President Obama’s budget proposal to repeal in fiscal year (FY) 2011 $36.5 billion in tax breaks for the oil and natural gas industry — 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 (see Daily GPI, Feb. 2).

“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” 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.

“Rather than fully repealing IDCs, Congress, we believe, 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,” Salisbury and Rashid said.

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 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 ($0.9 billion 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 analysts said.

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, they noted.

“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,” the FBR Capital analysts said.

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