Oil subsidies

Species at risk from drilling in the Alaska National Wildlife Refuge
Species at risk from drilling in the Alaska National Wildlife Refuge

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

Company 2008 2009 2010 2011 2012 2013 2014 2015
EXXON MOBIL CORP 10,000 17,100 21,300 25,600 21,300 21,200 10,600 4,500
CHEVRON CORP 9,368 5,491 6,975 9,025 9,292 9,150 8,135 3,745
VALERO ENERGY CORP 686 4,500 6,100 6,800 6,700 6,900 857 790
IMPERIAL OIL LTD 812 1,509 1,857 2,160 1,769 1,680 739 309
WESTERN REFINING INC 26 126 174 214 148 194 28 198
CALUMET SPECIALTY PRODS-LP 28 30 56 88 38 32 19 41
UNITED REFINING CO 153 5 50 92 78 109 110 6
CONOCOPHILLIPS 1,959 5,627 6,794 8,400 200 160 6 6
ALON USA ENERGY INC 4 100 115 93 58 61 8 1
HESS CORP 500 815 995 1,276 1,123 339 - -
HOLLYFRONTIER CORP 33 207 284 378 134 273 - -
MURPHY OIL CORP 202 551 735 580 571 269 - -
Total 23,771 36,061 45,435 54,706 41,411 40,367 20,502 9,596
Source: June Li and Megan Y. Sun, "LIFO Distortion in the Oil Industry – Revisited," Accounting and Finance Research, V. 6, No. 3; 2017.


  • 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.

Irrational Exemption: Tar sands pipeline subsidies and why they must end

For the past decade imports of tar sands crude oil or bitumen have been increasing. Tar sands is stripmined and drilled in an energy‐and water‐intensive process from under the Boreal forests and wetlands of Alberta. In the process, Canada is destroying critical habitat while releasing three times the greenhouse gas emissions as conventional oil production.

Natural gas fracking well in Louisiana

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.

Natural gas fracking well in Louisiana

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.


Natural gas fracking well in Louisiana

This May 2011 piece (What's an Oil Subsidy?) by Nick Loris and Curtis Dubay took the issue of subsidies to the oil and gas industry head-on.  I've had discussions with Heritage over a number of years on the issue of energy subsidies, though primarily those dealing with nuclear and ethanol. I hope those discussions will continue, and broad support for eliminating expensive and damaging energy subsidies will require support across the political spectrum.

In the May piece, Loris and Dubay took some positive steps in explicitly targeting some oil and gas subsidies for removal, something I don't think Heritage would have been willing to do ten years ago.  But the authors' defense of many of the other subsidies listed was disappointing and incorrect.

1)  Section 199 Deduction to support domestic manufacturing was defended on the grounds that it goes to all manufacturing, not just energy.  Many subsidies benefit more than one industry, and the argument that it is therefore part of the "tax baseline" is always used to protect the subsidy and divert prying eyes elsewhere.  This claim should almost never be accepted outright.  Rather, more careful review to assess whether the "general" subsidy disproportionately benefits a particular industry, geographic region, or fuel is needed.  In some cases, the fine print on eligibility actually codifies far more favorable rules for some market participants than for others under what is supposedly a "baseline" subsidy.  In others, the rules may seem neutral but be of far more practical value to one industry than another.

On Section 199, I think the whole thing should be killed.  But if it remains and we are talking about oil and gas industry investments into extraction equipment or refineries, I tend to agree with Loris and Dubay that the spending is fairly similar in nature to investments in other sectors and shouldn't be singled out.  That is only part of the story, however.  As I noted in an earlier blog post, the argument breaks down when counting the endowment value of extracted raw materials as though it were manufacturing.  It is not, and should not be includible in the calculation of section 199 credits.

2)  Foreign tax credit (FTC).  Loris and Dubay inaccurately portray the rationale for modifying the rules on the FTC.  The reforms would establish a better system and help eliminate abuses that are particularly easy for royalty-paying extractive industries.  The authors' have characterized the discussion of FTC-related subsidies as aiming to kill the FTC entirely for oil and gas firms, a move they say (correctly) would result in the double taxation of foreign operations.  But full elimination of the FTC is not what is being discussed now.  Nor has it been the recommendation of any subsidy study I've ever done or looked at. 

Rather, the goal is to end the abuses:  where corporate tax rates on oil, gas, or mining are more than those levied on other corporations, it is quite likely that royalties (which are deductible against US taxes) are being disguised as corporate taxes (which, under the FTC, would receive the much more generous tax credit).  This should end; and if doing so drives up the effective tax rate on foreign producers of oil, gas, or other minerals because they have been gaming the system for decades, so be it.

3)  Expensing.  The authors argue for immediate expensing of all capital equipment.  This same argument is included in a more recent posting by Loris here.  I will defer a detailed discussion on whether immediate expensing makes sense or not for our economy, as I've asked Nick for more info on the empirical justifications for such a move so we can have a more useful discussion on the topic at a future time.  However, the argument put forth in the posts is that immediate expensing reduces the cost of capital, and that this outcome somehow justifies the policy of full expensing. 

Such an outcome is self-evident, and not at all relevant to the underlying policy issue.  Expensing is a subsidy to capital (you are increasing the speed at which multi-year capital may be written off from current year taxes, creating a time-value of money benefit similar to an interest-free loan from the government), and subsidies generally reduce costs or prices. Government loan guarantees, insurance caps, and investment tax credits all reduce the cost of capital as well.  But minimizing the cost of capital is not the primary objective of economic policy.  If fact, subsidizing multi-year capital can distort economic choices across sectors and between capital-intensive and capital-saving methods to provide similar goods and services.  This is not a good thing.

On the positive side, the way Heritage covered the issue implicitly recognizes that under our current system of capital depreciation, special rules for one asset class versus another do create differential levels of subsidy support.  Thus, if we were to decide not to shift to the full expensing system of taxation Heritage is advocating, Heritage should be supporting policies that properly match depreciation periods with the actual asset service lives as their fallback position.  This would eliminate the political use of depreciation periods to reward favored industries, enhancing tax system neutrality across sectors.  Unfortunately, their actual fallback position appears far more partisan:

All companies, including oil and gas companies, should be able to expense their full capital costs immediately. Until that critical change in the tax code is made for all businesses, Congress should retain all provisions that move the tax code in the direction of expensing  [emphasis added].

Since the special rules have generally gone to the most effective lobbies rather than to the most effective technologies, maintaining the status quo does little more than protect the incumbent industries.

4)  Percentage depletion.  The assessment of percentage depletion allowances mimics the issue framing taken by the American Petroleum Institute (it is simply an "alternative" way to write off assets).  This is simply wrong.  Heritage notes that:

A depletion allowance is analogous to depreciation and is appropriate when the quantity of the potential resource is unknown, such as the amount of recoverable oil from a well. Independent oil and gas producers use a depletion allowance to recover capital investments over time. This is also available to producers involved in mining, timber, geothermal steam, and other natural deposits. The depletion allowance for independent oil and gas producers is 15 percent of the producer’s gross income from its average daily production, up to 1,000 barrels of oil. While there is nothing wrong with percentage depletion in theory, the question is whether at 15 percent it is overly generous or, possibly, not generous enough and should be raised.

But there is something wrong with it in theory:  percentage depletion rules allows certain industries to deduct from taxes more than they have actually invested into an asset.  As a result, the policy is a clear subsidy.  End of story. 

The issue of allowable percentage depletion rates matters only in terms of how big the subsidy is for one mineral versus another.  Recall that what is measured by Treasury and JCT is not the percentage depletion allowance per se, but the excess of percentage depletion over cost depletion.  Firms can shift to cost depletion in any year it is more favorable, so if they are using percentage depletion (and they are, because it shows up every year in the federal tax expenditures budget) it is because they are saving money.

The size of the deposits or the market value of that production is irrelevant to basic concepts of depreciating investments over time. The authors are perhaps mixing up tax accounting and financial reporting.  For tax accounting purposes, only the cost of the investment matters.  Absent the gain or loss on the sale of a well or mine, the IRS shouldn't care what your asset is worth because in a normal industry it does not affect taxable income (though obviously with percentage depletion it does). 

Assets across many industries shift in value year-to-year.  And, as with oil properties, the estimates of the remaining lives and gross future production capacity are also volatile for nearly all businesses -- dependent on broader market conditions regarding demand, market prices, and evolving production technologies.  Factories can be shuttered in bad times, and re-opened (at a cost) if market prices change.  Changes in the operating environment can have dramatic effects on asset values.  A biotech company that had invested $100m into its production facility, for example, might see that asset surge in value if FDA extended the medical conditions for which its approved drug could be prescribed.  Conversely, the rise of a competitor would not change the plant, but would alter expected future cash flows, and therefore depress the market value of the facility.  Yet, absent a bankruptcy, neither case would change tax depreciation schedules one whit.  Substitute "oil well" for biotech facility, and percentage depletion deductions would surge in the first and drop in the second.  It makes no sense.

If the firm wants to track well depletion for financial reporting, no problem.  The data may help its managers and investors assess future market trends and investment needs.  But the appropriate method for tracking assets for internal financial reporting is no justification at all to keep percentage depletion subsidies in our tax code.

Natural gas fracking well in Louisiana

With pressure building in Congress to strip out at least the most obvious subsidies to oil and gas, Taxyapers for Common Sense has released a new tally of some of the major ones.  The report is useful in providing updated cost estimates, and for going beyond the narrow set of provisions that the legislation has targeted.  For example, they pick up the billions in losses due to negligence by the Minerals Management Service in structuring lease contracts for 1998 and 1999 that resulted in taxpayers getting no royalties at all for massive quantities of oil and gas in the Gulf of Mexico. 

There are some areas where I disagree with how provisions are characterized, however.

VEETC.  The single largest subsidy tagged in the report is the volumetric ethanol excise tax credit.  The arguments I've seen presented to include this as a subsidy to oil rather than to ethanol have been that (a) the subsidy is paid at the point of blending, and the blenders are often oil companies; and (b) the subsidy is totally unnecessary since blenders would have been required to use the ethanol anyway under the Renewable Fuel Standards (RFS).  The RFS mandate use of pre-set levels of ethanol in the nation's motor fuel supply. 

Both arguments are inaccurate.

  • Regardless of what point in the value chain the credit is earned, it is earned only for using ethanol and skews markets towards this input rather than other blending agents or fuel extenders.  The economic incidence of any subsidy (who ends up with the improved economic returns) often differs from the point of payment, and often shifts over time as the relative market power of different parts of the value chain shift.  But the policy clearly provides government payments for using ethanol, not oil.  
  • It is true that the tax credit and the RFS are, indeed, duplicative.  But this duplication plays out through the price system.  The larger the tax credit, the lower the incremental cost (as measured by the trading price of a compliance unit under the mandate called a "Renewable Identification Number" or "RIN") will trade for.  Proper accounting for ethanol subsidies would be the sum of subsidies under the RFS and the credit (plus other policies as well).  All of these support the use of ethanol.  But the existence of dual systems merely means the full subsidy cost needed to reach the mandated level of consumption is split between taxpayer costs (through the credit) and consumer costs (through RIN prices pushed through into fuel prices).  It does not mean that the entire credit is a windfall to oil companies.

LIFO.  Last-in first-out accounting is one of a range of inventory accounting methods allowed to all industries under US law.  During times of rising prices (including those due to inflation), LIFO approaches result in higher near-term tax deductions.  During times of falling prices, first-in last-out (FIFO) results in higher near-term deductions.  With flat prices it doesn't matter much.  Over a longer period of time, the tax impacts of large past price surges begin to subside.

Thus, during a run-up in oil prices LIFO will provide large benefits, but if prices stay high for awhile the benefits to the Treasury from banning LIFO will diminish because more and more of the investory will have been procured at the new, higher prices.  Estimates of the tax savings from eliminating LIFO in oil and gas were done during a time of rising prices, and reflected the time window during which the changes in tax revenues were highest.  However, this is a short-term surge, not one that will result in continued higher revenues, year-in and year-out.  In constrast, overdue reforms such as eliminating the silly percentage depletion rules would generate recurring subsidy reductions.

LIFO may well fall in order for the US to comply with international accounting standards (which bar LIFO), but I don't consider it a subsidy to any one sector today.

The other two "general" tax subsidies TCS listed were the Manufacturing Tax Deduction for Oil and Gas Companies and Deductions for Foreign Tax Credits that are really related to resource payments.  I believe there are strong arguments for at least substantial portions of both of these programs to be counted as subsidies to oil and gas, and would actually favor including that portion within the primary list of subsidies to the industry (TCS has included these in a separate table).  More on the Manufacturing Tax Deduction here.

The TCS report did not cover all subsidies to oil and gas.  Among those left are large subsidies to bulk transport of oil via our inland waterway system, subsidized financing and operation of the Strategic Petroleum Reserve, oil defense, a variety of other accelerated depreciation provision for oil and gas infrastructure, and massive shortfalls in fuel tax collections to finance the nation's interstate highway system.  Thus, I expect that even with the adjustments noted above, the aggregate subsidy levels to oil and gas would be higher, not lower, than what they have reported.