This Is No Time to Discourage U.S. Oil and Gas Production

The president wants to cut $4.4 billion in ’tax breaks’ for Big Oil. This would cost consumers far more in higher prices and greater reliance on foreign supplies.

Of all the times for the U.S. to be discouraging domestic production of oil and natural gas, right now might be the worst. Libya’s descent into chaos is fueling a rapid rise in oil prices, and unrest in other oil-producing countries in the Middle East and North Africa has led some analysts to predict unprecedented oil-price spikes may be looming.

Nevertheless, President Barack Obama’s administration has not only stopped issuing permits for deep water drilling in the Gulf of Mexico, it also wants to stop “subsidizing yesterday’s energy” so that the federal government can boost revenues and spend more on developing alternative energy sources. The president’s 2012 budget, released earlier this month, calls for eliminating a dozen tax incentives that benefit producers of coal, oil and natural gas. Mr. Obama is most eager to eliminate what he calls “costly tax cuts for oil companies.”

Big Oil has long been a plump piñata for politicos and environmental groups, but a simple cost-benefit analysis shows that eliminating decades-old tax rules for oil and gas could be a lousy deal for consumers.

Two tax deductions for the oil and gas sector are most important: percentage depletion (part of the tax code since 1926) and intangible drilling costs (part of the tax code since 1913.) According to Mr. Obama’s budget, those two items will cost taxpayers about $2.4 billion per year over the next decade. A handful of other oil- and gas-related tax policies, including an increase in the amortization period for geological and geophysical expenses, cost taxpayers an additional $2 billion per year. So the sector’s total annual tax advantages amount to about $4.4 billion.

Percentage depletion allows well owners to deduct a certain amount of the value of their production in a given year. It’s significant, but the really important tax rule is the deduction for intangible drilling costs, or IDC. That allows drillers to immediately expense, rather than capitalize over years, many of the costs associated with drilling a well, including labor, supplies and fuel.

The energy industry contends that the deduction encourages capital formation—and greater production—in their high-risk business. And many economists have long favored expensing to encourage capital formation throughout the economy. Still, even if we assume that the IDC deduction is in fact a subsidy, are consumers getting a tangible benefit?

Consider natural gas. Thanks to the increasing use of horizontal drilling and hydraulic fracturing, U.S. gas production has soared over the past few years. The result: Methane prices are now about half what they were in 2008.

Various studies—including one done in 2009 by Tudor, Pickering, Holt & Co., a Houston-based, energy-focused investment bank—predict that eliminating the deduction for intangible drilling costs could increase natural gas prices by 50 cents per thousand cubic feet. Their reasoning is simple: As the industry sees its costs increased and cash flow reduced, it will drill fewer wells and recover less gas. Given that the U.S. burns about 23 trillion cubic feet of gas per year, simple arithmetic shows that eliminating the deduction could mean an increased cost to consumers of $11.5 billion per year in the form of higher natural gas prices.

Changing the tax rules could also slow the surprising resurgence of the U.S. oil industry. After decades of declining production, domestic drillers are increasing their oil output because they are tapping shale deposits with the same new techniques that have helped increase gas production. The result: Domestic oil output could jump by as much as one million barrels per day by 2015, according to the analytics firm Bentek Energy.

This is great news for tax-starved local and state governments. And it’s directly in line with one of the stated goals of Mr. Obama’s 2012 budget: to “enhance our national security by reducing dependence on foreign oil.”

The president also wants to “break our dependence on oil with biofuels,” as he said in his State of the Union address. But using biofuels to displace oil requires massive subsidies.

Last year, the Congressional Budget Office (CBO) reported that the cost to taxpayers of using corn ethanol to reduce gas consumption by one gallon is $1.78. This year, the corn ethanol sector will produce about 13.8 billion gallons of ethanol, the energy equivalent of about 9.1 billion gallons of gasoline. Using the CBO’s numbers, that means the total cost to taxpayers this year for the ethanol boondoggle will be about $16.2 billion. That’s compared to the $4.4 billion in foregone tax revenue for oil and gas tax rules.

So annual ethanol subsidies are nearly four times as great as those provided for oil and gas, even though domestic drilling provides about 36 times as much energy to the U.S. economy. Per unit of energy produced, the tax preferences given to corn ethanol are 130 times as great as those given to oil and gas.

If the president is truly serious about raising revenue, then he should eliminate all energy-related tax preferences and let all sources compete—fair field, no favor. Short of that, he should at least subject ethanol to the same treatment he’s giving to oil and gas.

This piece originally appeared in Wall Street Journal

This piece originally appeared in The Wall Street Journal