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Taxation Concerns Weigh On the Minds of Natural Gas Investors

Wall Street is running scared, and its concern over who is going to pay for the massive federal budget deficits extends to the energy industry.

Questions from the investment community at an "Outlook for the Natural Gas Industry" review in New York City last week showed an overriding concern for the tax burden that may impact the industry. The event, hosted by the American Gas Association and the New York Society of Security Analysts (NYSSA), was focused on extolling the long-term virtues of natural gas, and on the AGA's agenda for the year.

But the questions from the audience were mostly on potential taxes. One area where the U.S. government could increase tax revenue would be to simply eliminate master limited partnerships (MLP), since those entities are not taxed at the federal level. AGA Chairman Bob Skaggs, who also is CEO of NiSource Inc., said he expects MLPs will survive, but he admitted this was just a "gut response."

Eliminating the preferential tax treatment of energy companies in North America is not without precedent. Beginning in 2011 the Canadian government will remove the tax-free treatment of Canadian royalty trusts and begin taxing those entities at the full 31.5% tax rate.

But if the United States government were to ever eliminate the preferential tax treatment of MLPs, it would likely have just a nominal impact on its overall tax revenues. Between the fourth quarter of 2008 and the third quarter of 2009, the 70 natural resource MLPs that are currently publicly traded generated a combined pre-tax profit of approximately $11.1 billion. If those entities were taxed at the full 35% marginal corporate U.S. tax rate, that would generate $3.9 billion in additional federal revenue, a scant 0.3% of the $1.42 trillion dollar increase in the U.S. federal budget deficit over the same time period, and just 1.3% of the average annual $303 billion increase in the U.S. federal budget deficit between the more "normalized" years of 2003-2007.

AGA President Dave Parker also believes the United States government is not likely to repeal the tax deductions for intangible drilling costs. Parker expects that the Obama administration will look into it but will ultimately decide that eliminating those deductions would be too harmful to the industry (see related story).

Parker further observed that the scheduled expiration of the Bush tax credits is one of the two main issues facing the U.S. natural gas industry in 2010, with the other being the Nov. 2 Congressional elections. Parker noted that the House of Representatives, in particular, has been friendly to the natural gas industry, citing the treatment the industry received in the House version of the cap-and-trade bill.

But while changes in U.S. tax policy on the energy industry may help lessen the federal budget deficit, Skaggs does not believe the U.S. natural gas industry will come to the aid of the U.S. trade deficit, which through the first 11 months of 2009 totaled $341 billion. When asked if the U.S. government may eventually issue liquefied natural gas (LNG) export licenses to domestic natural gas producers, Skaggs simply opined "this is a domestic market. It's hard for me to envision natural gas ever becoming part of foreign commerce."

Skaggs also believes that U.S. natural gas producers are not likely to contract directly with utility companies any time soon. "Wow. A lot has to happen before those type of contractual arrangements happen in our industry," he told the audience. However, he did admit that with the dramatic increase in the U.S. natural gas supply base, "there will be a hunt for markets" by producers looking to lock in sales volumes.

He alluded to the old pipeline supply contracts in the days before Federal Energy Regulatory Commission Order 636 as the reason that utilities would likely be reluctant to sign too many long-term fixed priced supply deals. However, producers may feel more pressure to enter into these types of supply contracts if the U.S. government were to ever limit the use of derivative contracts to hedge price risk, since signing fixed-priced contracts with mostly investment-grade utility counterparties would help make up for any restrictions in the over-the-counter swap market.

Of course, no investor conference would be complete without questions concerning the potential regulation of hydraulic fracturing, and the NYSSA attendees were particularly eager for news on this front. The AGA officials seemed to mirror the comments of industry executives in their confidence that the issue will be resolved in a satisfactory manner. "Many of the issues [regarding hydraulic fracturing] are local and have to be worked through between the companies and the localities themselves," an AGA official noted.

Chairman Skaggs also believes that the abundance of North American shale gas will not make U.S. utilities less likely to sign long-term pipeline take-or-pay contracts, but he declared that "it is still too early to sort through that."

In the prepared comments portion of the meeting, Parker set the AGA's agenda for 2010. Initiatives are:

Skaggs kicked off the meeting by relaying the AGA's message that "gas is good," and argued that "natural gas is the best value proposition among all energy producers." He further observed that the "industry is the most united it has been in my 30 years in the industry."

While noting that the recent surge in U.S. shale production helped proved U.S. natural gas reserves grow 45% from 1990 to 2008, Skaggs believes a "common sense policy approach" will be a key driver in stimulating demand for that increased supply. He opined that using more natural gas in the power generation market "is a no-brainer," but that "the real story" is the amount of demand growth among residential and commercial users that could result from climate control legislation.

Skaggs specifically pointed out that the number of residential customers in the United States grew to 65.3 million in 2008 from 38.1 million in 1970, yet overall residential demand usage remained flattish over that time period. A main reason for that is the 29% efficiency improvement in average residential consumption between 1980 and 2008.

"Congress should embrace policy to encourage direct use of natural gas in the home and business," Skaggs said, through such means as gas heat pumps, radiant heating, and localized natural gas vehicle filling stations.

Skaggs concluded his comments by declaring "our message to the investment community is that the gas utility industry is a solid, responsible, 'common sense' investment choice." He noted that from Jan. 1, 2000 to Jan. 1, 2010, the respective total returns for the AGA Index and the Dow Jones Utilities Index were 7.91% and 7.28%, versus just 0.95% for the S&P 500. Of course, those figures trail the 9.1% return the S&P 500 Index has turned in since 1927, the year the firm Ibbotson Associates begins tracking securities returns, but Skaggs' data drive home the point that the seemingly stodgy and conservative U.S. utility industry has firmly outperformed the overall U.S. stock market over the last decade.

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