Pennsylvania's Democratic-controlled House has approved legislation (SB 1155) that would impose a 39 cents/Mcf (about 10%) severance tax on natural gas drilling in the state, but the fate of a tax was far from assured as leaders of the Republican-controlled Senate blasted what they called a "punitive" tax rate that would drive business to other states.

At this point the state Senate can either vote down the bill or send their own version with a lower tax rate back to the House, which in turn would have to approve or disapprove it -- or the two parties could do what some have urged all along, which is come up with a compromise. The problem: time is running out.

The Pennsylvania Senate is not scheduled to reconvene until Oct. 12 during a week when the House is not in session, and the fall elections are Nov. 2. The legislative session does not officially end until Nov. 30, but the state General Assembly very rarely comes back for a post-election session.

The final House vote on the bill, taken late Wednesday, was 104-94. The bill calls for a 39 cents/Mcf rate, which at today's prices would be about 10%. That's way too high, according to Republican opponents, who have been touting their own proposal for a 1.5% tax for a well's first three years and then increasing to 5%.

Also being floated is Gov. Ed Rendell's own proposal for a 5% extraction tax, plus 4.7 cents/Mcf.

"Watching the debate and what seems to be the final product coming over from the House raises serious red flags with us here on the issue of Marcellus Shale policy here in the Commonwealth," said Pennsylvania Senate President Pro Tem Joe Scarnati (R-Jefferson). "First and foremost, the process that the House has embarked on didn't involve at all consultation with the Senate to try to get a product that we can get to the goal line...we're not going to entertain a tax rate here in the Senate that's punitive to this industry."

The bill would send 40% of the revenue generated by the tax which would go into effect Jan. 1, 2011 to Pennsylvania's general fund and the remaining 60% would be divided up between environmental uses and allocations to municipalities and counties to deal with costs caused by drilling. The bill had originally called for 60% of the revenue to go to the general fund, which faces a deficit.

The 60/40 allocation was reversed by a 154-45 vote on an amendment the night before the final vote with some Republican support. The amendment by Rep. Kate Harper (R-Montgomery) would shift some severance tax revenue to environmental causes, including 12% of the revenue going to the state's Environmental Stewardship Fund.

"[Democratic] members decided to support that Republican amendment," Johnna Pro, press secretary for Rep. Dwight Evans (D-Philadelphia), chairman of the House Appropriations Committee, told NGI prior to the final vote on Wednesday. "I think it's fair to say that this is a first step, but it's an important first step. What's encouraging to us is through the debate [Tuesday] we were able to reach a compromise with Republicans in the House...so we're confident today that it will come out of the House with a bipartisan message and bipartisan support, and that bodes well for it as it arrives in the Senate, which is controlled by Republicans."

However, a House Republican opponent suggested the bill would be "dead on arrival" in the senate.

The House's proposed severance tax would produce about $120 million of revenue in fiscal year (FY) 2010-11 and $326 million of revenue in FY 2011-12, according to a House Appropriations Committee analysis of the measure.

The 39 cents/Mcf rate "shall never be less than the base rate," according to the legislation, which calls for an annual adjustment of the tax rate if 7% of the average New York Mercantile Exchange Henry Hub settled price is greater than 39 cents. The calculation of the adjustment would be 50% of the difference between 7% of the Nymex Henry Hub price and 39 cents and producers would be prohibited from recovering any portion of the tax from royalty owners.

The bill would exempt gas taken from stripper wells producing less than 60 Mcf/d, gas provided free of charge to surface owners or sold to surface owners for use in manufacturing, and coalbed methane.

A $28 billion 2010-2011 state budget passed earlier this year by Pennsylvania legislators did not include a severance tax on natural gas production, but budget negotiators agreed to such a tax in principle, and House and Senate members agreed to enact a severance tax by the end of last week (see NGI, July 5). During the leadup to final negotiations on the tax, even Rendell appeared to have lost confidence that a deal would emerge (see NGI, Sept. 13).

The House-approved bill may be little more than a starting point for negotiations when it reaches the Senate and the two chambers begin their search for an acceptable middle ground. "A likely compromise is an industry-friendly 5%," according to analysts at FBR Capital Markets, who said there are indications that Republicans will gain seats in the legislature in the Nov. 2 elections, "empowering the industry in ongoing negotiations." In the end, Pennsylvania's severance tax rate will probably be about the same as that proposed by Rendell, they said.

The 39 cents/Mcf tax rate would not crush Pennsylvania's natural gas industry and "is not, as some have claimed, the highest in the nation," according to analysts at the Pennsylvania Budget and Policy Center (PBPC). When taking into account property taxes paid by drillers in other energy-producing states -- but not levied in Pennsylvania -- the PBPC analysts found that "the effective tax rate in the House bill is lower than that in Montana, New Mexico and Wyoming."

Earlier this year a think tank said a tax of 30-35 cents/Mcf would be "more than competitive with other gas-producing states" (see NGI, Sept. 6).

A severance tax on gas production would add to drilling companies' operating costs, but the revenue it would produce would yield positive results for Pennsylvania's economy and residents, according to researchers at Penn State's Institute for Research in Training & Development (see NGI, Sept. 20).

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