Oil subsidies

When the drinks are flowing at the open bar, it's not a big surprise that patrons swarm for their free pints.  Tax bills are the same, with amendments aplenty as the hours ticked on towards the Senate passage of a massive tax reform package last week.  Hey, when you are spending somebody else's money and nobody has time to read what you are sticking in anyway, why not take a gander on a nice payout for your district friends?

Here's a rundown of a few energy-related items of interest in the tax bill.  The Senate version, with hand markups and all, and run through OCR so you can search it, can be accessed here.

1)  Wildlife reserves are for drilling 

Tax bills aren't just for taxes, and wildlife reserves aren't just for wildlife.  After decades of trying, the Senate moved to open the coastal areas of the Alaska National Wildlife Refuge (ANWR) for oil and gas exploration and leasing (see Title II, page 474) of the bill.  

Some background on the remaining hurdles and not so great economics of oil and gas in ANWR are found in this useful piece by Oil Change's Andy Rowell.  Analysis I did with the Stockholm Environmental Institute looking at field-level data across the US also indicated these areas well below breakeven at current market prices. 

No such ambiguity about the move can be seen from Alaska Senator Lisa Murkowski though.  She fought hard for this change and believes it'll bring great wealth even if scientists and economists don't.  But other short-term factors are also driving this decision.  First, Alaska's budget remains heavily dependent on oil and gas revenues -- something that aging fields and falling prices have hurt.  Second, the Trans-Alaska Pipeline System (TAPS) needs more product to keep the unit costs low and the infrastructure maintained.  Indeed, it turns out that getting flow from ANWR was a core assumption when it was designed.1   And boosting the flows will reduce unit costs, reduce operating costs (low flows in a massive diameter line cost more to keep moving), and boost confidence in continued service to existing fields that would be stranded were the line to close.  One final benefit of keeping TAPS running:  pipeline operator Alyeska can continue to defer its responsibility (and associated cost) to dismantle the pipeline and clean up the right-of-way. 

Oil revenues are easier to measure than fish and wildlife values, and there is quite a bit of wildlife in the areas being opened for drilling.  Audubon magazine notes the region being opened has the highest biological diversity for any protected area above the Arctic Circle.

Look for low realized values on the lease sales due to a low price environment, remote and expensive fields, and a high risk of delays from court challenges.  Expect state or federal subsidies to infrastructure, perhaps combined with weak financial assurance requirements for the drillers to spur deals along.  And finally, expect some spills and other damage to natural resources.  All will erode the net gains to the state from this move.

But in the arcane rule of budgets, all that counts is the gross gain to Treasury from the sale of a natural resource, resulting in net offsetting receipts of $1.1 billion according to CBO.  Not much in the context of an increased deficit of $1.5 trillion, and even this low value treats as zero the damages to natural resources or other property values.  But that, unfortunately, is how this rather bizarre world operates.

2)  Strategic reserves are for selling (to help offset continued subsidies to hedge fund managers)

The very last section (Section 20003) of the Senate bill authorizes the sale of $600 million of oil from the Strategic Petroleum Reserve in 2026 and 2027.  This is a very small amount of money at the very end of the scoring period for this bill. Yet, it does help a bit to offset some of new tax subsidies in the bill.

How's it relate to hedge fund managers?  Because the Senate instituted a 3 year holding period (up from one) on private equity and hedge fund carried interests, boosting revenue by only $1.2 billion over 10 years.  Had they instead eliminated carried interest subsidies altogether, tax revenues would have been increased by $16 to $180 billion over the same period.  

Not making the hard decisions leaves the Republican Senators using a combination of gimmicks, like selling oil from SPR starting in 9 years -- and simply running up the debt -- instead. 

3)  Tax-favored status on pass-throughs confirmed to apply to MLPs 

Pass-through entities escape corporate level taxation, but historically were taxed at the individual level based on the economic situation of the individual partner.  Many of these partners are wealthy and taxed at the highest marginal rates.  They don't like this.

The House bill caps the individual rate on income from pass-throughs at 25%.  The Senate bill instead allows up to 23% of expenses to be deducted from taxable income, with a similar effect on the effective tax rate.  Earlier versions of the Senate bill capped deductions at 17.5%; boosting it to 23% increased the revenue loss by $114 billion (to a total of $476 billion) over the 2018-27 period.2

A last-minute amendment sought to expand this benefit to both MLPs and to financial PTPs such as Blackstone.  Only the first got through -- though it's a big one.  It further extends the tax subsidies on offer to oil and gas MLPs by reducing the taxes even the partners have to pay.

I remain unclear as to whether even the financial MLPs are fully frozen out of this new subsidy.  To the extent their energy investments are organized as limited partnerships within the larger PTP, income would flow out of the investments both to the parent company (and those invested in the traded shares) and directly to the limited partners who have bought into the individual investments or investment funds.  For this latter group, my assumption would be that the lower tax rate would apply.  Please email if you know the definitive answer on this. 

4)  LIFO no more for Grandaddy; but still available for ExxonMobil  

Any tax rules that enable taxpayers to deduct a higher proportion of their expenses more quickly generates a financial benefit on a time-value-of-money basis.  Inventory turns out to be important in this way.  Firms usually have many identical products in their inventory -- whether barrels of oil or computers.  When they sell a product, they deduct the cost of that product (via cost of goods sold) from revenues in order to calculate the taxable income.  The costs of that product are not identical over time:  commodities may change sharply in value over the inventory turnover cycle; and during periods of inflation costs across all sectors can change quickly.  The freedom to deduct the highest COGs sooner can greatly reduce near-term taxable income.

Historically, firms could choose whether to deduct the costs of each sale based on the COGS for the oldest item (or barrel of oil) still in inventory (FIFO, or "first-in, first-out"); or select more recent costs if those were higher (LIFO, or "last-in, last-out").  This same logic applied to people's stock portfolios.  It Grandad bought 400 shares of Apple Computer for $10 share (split-adjusted) back in 2006, and another 400 shares at $115 each back in 2015, and he needed to raise cash to pay for home repairs, he could decide which "inventory" to sell from.  Selling the 2006 shares would generate a much larger capital gains tax cost than selling the 2015 shares; the tax cost would drive which shares he picked. 

Too bad for Grandaddy:  the bill the Senate passed (section 13533) removes this choice and requires that whatever shares were purchased first get applied to any sale (first-in-first-out).  Taxes for him, and millions of other individual investors will rise.  Investors in mutual funds could be particularly hurt. 

No such constraints are being put on the oil industry -- even though the International Financial Reporting Standards (IFRS) have not allowed LIFO for many years.  Though pressure has been building for the US firms to comply with international standards, for now LIFO is still allowed in corporate accounting.  US accounting rules do require firms to track the difference between the first-in-first-out method required internationally and the tax-favored LIFO approach via a line item called the "LIFO Reserve."  This data allows one to see which firms and industries are benefiting most from LIFO accounting:  the bigger the reserve, the more the firm is saving.  Privately-held firms can also benefit from this, but there is no public data to see the resultant amounts.

Available data illustrates that some of the biggest beneficiaries of LIFO are the oil industry.  Using data from Moody's Investor Services, CFO Magazine estimated that in 2010, that two thirds of the LIFO reserve for the energy sector was ExxonMobil alone; and that the energy sector comprised 37% of the total LIFO reserve for all public firms.

More recent data on the energy sector shows that the beneficiaries of LIFO are highly concentrated, still dominated by Exxon Mobil (see Table 1).

Table 1. LIFO Reserve (2008-2015) in Millions

• 1In his extensive article on the role of boosting flow in pushing for drilling in ANWR, Philip Wight notes that "In 1970, M.A. “Mike” Wright, the CEO of Humble Oil (soon to be renamed Exxon), delivered extemporaneous remarks to a government task force and offered a rare glimpse of the oil industry’s plans for Arctic development. Wright explained that the industry committed to a 48-inch-diameter pipeline in part because it anticipated drilling offshore in the Arctic Ocean and restricted onshore areas, including the Arctic National Wildlife Refuge. Production from these areas would be necessary to realize the pipeline’s optimum daily flow. Wright’s statements were not only the first public announcement that the oil industry wanted to drill in ANWR, but a revelation that the pipeline’s design was intimately tied to extracting oil from it."
• 2JCX-62-17, p. 1; and JCX-59-17.

Transocean owns operates complex offshore oil rigs, including the one that blew out in the Gulf of Mexico back in 2012, killing 11 workers and despoiling the Gulf of Mexico.  There do not appear to be any similar lapses in its continued effort to push its taxes down as close to zero as possible, however.

Multinational companies have a few common strategies to reach this goal, and Transocean seems to use them all.  First, locate enough of your corporation in a tax haven country so that it passes the laugh test.  The shift in the domicile of corporate headquarters alone can dramatically reduce the tax cost even if most operations remain in countries with much higher tax rates.  Second, use techniques such as internal transfer pricing between divisions so that the vast majority of corporate profits happen to end in the tax haven country.  Third, where domestic operations remain important, use tax-favored or tax-exempt corporate structures such as Master Limited Partnerships, to soften or eliminate the tax bite.

Transocean has also been quite creative in trying to shed liabilities, particularly after the Gulf spill.  It initially claimed it had almost no exposure by classifying its rig as a ship and arguing for protection under a the Limitation of Liability Act of 1851. 

Transocean's Roster of Tax Avoidance Strategies

1)  Corporate inversion.  Completed in 1999, the move shifted the corporate headquarters from the US to the Cayman Islands, cutting the firm's marginal tax rate from 31.6% to 16.9% in the process.  US taxes dropped by an estimated $2 billion during the 1999-2009 period.  Tax Notes, a trade publication,1 quotes the US Treasury on this issue:

Although an inversion transaction requires significant restructuring as a corporate law matter, the effect of such a transaction on the actual management and operation of the inverted company is generally limited.

Robert McInyte of Citizens for Tax Justice published a useful overview of the corporate inversion issue and why common company justifications are often off-base.  Firms often argue that US corporate rates are too high; but McIntyre notes that existing subsidies mean that their actual rates are far lower.  Further, he writes that "reducing the nation's corporate tax rate cannot address the fact that many corporations are employing various means to avoid U.S. taxes altogether."

2)  Relocation of corporate headquarters after the inversion.  Transocean moved its corporate headquarters from the Cayman Islands to Switzerland in 2008.  This was done because Caribbean tax havens were coming under pressure, and Switzerland was deemed more resistent to US efforts to close corporate tax loopholes.

3)  Shifting profits and assets to low-tax jurisdictions.  Transfer pricing and shifting of assets from high-tax to low tax jurisdictions has been a recurring issue for Transocean, and one that frequently ends up in litigation between the firm and taxing authorities in multiple countries, including the US.  There is a great deal of money at stake here, and the firm fights hard to win.  A long-running case in Norway, for example, was recently decided in favor of the corporation, though the government is appealing the ruling arguing that a loss would undermine core principles of corporate taxation within the country. 

4)  Coming home to America, but only without taxes:
Transocean launches a tax free Master Limited Partnership

On July 22nd, Transocean Partners LLC, a spin-off from Transocean Ltd, filed an initial public offering with the U.S. Securities and Exchange Commission.  The new company will be a tax-free Master Limited Partnership, or MLP.  As we detailed in a report released last year (Too Big to Ignore: Subsidies to Fossil Fuel Master Limited Partnerships), MLPs provide substantial tax advantages to a growing number of firms.  The vast majority of MLPs are in the oil and gas sector.

The current deal size is quite substantial, and the implications if asset distributions continue are even more worrying.  The IPO will put three drillships into the LLC, 51% of which will be sold the public and 49% retained by the parent company.  The value of the IPO is estimated at $350 million, making the cap value of the new corporation about $686 million, or roughly $228 million per rig.  Bloomberg News notes that the company owns 74 additional rigs, and is building 9 more.  Should distributions of these rigs to MLPs reach their logical conclusion -- with all rigs held in this tax free format -- the assets back in the US, though corporate-tax free, could be as high as $19 billion.2

As a further indication of the complexity of these corporate structures to arbitrage differing tax and liability regimes,

Marshall Islands-registered Transocean Partners says it will be resident in Scotland for “tax purposes”.

“The company does not expect to pay Marshall Islands taxes, nor does it expect to pay “a material amount” of tax in the UK,” it said.

And there you have it.

• 1Stuart Webber, "Escaping the U.S. Tax System: From Corporate Inversinos to Re-Domiciling," Tax Notes, July 25, 2011, pp. 273-295.
• 283 current and planned rigs not in an MLP x $228m/rig.

I guess if I'm to listen to Fareed Zakaria "The Case for Making it in the USA: Like it or not (and I don't) we need a manufacturing policy to stay competitive," subsidies up-and-down the Keystone XL pipeline should be viewed as just par for the course.  Though Zakaria acknowledges the government isn't good at picking winners, he thinks that, overall, public funding of a portfolio of private companies is necessary for the country.

Portfolio or not, I have far less confidence in the ability of our political system to make good choices on who gets public largesse and who goes hungry.  Frankly, I'm not all that convinced that the Chinese do it well either -- we don't really know how much they are subsidizing particular sectors, or the opportunity costs of those decisions on other parts of their economy or social safety net.  Perhaps time (or trade cases) will make the contours and costs of their subsidy policies more clear.

There are certainly reasons to be skeptical.  Japan, after all, used to be the model of government-favored corporate champions leading the country forward.  But their protection of favorites has contributed to economic stagnation, slowed restructuring, and thrown up impediments to innovation.  Some highly successful companies such as Honda had to buck government favoritism and focus abroad in order to thrive.  Still, targeted investments in particular sectors are probably more likely to work in a centralized authoritarian system than in one (like the US) based on political payoffs to every group and frequent shifts in strategy as political dynamics change.  The lack of checks on authoritarian systems has a downside however:  the targeted investments are likely to be much larger and run longer before being corrected -- making the costs of, and fallout from, mistakes bigger as well.

Zakaria continues:

when you move from high-level policy to specific cases, you will often find one element that is rarely talked about: a foreign government’s role in boosting its domestic manufacturers with specific loans, subsidies, streamlined regulations and benefits. In effect, these governments— many in Asia, though some in Europe as well—have a national industrial policy to help manufacturers.

Industrial policy is already here

Indeed.  But couldn't that paragraph describe just as well US energy investments over the past decade?  Do a quick query to Good Jobs First and their database of subsidies to specific firms and industrial plants, or a review of DOE's energy loan guarantees, if you disagree. 

With the Keystone XL pipeline project, and far too many others, it seems as though our reliance on government handouts has already moved into lead position in terms of what does and doesn't get built.  Relegated to second tier is the price mechanism, that supposedly miraculous signaler of scarcity and overstock on which an efficient market economy has historically relied. 

And it's not just about the pipeline itself.  It's the entire subsidy "ecosystem" of getting tar sands out of Canada, shipped through the US, and refined into products.  Subsidies along the chain combine in a perverse, though mutually reinforcing, system of pork and props.  The result is we get expensive and complicated infrastructure and machines built that most likely would not have been funded based on market demand alone.  The fact that most of the oil from the Keystone XL line, though refined in the US (albeit, not technically so since the refineries are in foreign trade zones), is expected to be re-exported merely adds to the irony.

Refinery expensing adds $1-1.8 billion to the Keystone XL Subsidy System

Earth Track recently teamed up with Oil Change International to look at one part of this subsidy ecosystem:  highly favorable depreciation rules.  Section 179C of the tax code, "Election to Expense Certain Refineries" was enacted in 2005, though eligibility wasn't extended to projects processing tar sands until 2008.  The three refinery projects we looked at (Valero, Total, and Motiva), all in Port Arthur, TX, will receive subsidies of between $1 and $1.8 billion dollars, net present value.   You can read the analysis here.  Additional background on the projects and their connection to the tar sands can be found in Oil Change's blog on the paper.

When the provision was first put in place, the justification was that the US was under-investing in refining capacity and had too much of its existing infrastructure located in the storm-prone gulf coast.  Yet today, the US is exporting ever-larger quantities of refined fuels.  By value, fuel was actually the country's largest export in 2011.  And the three investments analyzed will do nothing about diversifying our refinery assets geographically to reduce the energy security risks from large storm events -- they are all right in the hurricane zone.

Like so many attempts to strip away senseless subsidies before it, the most recent Congressional push to eliminate at least a handful of expensive subsidies to the oil and gas industry was blocked in May.  But the growing deficits remain, and with them the pressure for fiscal austerity and the need to demonstrate a competant bi-partisan ability to govern.  The push to kill these subsidies may well rise again.

Here's a rundown of some of the coverage of the oil subsidy issue I found notable.

1)  Why end oil and gas subsidies.  Dan Primack's (Fortune Magazine) synthesis of the reasons to end oil and gas tax breaks is concise and articulate.  Well worth a read.  Great suggestions as well in the 2011 Green Scissors Report, produced through a joint effort of Taxpayers for Common Sense, Friends of the Earth, Public Citizen, and the Heartland Institute. 

2)  Save our subsidies:  the role of lobbying.  Steve Kretzmann over at Oil Change ran the numbers on political contributions and saving the subsidies to oil and gas.  Their finding?  Those protecting the subsidies got average donations five times the level of those voting for reform.  I know you are all shocked...  An interesting update on this work looked at links between oil and gas industry contributions and the core "Super Congress" chosen to serve on the Joint Committee on Deficit Reduction, slated with identifying deficit-cutting options for the country.  The hope, of course, is that regardless of past affiliations these individuals can rise above parochial interests to do what is right for the country as a whole.  Time will tell.

3)  What's good for big oil is good for the USA.  Industry profits continue to surge, but this has no bearing on whether or not to get rid of subsidies according to industry boosters.  They are good for all of us, industry officials say.  Here's a quote from the American Petroleum Institute's Kyle Isakower that I think is destined to become an industry classic:

"When our industry does well, much of America does well also," Kyle Isakower, API's vice president of regulatory and economic policy, said in a briefing with reporters Monday, adding that the industry's reinvestment drives "economic progress and translates to billions of jobs supported, vast amounts of retirement income protected and billions in government revenue generated."

So I guess we should give them more money?  Isakower's linkage of oil subsidies to "retirement income protected" is a new one to me, and among the most absurd of the claims I've seen put forth by industries trying to defend their continued access to the federal trough.  Subsidy elimination would have very little impact on oil company share prices, which aggregate production from multiple business lines in many countries of the world.  Further, it is quite clear that fiscal default and ballooning deficits even without short-term default will have a far more detrimental impact on retirement funds and funding than stripping the favorable tax rules that have fed the fossil fuels industry for more than eight decades.