The state of Texas is losing billions of dollars because of tax rate deductions for unconventional natural gas wells drilled using hydraulic fracturing (fracking), which are classified as “high-cost wells,” according to a report by the state Legislative Budget Board (LBB).

The board recommended modifying the tax code to restrict deductions granted to unconventional gas drillers in its report to the state legislature on government effectiveness and efficiency.

“The future revenue generating capability of the natural gas production tax is in doubt,” the report stated, noting that the deduction has cost the state $9.4 billion in revenue since fiscal year (FY)2004. Wellhead prices below $3.00/Mcf have lowered the industry’s total tax burden, which is 7.5% of the market value of production within state borders. Various deductions, including the deduction, mean that many drillers have an effective tax rate of zero, according to the report. Still, the natural gas industry paid taxes worth $1.5 billion in FY2012, a 38% increase from 2011.

Under the current tax code the gas tax rate deduction enables drillers to be classified as “high cost” based on the type of production and gas produced, not actual operating costs. “The effect is that all wells drilled within the Barnett Shale and Eagle Ford Shale qualify as high-cost wells regardless of the actual drilling costs,” said the report. Because of unconventional drilling using fracking in those regions, output classified as high-cost has surpassed that from other wells every year beginning in FY2007. High-cost wells accounted for 55% of the state’s gas production in FY2011.

The state has seen gas production tax revenue grow from $628.5 million in 2002 to a high of $2.68 billion in 2008, when the Henry Hub price averaged $8.90, according to the Texas Comptroller of Public Accounts.

Among the specific recommendations are an adjustment in calculating the tax benefit that would result in smaller deductions for about 90% of high-cost wells, and examining at what price, if any, the high-cost gas rate reduction improve output.

The report suggests that the deduction doesn’t improve production at all, as “it is likely that high natural gas prices would be sufficient to incentive production without the assistance of an additional tax benefit. It is also likely that at very low gas prices the rate of reduction would not be sufficient to incentivize added production.”

The study noted thatgas production in Pennsylvania and West Virginia increased by a similar rate between 2004 and 2009 even though West Virginia enacted a severance tax of 5%; Pennsylvania has enacted an impact fee. Other states, including Ohio, are considering higher production taxes.

While the the LBB recommends reducing the deduction, State Rep. Lon Burnam (D-Forth Worth) has proposed a bill (HB 55) to eliminate it, similar to a bill in 2011 (see NGI, April 4, 2011). State Sen. Rodney Ellis (D-Houston) also has filed a bill (SB 71) to reduce the deduction.

“The LBB effectively endorses our view that the special rate for fracking is an outdated and unaffordable exemption. It doesn’t go as far as we would like, but it at least chips away at the problem,” Burnam’s chief of staff Conor Kenny told NGI. “Will the legislature have the courage to eliminate this giveaway?”

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