oil and gas production and greater energy security, thousands of jobs exist today because of the royalty relief program.

Question: Last-In, First-Out (LIFO) accounting allows oil companies to value their inventories at deeply discounted prices. Repealing this subsidy for the largest oil and gas companies would generate at least $14.1 billion over 10 years, according to the Joint Committee on Taxation (JCT). Is there any other industry that benefits from this tax subsidy as much as the oil and gas sector? If so, which sector(s) and how much do they benefit from this subsidy? Would you support ending this accounting methodology for all taxpayers?

Response: All U.S. taxpayers may use the LIFO (Last-In-First-Out) method of accounting for inventories. Repealing this provision for just the oil and gas industry would be particularly detrimental to refiners, who maintain large inventories of both crude and refined products. I believe that all industries should be treated the same under the U.S. tax law and that one industry should not be singled out for differential treatment. This accounting methodology should either be allowed for all taxpayers or repealed for all taxpayers.

Question: Foreign tax credits allow all companies that do business abroad to reduce from their U.S. tax bill by any income taxes paid to other governments. However, these rules were not intended to allow oil companies to claim deductions for what amount to royalty payments to foreign governments. Such payments are not income taxes but fees for the privilege of producing valuable natural resources abroad. Yet, as a result of loosely drafted rules, oil companies are frequently deducting these payments from their U.S. tax liability. Eliminating this tax treatment for the largest oil companies would generate at least $6.5 billion over 10 years, according to the JCT. Would you support ending this tax subsidy for the largest oil companies? Is there any other industry that benefits from this tax subsidy as much as the oil and gas sector? If so, which sector(s) and how much do they benefit from this provision.

Response: The above issue relates to dual capacity rules and according to the Joint Committee on Taxation, U.S. oil and gas companies are already limited in their ability to claim these credits.[vi] Further, the purported issue that you describe, i.e. that companies claim royalty payments as a foreign tax credit, is prevented by the current rules for this provision. Oil and gas companies are under constant audit by the Internal Revenue Service. As a part of these audits, teams of examiners focus heavily on this very issue. If an IRS agent feels that there is an issue related to mischaracterization of a tax payment, he or she need not “prove” the case, but merely needs to raise the question. The taxpayer is then required, under the law, to prove that the payment was, in fact, a payment of tax and not a royalty, and to provide that proof in court, if necessary. The burden of proof rests heavily on the taxpayer in this instance. Modifications to this provision will make U.S. companies less competitive and place a greater share of oil and gas reserves into the hands of non-U.S. companies, employing non-U.S. workers; many of which are foreign-government-controlled.

Question: The section 199 domestic manufacturing deduction was enacted in 2004 and re-categorized the oil industry as a manufacturing industry, thus making it eligible for this deduction. Repealing this provision for the largest oil companies would save $10.4 billion over the next 10 years, according to the JCT. Would you support ending this tax subsidy for the largest oil companies?

Response:The purpose of the domestic manufacturing tax deduction is to incentivize companies to continue to do business in America. The United States now has the highest tax rate in the world among developed countries, and due to these high tax rates, companies have been making investments overseas.[vii] The domestic manufacturing tax deduction allows all industries and businesses (not just oil companies) to deduct a certain percentage of their profits. For the oil and gas industry, the tax deduction is 6 percent; for all other industries (software developers, video game developers, the motion picture industry, among others), it is a 9 percent deduction.[viii] Removing these tax deductions will result in oil companies taking capital abroad to make their investments, reducing U.S. oil production and tax revenues and increasing imports of foreign oil. Given that oil and gas production-related employment on non-federal lands in the United States is one of the few bright spots in the worst economic recovery since the Great Depression, such a result would undermine job creation.

Question: The expensing of intangible drilling costs allows intangible drilling costs, such as wages, repairs, and supplies related to and necessary for drilling and preparing wells for the production of oil and gas, to be deducted in the year they occurred. Non-energy companies must depreciate these costs over time. The JCT estimates that repealing this subsidy will generate $13.2 billion over 10 years. Are any other companies besides oil and gas production companies eligible for this claiming this tax provision? Would you support ending this tax subsidy?

Response: This incentive exists to encourage small companies (less than 20 employees) to produce oil from marginal wells that are old or small and do not produce much oil individually. According to the Independent Petroleum Association of America, independent producers drill 95 percent of the oil and natural gas wells in America, producing 54 percent of U.S. liquids – 54 percent oil and 81 percent condensates. They reinvest 150 percent of their American cash flow back into new American production.[ix]

Independent oil producers are allowed to count certain costs associated with the drilling and development of these wells as business expenses. This ability to expense these costs is analogous to the research and development (R&D) deduction available to all taxpayers engaged in R&D activities. The law allows the small producers to expense the full value of these costs, known as intangible drilling costs, every year to encourage them to explore for new oil. The major companies get a portion of this deduction—they can expense a third of intangible drilling costs, but they must spread the deductions across a five-year period.[x]

Again, I believe that all industries should be treated the same under the tax law and that one industry should not be singled out for differential treatment because the terminology used is different.

Question: Certain oil companies amortize the costs of exploratory work in two years, while other companies must amortize those same costs over seven years. Increasing geological and geophysical amortization periods for oil and gas companies to seven years would harmonize this policy across industries and operators. The JCT estimates that making this change would save taxpayers as much as $1.1 billion over 10 years.Would you support this change in tax policy to eliminate a subsidy?

Response: Independent producers and smaller integrated companies are currently allowed to amortize geological and geophysical (G&G) costs over a 2-year period, whereas major integrated producers may only amortize over 7 years.[xi] According to the Joint Committee on Taxation, G&G costs are costs incurred for the purpose of obtaining and accumulating data that will serve as acquisition and retention of mineral properties[xii], which are akin to research and development expenses that most companies can expense in one year.

“Research and development, or R&D, are the lifeblood of technological advancement, and they factor heavily in most corporate enterprises’ planning and growth. Recognizing the importance of technology and business growth in the international marketplace, the U.S. Congress created tax breaks for companies that engage in R&D. As an incentive to engage in research and development, the IRS permits businesses to deduct all R&D expenses in a single year instead of amortizing as a capital expense.”[xiii]

Again, I believe that all industries should be treated the same under the tax law and that one industry should not be singled out for differential treatment because the terminology used is different.

Question: Oil and gas properties qualify for “percentage depletion,” a tax deduction of 15 percent of gross revenues from the well, even if the deductions exceed the well’s value over time. The JCT estimates that repealing this provision for the large oil companies would generate $11.9 billion over 10 years. Do you support the repeal of this tax subsidy? Are any other companies besides oil and gas production companies eligible for claiming this tax subsidy?

Response: I am grateful for the opportunity to set the record straight on the percentage depletion tax deduction that the small independent oil producers are allowed to deduct on their taxes. As the oil and gas in a well is depleted, the small independent producers are allowed a percentage depletion allowance to be deducted from their taxes. While the percentage depletion allowance sounds complicated, it is similar to the treatment given other businesses for depreciation of an asset. The tax code essentially treats the value of a well as it does the value of a newly constructed factory, allowing a percentage of the value to be depreciated each year. This allowance was first instituted in 1926 to compensate for the decreasing value of the resource, and was eliminated for major oil companies in 1975.[xiv] This allowance applies only to the first 1,000 barrels of production during the period, so it is of little significance to large independent producers. It saves the independent oil and gas producers about $1 billion in taxes per year.[xv] It is true that repealing this provision would extract more tax revenue from these energy producers since that is what tax hikes do, but it would make sense from neither an economic nor accounting perspective. When oil is removed from a well and sold, the remaining value of the well does go down. The percentage depletion deduction addresses this reality of oil and gas production.

Question: Under the tax rules governing tertiary injectants, oil companies deduct expenses relating to the cost of tertiary injectants during the taxable year, instead of depreciating these costs over a typical cost recovery schedule. Ending this subsidy for large oil companies would generate $32 million over 10 years, according to the JCT. Do you support the repeal of this tax subsidy? Are any other companies besides oil and gas production companies eligible for this claiming this tax subsidy?

Response: According to the Joint Committee on Taxation, oil and gas companies can deduct tertiary injectant expenses during the taxable year[xvi], similar to a business expense of other companies. This provision was provided to the oil and gas industry to increase domestic oil production, providing greater energy security for the nation. And, it is continuing to be effective. For example, domestic oil production from enhanced oil recovery is expected to increase in EIA’s Annual Energy Outlook projections by over 160 percent between 2012 and 2040[xvii], which shows that this tax provision is fulfilling its intended purpose of increasing domestic oil production, thereby increasing energy security.

Question: Taxpayers can shelter active income through passive losses or credits associated with the production of oil and gas, a condition that does not apply to other sources of passive income or credit. Repealing the exception for passive loss limitations for oil and gas properties for oil companies with revenues above $50 million per year would generate $9 million over 10 years, according to the JCT. Would you support this change to harmonize tax treatment so as not to favor oil and gas investments over other types of energy investments?

Response: Although this is not a specifically energy-related topic, in the spirit of promoting economic efficiency and avoiding the government picking winners and losers, IER supports broad-based tax reform that would eliminate all tax credits and deductions for all firms, so long as marginal tax rates were reduced across-the-board to maintain revenue neutrality. This reform would flatten the tax code and consistently apply the same rules to everybody, removing the temptation for government officials to dole out privileges to favored groups by partially shielding them from the full burden of the code. IER would fully support Senator Markey if he chooses to promote such broad-based tax reform. However, if Senator Markey believes it is good policy to discriminate against a particular industry merely because they produce hydrocarbons, then Senator Markey’s proposal will not provide efficient tax reform but instead will simply be a tax hike on one of the few sectors of our economy that has been consistently producing jobs since the recession began.

[i] Ernst and Young, US E&P Benchmark Study, June 2012, http://www.ey.com/Publication/vwLUAssets/US_E_and_P_benchmark_study_-_June_2012/$FILE/US_EP_benchmark_study_2012.pdf

[ii] https://beta.congress.gov/bill/113th-congress/senate-bill/2433.

[iii] Energy Information Administration, Levelized Cost and Levelized Avoided Cost of New Generation Resources in the Annual Energy Outlook 2014, April 17, 2014, http://www.eia.gov/forecasts/aeo/electricity_generation.cfm

[iv] Encyclopedia of Earth, Deep Water Royalty Relief Act, July 17, 2011, http://www.eoearth.org/view/article/160979/

[v] Congressional Record, November 8, 1995, http://www.gpo.gov/fdsys/pkg/CREC-1995-11-08/pdf/CREC-1995-11-08.pdf

[vi] Joint Committee on Taxation, Description of Present Law and Select Proposals Relating to the Oil and Gas Industry, May 12, 2011, https://www.jct.gov/publications.html?func=startdown&id=3787

[vii] US News, World’s Highest Corporate Tax Rate Hurts U.S. Economically, April 2, 2012, http://www.usnews.com/opinion/economic-intelligence/2012/04/02/worlds-highest-corporate-tax-rate-hurts-us-economically

[viii] Scientific American, End Oil Subsidies? The $4 Billion Dollar Question, February 21, 2012, http://blogs.scientificamerican.com/plugged-in/2012/02/21/guest-post-end-oil-subsidies-the-4-billion-question/

[ix] Independent Petroleum Association of America, http://oilindependents.org/about/

[x] Trib.com, Obama tax changes could hit small oil and gas operators in Wyoming, March 30, 2012, http://trib.com/news/state-and-regional/obama-tax-changes-could-hit-small-oil-and-gas-operators/article_6b18a423-f5ec-5301-b920-05491a9d40ab.html

[xi] Joint Committee on Taxation, Description of Present Law and Select Proposals Relating to the Oil and Gas Industry, May 12, 2011, https://www.jct.gov/publications.html?func=startdown&id=3787

[xii] Joint Committee on Taxation, Description of Present Law and Select Proposals Relating to the Oil and Gas Industry, May 12, 2011, https://www.jct.gov/publications.html?func=startdown&id=3787

[xiii] Small Business, Tax Breaks for R&D, http://smallbusiness.chron.com/tax-breaks-rd-36815.html

[xiv] Star Tribune, Obama tax changes could hit small oil and gas operators in Wyoming, March 30, 2012, http://trib.com/news/state-and-regional/obama-tax-changes-could-hit-small-oil-and-gas-operators/article_6b18a423-f5ec-5301-b920-05491a9d40ab.html

[xv]Scientific American, End Oil Subsidies? The $4 Billion Dollar Question, February 21, 2012, http://blogs.scientificamerican.com/plugged-in/2012/02/21/guest-post-end-oil-subsidies-the-4-billion-question/

[xvi] Joint Committee on Taxation, Description of Present Law and Select Proposals Relating to the Oil and Gas Industry, May 12, 2011, https://www.jct.gov/publications.html?func=startdown&id=3787

[xvii] Energy Information Administration, Annual Energy Outlook 2014, http://www.eia.gov/forecasts/aeo/pdf/tbla14.pdf