Oklahoma Tax Break Set To Expire For Horizontal Drilling

Wednesday, May 21st 2014, 10:34 am
By: News On 6

By Warren Vieth, Oklahoma Watch

The CEOs of three big Oklahoma-based oil companies have declared publicly they might curtail their drilling activity in the state by as much as half if the state doesn't act by the end of the month to extend an expiring tax break for horizontal wells.

The three firms — Continental Resources Inc., Chesapeake Energy Corp. and Devon Energy Corp. — said restoring the state's 7 percent production tax on horizontal wells would reduce future returns and cause them to shift their drilling to other states.

They've been singing a slightly different tune in their reports to investors and presentations to Wall Street.

In documents filed with the Securities and Exchange Commission and in discussions with security analysts as recently as last week, the firms describe their Oklahoma drilling programs in enthusiastic terms, touting "world-class" plays and "premier" geological formations.

"We're just real excited about what we're seeing down there," Continental Resources Senior Vice President Richard Muncrief told Wall Street analysts last August, describing the company's big push to drill more horizontal wells in southern Oklahoma.

Their SEC filings recite dozens of specific risks that could reduce future profitability, including potential changes in federal tax law and possible legislative responses to climate change and hydraulic fracturing, or "fracking." But only one firm, Chesapeake, mentions Oklahoma's gross production tax as a potential liability.

Under a tax break enacted in 1994 and set to expire in mid-2015, the three companies pay Oklahoma a gross production tax of 1 percent during the first four years of production from horizontal wells.

Responding to the companies' appeals, the Legislature is considering a bill that would set a new permanent tax rate for all wells, horizontal and vertical, at 2 percent during the first three years of production and 7 percent thereafter.

In 1994 horizontal drilling was an exotic new technology. Today it accounts for about 70 percent of all drilling in the state, according to the Oklahoma Corporation Commission.

If the tax cut expires as scheduled, the rate of return from new horizontal wells in Oklahoma would be reduced by 6 percentage points for four years. The effect on profitability over the life of the wells would be less because about two-thirds of a typical well's production occurs during the first four years, when the 1 percent tax is currently in effect; the remainder is already taxed at the 7 percent rate.

Some Oklahoma oil energy veterans contend the big three companies are overstating the importance of the gross production tax in their drilling calculations.

They include George Kaiser, primary owner of Kaiser-Francis Oil Co. in Tulsa. Kaiser has stated publicly that the gross production tax is a relatively minor factor in companies' calculations about where to drill, while the tax break deprives the state of revenue needed to fund education and other public services.

The George Kaiser Family Foundation is one of Oklahoma Watch's principal funders, and a foundation consultant is one of five members of the nonprofit publication's board.

Another oil patch dissenter is Stacy Schusterman, CEO of Samson Energy Co. in Tulsa, which was actively engaged in Oklahoma drilling ventures before it sold most of its onshore operations for $7 billion in 2011. It continues to explore in the Gulf Coast.

"The change that would result from going from the 1 percent to 7 percent will not deter drilling, despite what they say," Schusterman said in an interview.

Schusterman said the scheduled restoration of Oklahoma's traditional 7 percent gross production tax would have much less impact on the future profitability of wells drilled in the state than the routine swings of oil and gas prices.

"It's very small compared to what you expect to find in reserves and what you expect prices to be over the life of the well. The price of oil and gas varies more in a week than what we're talking about here," she said.

"I'd be happy to drill those wells if they don't want to."

Tom Ward, former CEO of SandRidge Energy Inc. of Oklahoma City and current CEO of Tapstone Energy LLC, said he, too, considered the gross production tax to be a small consideration in deciding where to drill.

"I have overseen the budgeting process of drilling thousands of wells at two different companies in Oklahoma. In the process of drilling a well, there were many factors that are considered. However, the implication of a state's gross production tax has never had a material impact on whether to drill or not drill," Ward said in an email.

"The intent of the Oklahoma gross production tax holiday has outlived its purpose of subsidizing the experiment of horizontal drilling … The tax holiday had an expiration for good reason and was never intended to create a long-term entitlement for the industry."

The CEOs of Continental, Chesapeake and Devon declined to be interviewed for this story.

Chad Warmington, president of the Oklahoma Oil & Gas Association, said restoration of the 7 percent rate through the life of the well would cause at least some drilling to shift to other states.

"There certainly will be reductions as the tax rate increases," Warmington said in an email.

"Large producers with acreage positions in several key plays across the United States have attractive options not in Oklahoma," Warmington said. "Small oil and gas service companies located in rural Oklahoma and the economies of those communities will be hurt the most by any reduction in drilling activities."

The companies' public disclosures do not include state-by-state breakdowns of well costs and return rates. For that reason, it is difficult to determine exactly how many drilling prospects in Oklahoma would become less attractive than competing ones in other states if the 7 percent rate were restored.

But their discussions of specific oil and gas plays suggest that in at least some cases, the rates of return in Oklahoma would remain higher than those elsewhere, even if several percentage points were shaved from incentive.