'Big Oil' Budget Hit's a Big Mistake

President Obama’s Fiscal Year 2012 Budget proposes to increase the tax liability of energy companies, to the tune of about $46 billion over the next 10 years.  In his statement, Obama said, “We shouldn’t provide special treatment to the oil industry when they’ve been making huge profits.”
In his 2011 State of the Union address, the President asked Congress “to eliminate the billions in taxpayer dollars we currently give to oil companies.  I don’t know if you’ve noticed, but they’re doing just fine on their own.”
The approach is reminiscent of Candidate Obama’s support of capital gains tax rate increases during the 2008 debates, in the interest of “fairness.”  It has been repeatedly shown that lower cap gains rates translate to more federal revenue, yet Obama the ideologue values punishing his political enemies over achieving tangible results.
Aside from whatever satisfaction his political base may derive from demonizing “Big Oil,” the President’s proposal will miss its intended target.  As we shall see if they’re enacted, Obama’s proposed cuts would mostly hurt small domestic producers and natural gas, not Big Oil.  In the process, we would step away from, not toward, the elusive goal of energy security.
So how are the oil companies fairing financially?
Not bad, but not great.  In one recent quarter (2Q 2010), the oil and natural gas industry’s profit (net income) to sales ratio was 7.1%, versus 8.7% for all manufacturing companies.  In terms of return-on-investment, oil and gas usually lag in the S&P 500.
What about the “huge profits”?  The profit numbers are huge because the companies themselves are huge.  The integrated multinational companies—Big Oil—need economies of scale to satisfy our insatiable demand for petroleum products.
But why are we giving taxpayer dollars to oil companies, as the President says?  What have they ever done to deserve “special treatment”?
Three really big-ticket items are targeted in the budget proposal.  Taken together, they comprise about 90% of the estimated increase in tax revenue.
The first is the Manufacturing Tax Credit, otherwise known as the Section 199 Tax Credit.  Repeal of the Section 199 credit for oil companies would net the Treasury an estimated $18.2 billion.  The credit was passed in 2004 to encourage capital investment, and therefore to stimulate the economy.  It applies to all manufacturing companies.  Oil and gas companies are singled out for repeal.  So much for special treatment.
The second big-ticket item is the favorable tax treatment of Intangible Drilling Costs (IDCs), a concept that is peculiar to oil and gas drilling.  The special treatment afforded IDCs (items such as labor or trucking that have no salvage value) amounts to accelerated depreciation—they can be written off in the year incurred instead of over time.  The current treatment of IDCs has been in the tax code since 1913.  Repeal of this provision would net $12.4 billion over 10 years.  But there’s a catch:  Only smaller “independent” producers fully enjoy the benefit of IDCs, and only on domestic production.  The tax code already punishes Big Oil.
The third big item is Percentage Depletion, first applied to oil and gas in 1926.  Mineral resources are a finite, depleting asset, and Percentage Depletion is designed to help producers replace their reserves.  Removing this provision would add $11.2 billion to Treasury coffers over the next 10 years.
Note that the preceding paragraph refers to “mineral resources.”  Percentage Depletion applies to all extractive industries, even resources such as timber.  As we saw with the Section 199 Tax Credit, the only special treatment for oil and gas would be removal from the list of industries eligible for Percentage Depletion.
Another catch:  Percentage Depletion benefits only the small producer, and especially the operators of marginal “stripper” production.  It’s not an issue that registers on Big Oil’s radar, because Congress took away its eligibility years ago.
Obama and his advisers miss one other key point.  All of the tax provisions that apply to oil also apply to natural gas.  Because 80% or more of domestic drilling activity targets natural gas, most of the special treatment in the tax code has actually benefitted gas, a clean, abundant, and nearly 100% domestic fuel.  The President touted natural gas in his State of the Union address as one of the cornerstone fuels of the clean energy future, but his tax policy, if enacted, would cripple its development.
The President’s proposal is a tax increase that would divert dollars to the federal Treasury and away from domestic drilling.  Less drilling means fewer discoveries.  Fewer discoveries mean higher prices for oil, natural gas, and gasoline, and more dependence on foreign sources.
Another path would be to realize that energy security is an achievable goal, thanks to recent advances in oil and natural gas extraction technology.  Achieving that goal would take a national commitment to support our domestic energy industry, no longer using it as a cash cow but as an engine of growth.  Ironically, Obama is the first President since Nixon to have a path to real energy security so clearly defined.
“Yes We Can,” Mr. President.