Independents resume the search for oil. Treasury's tax plan stirs anxiety among wildcatters
Wildcatters are worried. They look at the Treasury Department's new tax proposal and see three items that could put much of their business -- independent oil and gas exploration -- completely out of business. Tax reform would eliminate both intangible drilling costs (IDCs) as a one-year deduction and the percentage depletion allowance. If passed, that could dry up many companies' ability to finance energy exploration. In addition, Treasury wants to tax limited partnerships with more than 35 partners as it does corporations, a move that would virtually shut down limited partnerships, experts say. Those limited partnerships are an important source of investor dollars.
The first two proposals would remove the main tax advantages of oil and gas investing for high-bracket investors while the third closes out those in middle incomes. The industry depends heavily on both groups to finance drilling projects. For larger companies and the few smaller wildcatters that use internal operating capital, losing tax benefits is the equivalent of raising operating costs and shortening profits.
``Large companies would be hurt and small companies will go out of business in large numbers,'' says Furhman Nettles, vice-president of Robert H. Stanger & Associates, which follows tax-shelter developments. ``The longer-run impact will be to restrict oil development and raise prices.''
Michael Foy believes the tax proposals won't make the congressional hurdle, but he adds that if they do, the effects would be devastating. Foy is the vice-president of finance for Bellwether Exploration Inc., a small oil and gas exploration firm in Denver. His company raises about $10 million a year from investors who put in an average $150,000 each. Their money is spread over several drilling projects in hopes of finding a producing well for the eight or nine dry holes they will likely own as well.
``[Investors are] where most of our drilling money comes from. It lets us try to share the risk of drilling a well,'' says Mr. Foy. ``To lose the tax benefits is just such a severe impact.''
The IDC covers dollars spent on things that can't be resold or removed: roads to the site, preparation of the site, the cost of drilling. ``The tax law lets you deduct immediately those costs which have no salvage value,'' explains Joseph Feiten, a director of the Petroleum Engineering Consulting Service in the Denver office of the Coopers & Lybrand accounting firm.
The Treasury proposal would spread the intangible drilling cost deduction over the life of the oil well. Mr. Feiten argues that the IDC is not a special loophole. The impact is virtually the same as the combination of investment tax credit and five-year depreciation allowed all businesses for equipment purchases, he says.
The purpose of tax benefits is to encourage both investors and oil companies to reinvest in new exploration, he adds.
For example, an investor in the 50 percent tax bracket may put $250,000 into drilling an exploratory well. Some $150,000 might go for intangible drilling costs and the rest for equipment. With a dry well, the investor has a $75,000 tax benefit and $80,000 in salvage value on the rest of the equipment: $155,000 left out of $250,000 -- a bad investment but not a total loss. And the prospect of finding a producing well, keeps the industry looking.
The percentage depletion allowance allows investors or oil companies to deduct 15 percent from the first year's taxable income off a producing well.
``The tax benefits are a way for the government to ease the risks of this business,'' says Mr. Feiten. ``The reason the government should want to ease that risk is because it's in the national interest to look for and find oil and gas deposits.''
Schneider, Bernet & Hickman Inc. of Dallas, an investment banking subsidiary of Thompson, McKinnon Inc., estimates that tax changes will cost independent energy companies $8 billion, $5 billion of that from having to capitalize intangible drilling costs. By contrast, the firm estimates virtually no net impact on the major oil and gas companies. In an investment strategy newsletter, the firm goes says the proposed changes make it difficult to recommend investing in drilling funds.
``If this thing had been in effect this year, it probably would have done away with about 4,000 independents,'' says Peter Wellish of the Independent Petroleum Association of America, representing over half the independents.
Smaller independents -- those that would suffer most from proposed tax changes -- generally run ``stripper wells,'' which bring in under 10 barrels a day. For every Marvin Davis -- the independent oil man who paid cash for 20th Century Fox -- thousands earn an average living. But they are important: Strippers bring in 15 percent of domestic crude, currently 8.7 million barrels a day.
Perhaps most onerous for the entire investment community, as well as the oil and gas business, is the proposal to tax limited partnerships with over 35 partners as corporations, a move that would effectively remove limited partnerships from the marketplace. Such legislation would essentially tax income to investors twice. Mr. Nettles contends that ``all Treasury has to do is introduce the legislation, and that will have the same impact as if the legislation passed.''