During 2015, the Texas Railroad Commission reclassified 844 "oil wells" as "gas wells" (Oil or Gas Well? The Distinction Costs State Millions). This number was up from 145 in 2013. Most of us probably would say: "So what?". But in reality this is a pretty big "what". In Texas, oil and gas production revenues are taxed differently. Natural gas is taxed (severence) at a rate of 7.5% of the market value of the production, while oil (and "condensate") is taxed at 4.6%. This makes the "so what" even more troubling. Why would anyone want their oil well reclassified as a gas well? It turns out to be complicated.
Base severance taxes are not collected based on a well's classification, but are rather collected on the basis of which product is sold. But the Texas Legislature, as governments are wont to do, decided that it would use tax policy to affect markets. The 71st Texas Legislature (which was Democrat-controlled and serving alongside a Republican Governor) decided that "high-cost gas wells" (but not high-cost oil wells) should be eligible for a reduction in gas severance taxes. Natural gas produced from wells that produce from the following types of geologic formations (as determined by the Texas Railroad Commission) are eligible for the reduction (Texas Administrative Code §3.101).
- A completion which is located at a depth of more than 15,000 feet
- Geopressured brine
- Coal seams
- Devonian shale
- Designated tight formations or produced as a result of production enhancement work
Wells that are eligible for the tax credit can see up to 50% of their total drilling and completion cost recovered over a 10-yr period. The amount of the severance tax reduction depends on the price of gas. No exemption if gas prices are greater than $3.50 per thousand cubic feet, increasing to a 100% exemption for gas prices under $2.50. Since March 2015, high-cost gas wells have been eligible for a 100% severance tax exemption (Texas Comptroller of Public Accounts: Tax Exemption for Qualifying Low Producing Gas Wells). During 2014, there was no exemption for seven months and only a 25% exemption for five months. We should not be surprised that reclassification applications increased in 2015. The importance of the gas severance tax exemption also became more important in 2015, as revenues from oil production declined far more than revenues from gas production.
The high-cost gas well tax exemption means that severance taxes are reduced for certain kinds of wells. Oil wells that produce gas are not eligible for the exemption for the associated gas produced along with the oil. But physically characterizing a well as a gas well or an oil well can be problematic. Hydrocarbon reservoirs produce a combinaton of both. Some wells produce nearly all gas. At the other end of the spectrum are wells that produce nearly all oil. There is a continuum in between. Petroleum engineers classify reservoirs based on the"phase" that exists in the reservoir at initial (discovered) reservoir conditions. In oil wells, the phase is initially a liquid (oil), but releases dissolved gas as pressure declines due to production. In gas wells, the phase is initially a gas. The gas phase, though, also contains oil components that condense in surface production and collection facilities. In some gas reservoirs, the oil (usually termed condensate) condenses in the reservoir. In others, condensation does not occur until the gas is in the wellbore or in the surface production system.
The Texas Railroad Commission has a number of rules that rely on a well's classification. In order to have a classification scheme that can be readily and consistently applied, the Commission has developed a number of "rules of thumb" based on petroleum engineering experience and knowledge. These rules of thumb are perfectly adequate for most conventional oil and gas wells. However, the expansion of hydrocarbon production to shales has meant that an increasing fraction of wells are falling into a range where the downhole "phase" is intermediary and more difficult to discern. The Railroad Commission rules of thumb end up providing a "bright line" demarcation that may or may not actually discern the actual condition of the fluids in the reservoir. In addition, the physical nature of shale reservoirs is such that the initial state of the production is highly variable both spatially and in time.
These complex physical issues mean that it is difficult for Texas voters to decide whether their regulatory agency (Railroad Commission) is working in their interest or not. The adequacy of Commission rules become a complex scientific and engineering issue that only those with significant specialized expertise can discern. And since most of those with such expertise work inside, or are associated with, the oil and gas industry, voters are left with the uneasy feeling that they are being hoodwinked.
There is a way out. Consider the following.
- Eliminate special tax incentives. Special tax incentives are known to distort markets in ways often not realized when legislation or regulation is passed. Those who pay taxes become incentivized to avoid taxes wherever possible, inevitably spending time and energy on tax avoidance rather than on increasing production revenues or decreasing production costs.
- Eliminate the discrepancy between oil and gas severance taxes. Though the issue discussed in this article is mostly related to the first item above, it still seems absurd to favor one underground hydrocarbon resource over another for taxation purposes. Given the continuum nature of actual petroleum resources (especially in the shale resources that are our future) a uniform severance tax would provide a more dependable way for operators to gauge their expected future tax burden when making drilling and completion decisions.
A simpler and more uniform tax structure will provide oil and gas producers with the certainty they need to make their best economic decisions, while still allowing Texas voters to believe that their tax system and regulatory agencies are not favoring particular commercial interests to the detriment of the State as a whole.