America's Most Obvious Tax Reform Idea: Kill the Oil and Gas Subsidies

(Reuters)

When Saudi Arabia's longtime oil minister, Ali Al-Naimi, opens his mouth, the world listens. Yesterday, during a speech in Hong Kong, he delivered a message that U.S. policy makers in particular would do well to take note of. The days of $100-a-barrel crude, he told the crowd, are here "for the foreseeable future."

If he's right, one thing that shouldn't be around for the foreseeable future are the outdated tax credits that protect oil and gas companies, which will be plenty profitable in a world of $100-a-barrel oil. If Democrats and Republicans are looking for safe ground to set up camp for the budget negotiations, let's start with these $7 billion-a-year subsidies.

Why Big Oil Doesn't Need Uncle Sam's Help
The oil industry's lobbyists like to argue that its array of tax write-offs (which allow companies to deduct everything from drilling costs to the declining value of their wells) aren't any different than other deductions for less publicly reviled companies. Cutting them will discourage new exploration and put jobs at risk, they claim.

Yet, some of the breaks are anachronisms that date back almost to the days of John D. Rockefeller. And in a world of permanently high crude prices, there's very little rationale for subsidizing the bottom lines of companies like ExxonMobil and BP.

Make no mistake, either: Those profits are perfectly healthy. Between drilling and refining, Exxon's U.S. operations alone earned $7.5 billion after taxes in 2012. California-based Occidental Petroleum Corporation, one of the so-called "independent" oil companies and the top oil driller in Texas, raked in $7.1 billion via its oil and gas division.

There are plenty of reasons, far beyond the word of a single middle-eastern oil man, to expect that those profits will stay high. Oil prices have continued to hover around the $100 mark in part because of instability in the Middle East, but also because, even in our sluggish global economy, demand is still relatively tight. As things improve, demand -- and prices -- will only increase. So if you think China's best days are still ahead of it, and that Europe will eventually pull out of its funk, you should expect prices to keep floating skyward. The Energy Information Administration, for one, believes the cost of a barrel will most likely increase to around $162 by 2040 (as shown on the blue line below).

The oil-filled shale formations in states like North Dakota and Texas that have powered the U.S. energy boom are notoriously expensive to drill. But if predictions like the EIA's come even close to true, then they should remain profitable plays for the industry for years to come. One might argue that without subsidies, they won't be quite profitable enough -- that by nixing the tax breaks that support domestic drilling and refining, we might encourage companies to put their money to do something else with their money. But as Harvard's Joseph Aldy has noted, independent analysts forecast that cutting the subsidy cord would have at most a minimal effect on U.S. drilling activity, possibly reducing it by as little as 26,000 barrels-a-day. Since 2009, he notes, production has been growing by 30,000 barrels a day.

If there's money to be made sucking oil out of the ground, in the end, somebody is likely to do it.

The Worst of the Worst
Some of the biggest subsidies are, well, a bit goofy. In its FY 2013 budget request, Obama administration singled out eight oil and gas tax breaks for the ax, worth about $38.5 billion over the next decade. Those are laid out in the table below from a Congressional Research Service report earlier this month. Let's take the three big ones highlighted in the table below.

Expensing Intangible Drilling Costs ($13.9 billion): Since 1913, this tax break has let oil companies write off some costs of exploring for oil and creating new wells. When it was created, drilling meant taking a gamble on what was below the earth without high-tech geological tools. But software-led advances in seismic analysis and drilling techniques have cut that risk down.
Deducting percentage depletion for oil and natural gas wells ($11.5 billion): Since 1926, this has given oil companies a tax breaks based on the amount of oil extracted from its wells. The logic is, if manufacturers get a break for the cost of aging machinery, drillers can deduct the cost of their aging resources. (You decide for yourself whether that makes any sense.) Since 1975, it's only available to "independent oil producers," not the big oil companies, like Exxon and BP. But most smaller companies aren't actually small. According to Oil Change International, the median independent has a market cap of more than $2 billion. So essentially, this is a tax break that subsidizes the Very Big oil companies at the expense of the Very Biggest.
The domestic manufacturing deduction for oil and natural gas companies ($11.6 billion): In 2004, as American manufacturing was being ravaged by China's entrance on the global scene, Congress passed legislation designed to encourage companies to keep factories operating in the U.S. Thanks to some intensive lobbying, the oil industry ended up as one of the beneficiaries. But while the refining process does involve high-tech manufacturing, there was never any danger that either drilling or refining was going to migrate overseas.

The big tax breaks don't stop there. For instance, accounting rules worth about $2 billion a year to the industry let companies deduct more for the cost of developing wells as oil prices rise. But it gives you a flavor of what we're talking about here -- bonuses that aren't even available to every company in the industry.

No matter how badly John Boehner and House Republicans might wish otherwise, any long-term deficit reduction deal is probably going to have to raise some taxes, probably by nixing deductions. At least, it will if it has any hope of making it past Senate Democrats and the White House. Just $40 billion to $70 billion won't be enough. But the oil and gas subsidies are breaks that, by all rights, have outlived their usefulness. It's time for them to go.