Originally Published on forbes.com on October 19th,2011
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In a post on the Job Acts, I raised the question of why we should end percentage depletion just for oil. I am agnostic on the subject of the merits of percentage depletion. My exposure to it is fairly limited. We see it on K-1′s coming from oil and gas deals and some hedge funds. Being in New England the only direct experience I have had with percentage depletion is in the case of gravel, where it does not seem to be that big a deal. It just seems to me that if we are going to not have percentage depletion for oil, maybe we should not have it for gold and silver and wollastonite (whatever that is). At any rate, you should be warned that if you make comments on my blog, you run the risk of being invited to do a guest post. I’m glad that Ben Bartelle has fallen into that trap, because he has a lot more to offer on the subject than I would have been able to learn.
Ben Bartelle is a scientist at NYU’s Skirball Institute for Biomolecular Medicine. He is an amateur environmental economist and a native Californian.
Percentage Depletion Allowances: Insult to Injury
The president’s recently rejected job’s bill proposed to, at least partially, fund it’s stimulus by eliminating a tax break enjoyed by oil and gascompanies called the “percentage depletion allowance.”
While the bill was voted down this isn’t the last we are going to hear about this tax break. Extraction companies have enjoyed record profits in the past few years, making the need for the subsidies they enjoy questionable at best. Of the many loopholes hidden away in the tax code, percentage depletion is one of the easiest targets and at the top of the list. This isn’t just true for oil. The Elimination of Double Subsidies for the Hard rock Mining Industry Act takes on depletion allowances for mineral extraction based industries.
Keep in mind that this one deduction is not the lynchpin of the entire industry. For some perspective, repealing percentage depletion for the petroleum industry is projected to generate $579 million in 2011. That may seem like a lot, but considering the petroleum industry made a combined $67 billion in profit in the first half of 2011 alone, closing this loophole would result in less than 0.4% reduction in profits.
So what is percentage depletion and why is it considered a subsidy? As Peter recently explained, this deduction of 15% of gross income from oil, gas, silver and gold extraction, can be applied creatively and cumulatively on the yearly gross returns from a mine or well. The opposition to percentage depletions is not just because they are so well employed however.
The percentage depletion deduction was conceived in 1932 based on the accepted corporate tax principle that business taxes should be reduced in scale as the value of company equipment, structures and other assets diminish over time. As applied to the mining industry, the principle suggests that a mine’s value declines as mineral production progresses. The intention here was to ameliorate the risks of mining and encourage more investment. Now, any tax break for natural resource extraction is in itself is a point of contention among environmentalists, myself included, but I will leave those arguments aside for now and focus on the purely economicissue with this tax deduction.
Peter presented an example of owning a gold mine with an estimated amount of gold in it so lets use that example. One would expect that in purchasing or leasing land for resource extraction estimating the value of that land would introduce some risk. Many initial strikes can go dry quickly or give a low yield. The depletion allowance offers a buffer to that risk to your initial investment. But suppose an extraction company estimates a gold deposit is worth approximately a million dollars and decides to stake a claim. How much is that mine worth in real terms? If that claim is on public land, absolutely nothing according to the General Mining Act of 1872.
There is free access to 216 million acres or about 9% of all public land for the purposes of hard rock mining. Furthermore, any mineral resources extracted from public land are royalty free. Public mineral resources become private the minute you pull them from the ground, meaning the only costs incurred from mining on public land are operating expenses. It turns out you don’t even have to own a gold mine to own a gold mine!
Perhaps you can see the problem here. A mine on public land apparently has no value to the taxpayers who own it, but to the extraction company reaping the benefits, it can be treated like a multi-million dollar tax liability.
Surprisingly, oil and gas extraction does not enjoy quite the same benefits as gold and other hard rock mining. Thanks to the Mineral Leasing act of 1920 public land is not freely available for petroleum mining, there are real costs in the form of an initial down payment or “bonus,” a yearly lease, and a royalty on profits from the oil or gas well. This is now standard practice for leasing extraction rights from private as well as public land. Originally the rates were a $2/acre bonus, $1.50/acre yearly lease and 12.5% royalties on profits. Today, these values have increased drastically for private land. In 2010 Talisman energy reportedly paid $5,000-14,000/ acre in bonuses and royalties up to 20% for gas rights on private land. In a recent deal Houston-based Anadarko Petroleum and Mitsui E&P USA LLC paid $1.4 billion with 20% royalties to private land owners for extraction rights to 100,000 acres in Pennsylvania.
Clearly it is profitable to lease land for petroleum extraction, leading to the private lease of such rights for hydraulic fracturing or “fracking” on a massive scale, despite environmental and health warnings.
There is certainly a boom in the leasing of petroleum rights on public lands, but for the taxpayers this venture isn’t nearly so lucrative.
According to the Bureau of land management, no matter how large the estimated reserve of oil or gas in public lands, the rates remain $1.50/acre lease and 12.5% royalty. The initial bonus still begins at $2/acre, however it is open to competitive bidding. This year the BLM has leased 755,000 acres for an average of $238/acre with a 12.5% royalty. It is true that much of this land goes undeveloped, but leasing the land is cheap compared to the potential revenue. According the American Petroleum Institute, a typical gas well can require as little as 5 acres of land for development, while it can generate $22 million in gas over a 50 year span. Again, negligible real costs for public resources treated as a multi-million dollar tax liability.
The dominant argument for maintaining the depletion deduction is that without these subsidies, domestic hard rock and petroleum mining would not be worthwhile. As much as I wish that were true, leasing in the private sector strongly indicates otherwise. If anything, the government should probably increase royalties to the private market rate. Another argument is that ending this deduction will lead to higher prices at for fuel. I would argue that we are already paying all of the costs and more. The steeply discounted rate at which public land is offered up for resource extraction is already an incredibly lucrative and reckless subsidy. Allowing companies to pretend they are losing money at 15% a year is adding insult to injury, and there is indeed injury here.
The dominant argument for maintaining the depletion deduction is that without these subsidies, domestic hard rock and petroleum mining would not be worthwhile. As much as I wish that were true, leasing in the private sector strongly indicates otherwise. If anything, the government should probably increase royalties to the private market rate. Another argument is that ending this deduction will lead to higher prices at for fuel. I would argue that we are already paying all of the costs and more. The steeply discounted rate at which public land is offered up for resource extraction is already an incredibly lucrative and reckless subsidy. Allowing companies to pretend they are losing money at 15% a year is adding insult to injury, and there is indeed injury here.
While the percentage depletion allowance saves the mining industry $100 million per year on profits gleaned from public land, cleaning up abandoned hard rock mines, which can leech heavy metals into the water supply, will cost $50 billion in taxpayer money according to the EPA.
Oil and gas companies enjoy savings of over $500 million each year from percentage depletion allowances in addition to other subsidies such as $6 billion in royalty free extraction from public land over the next 5 years according a report to the Government Accountability Office. Meanwhile, the societal, health and environmental costs of petroleum use are immeasurable. Estimates range from $500 billion to over $1 trillion dollars each year in added healthcare costs and environmental damage.
These hidden costs are, in effect, massive subsidies that taxpayers are forced to shoulder. We are essentially paying extraction companies to take our natural resources and sell them back to us. They shouldn’t get to pretend as if they are losing money on the deal.
You can follow me on twitter @peterreillycpa.
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