President Obama's budget proposal to wipe out $36.5 billion in tax breaks for the oil and natural gas industry in fiscal year (FY) 2011 -- notably the popular expensing of intangible drilling costs (IDC), which independent producers contend is critical to their business -- will meet with resistance in Congress, say energy analysts with FBR Capital Markets.

"Given the economic and political climate, we expect that many conservative Democrats will be uneager to significantly raise energy taxes, especially on domestic production," wrote analysts Benjamin Salisbury and Rehan Rashid in their "Policy Update" last Tuesday.

"However the need for 'revenue raisers' to offset an ambitious 2010 spending agenda will make the energy sector prime targets throughout the year. The first candidates for 'raisers' are a tax extenders bill and potential jobs legislation, although, at this early stage, energy taxes do not seem to be the most likely candidates," they said.

"Congress [is] unlikely to fully repeal IDCs. We believe that the Senate is aware of the risk that a repeal of intangible drilling costs would harm production and increase dependence on foreign energy," the FBR Capital analysts noted.

In a conference call with financial analysts last week, Anadarko Petroleum Corp. CEO Jim Hackett agreed that independents "are in a good place with regard to arguing on the IDCs, which is the biggest issue there by far."

Instead of fully repealing IDCs, Salisbury and Rashid believe Congress "is more likely to scale back [IDC] expensing closer to 70%, or to repeal IDCs just for the integrated oil companies (refiners) and give a pass to the smaller companies."

The Obama administration has projected that the revenue from repealing IDC expensing would be $1.2 billion for FY 2011; this is up considerably from its projection of $347 million for IDC repeal last year. The analysts conceded that the higher revenue number will make IDC repeal more appealing as a revenue raiser. Over the next 10 years, the administration estimates that revenue raised from rolling back IDC expensing would be $7.8 billion.

Expensing of IDCs, including labor, material, supplies and repairs, associated with drilling encourages domestic drilling and production by allowing oil and gas producers to write off the costs that typically account for more than two-thirds of the cost of bringing a well to production. Drillers are allowed to deduct these costs from their taxable income for the first year rather than capitalizing the costs over the life of the well. Deferring this tax liability thus increases the net present value of a new well, and the ability to continue deferring tax liability for smaller operators encourages continued drilling, according to Salisbury and Rashid.

In addition to IDC expensing, the administration has proposed the repeal of percentage depletion for oil and gas wells (raising $0.5 billion in FY 2011, and $10 billion over the next 10 years); repeal of domestic manufacturing tax deductions for oil and natural gas companies ($900 million in FY 2011, $17.3 billion over 10 years); and an increase in the geological and geophysical amortization period for independent producers to seven years ($44 million in FY 2011, and $1.1 billion over 10 years).

"Our conversations with policymakers suggest that repeal of the manufacturer's deduction and revision of percentage depletion are likely sources of raisers should Congress need them," the FBR Capital analysts said.

The Obama administration said the tax breaks for oil and gas are at odds with a clean economy. "As we work to create a clean energy economy, it is counterproductive to spend taxpayer dollars on incentives that run counter to this national priority," the administration said. "To further this goal, the budget eliminates tax preferences and funding for programs that provide inefficient fossil fuel subsidies that impede investment in clean energy sources and undermine efforts to deal with the threat of climate change."

Obama last year proposed rolling back about $30 billion in tax breaks for oil and gas producers, but the measure was held up in Congress by Republicans and Democrats representing oil and gas producing states (see NGI, March 2, 2009). "We will certainly do everything we can to oppose the [latest] tax changes," said Lee Fuller, vice president of government relations for the Independent Petroleum Association of America (IPAA), which represents independent producers.

"With America still recovering from recession and one in 10 Americans out of work, now is not the time to impose new taxes on the nation's oil and natural gas industry," said American Petroleum Institute President Jack Gerard last Monday.

The president's tax proposal "moves in the wrong direction," Fuller said. The proposed cuts in oil and gas tax breaks would reduce investment in U.S. production by 20% to 40%, and could drive down domestic oil production by 20% and gas production by 12%, potentially killing thousands of jobs, said IPAA President Barry Russell.

Rolling back the tax breaks "will hit the independent right in the pocketbook," said Alex Mills, president of the Texas Alliance of Energy Producers. He estimated the administration's proposals would cost the state of Texas $50 billion from loss of jobs, economic activity and state tax revenue over a 10-year period.

In addition to the proposed tax hikes on producers, the Obama budget for FY 2011 seeks billions of dollars in new fees for nonproducing leases, inspections and drilling applications, FBR's Salisbury and Rashid noted (see related story).

"The budget assumes $1 billion/10 years in revenue from Department of Interior rules to adjust onshore royalty rates, which currently stand at 12.5%. The president [also] proposed a $4-per-acre-per-year...fee on new nonproducing [onshore and offshore] federal leases to encourage companies to produce or relinquish leases. The provision would raise $8 million in 2011 and $760 million through 2020. An inspection fee for onshore oil and gas drilling activities through the Bureau of Land Management would raise $10 million in 2011. An increased inspection fee for offshore oil and gas drilling under the Minerals Management Service would raise $20 million in 2011. The president's budget also proposes to continue a $6,500 fee for processing drilling permits in place since 2009, worth roughly $45.5 million," they said.

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