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Report Questions Generosity of Texas Tax Breaks for High Cost (Shale) Gas Wells

Texas's tax rate reduction program for "high-cost" natural gas wells may not be as generous as those provided by other states, and the shift in exploration from natural gas in the Barnett Shale to oil in the Eagle Ford Shale could also be making the incentive less relevant, according to a report by the Texas Comptroller of Public Accounts.

Last year, the state legislature directed the comptroller to conduct a study of natural gas prices and determine when the tax rate reduction incentivizes production. The comptroller was to also evaluate the effectiveness of the tax rate reduction program and provide recommendations for increasing the program's effectiveness, among other things.

Texas's current state conventional tax rate is 7.5%. Under the tax rate reduction program -- as defined in Section 201.057 of the state tax code -- the amount of the tax reduction is computed by subtracting from the natural gas production tax the product of that tax rate, times the ratio of (the well's drilling and completion costs) to (twice the median drilling and completion costs for high-cost wells during the previous fiscal year), except that the effective tax rate cannot be reduced to zero.

"Examining the results produced by this formula for a new well drilled in 2014 and using the median drilling and completion cost from 2013 ($4.82 million), one may see that a well with a 2014 cost of $9.64 million (twice the 2013 median) or more would result in a tax rate of zero," the report said. "A 2014 cost equal to the 2013 median would produce a 3.75% tax rate. A 2014 well with a cost of $2 million would have a rate of 5.9%."

According to the report, producers submitted 2,670 high-cost wells to the comptroller for the tax break during the 2014 fiscal year (FY), and the average tax rate for the wells was 1.44%. The production volume associated with the high-cost wells totaled 3.52 Tcf, or 46% of total taxable production, and the cost of the reduction totaled $812.3 million.

But the report also showed that the number of wells submitted had decreased 13.6% from FY 2013 -- when operators submitted 3,092 wells -- and it was the lowest number submitted since FY 2001 (1,888 wells). Also, the production volume associated with high-cost wells was the lowest since FY 2007 (3.23 Tcf) and represented the lowest share of total production since FY 2005 (44%).

Commenting on the tax rate reduction program's effectiveness, the comptroller's office said other states may be viewed as more generous.

"The Texas high-cost tax rate incentive may not be perceived as favorably as the incentive granted by California and Pennsylvania, in that neither has a state natural gas severance tax," the report said. Citing a separate report by Headwaters Economics for the Oklahoma Policy Institute, "the Texas incentives for high-cost natural gas wells may not be as generous as those granted by three states surrounding Texas…Texas' effective tax on an unconventional natural gas well was greater that the effective tax rate for Arkansas, Louisiana and Oklahoma."

The comptroller's office said there appeared to be a direct connection between higher natural gas prices and increased production -- with the percentage of high-cost production increasing from 3% in FY 1997 (when national prices averaged $2.42/Mcf) to 62% in both FY 2011 and 2012, before falling to 46% in FY 2014 ($4.17/Mcf). Prices have been lower in recent years and technological improvements were bringing higher initial and overall production rates.

"Exploration activity in Texas moved away from the Barnett Shale (a natural gas play) toward the Eagle Ford Shale (primarily an oil play) concurrent with natural gas prices falling in late 2008, and remaining at lower levels," the report said. "While oil prices also fell in 2008, they quickly rose into the $80 range and continued to rise.

"Observing this movement from predominately natural gas exploration to that for oil, one might infer from those changes that economic factors outweighed other possible considerations, including this incentive."

The comptroller's office recommended streamlining the application process for producers to obtain a certificate from the Texas Railroad Commission for a high-cost well, and to streamline taxpayer reporting requirements.

The report said that although higher market prices were "clearly a factor in incentivizing the drilling of natural gas wells," there were other factors, too -- including geological formations, lease costs, contractual obligations to supply natural gas, anticipated drilling and completion costs and available pipeline infrastructure.

"The incentive could be of greater importance when a producer's decision whether to drill, or not, is a close one and the incentive becomes a determining factor," the report said, later adding that "many producers likely can, and do, alternate between exploring for oil and exploring for natural gas based on prevailing conditions such as price and the attractiveness of a play."

In January 2013, the Legislative Budget Board (LBB) said the state was losing billions in tax revenue and recommended modifying the high-cost natural gas tax rate reduction program (see Shale DailyJan. 23, 2013). To date, the legislature has not adopted the LBB's recommendations, but it did agree to have the comptroller's office conduct the study of the program.

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