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As Oil Prices Plunge, New Scrutiny of Gas Tax Credit

By reclassifying oil wells as gas wells, producers can often claim a generous state tax credit targeting “high cost” natural gas. Now, some lawmakers say the policy deserves a fresh look.

An oil pump.

In these days of plummeting oil prices, petroleum companies look to protect their bottom lines most any way they can — by scaling back production, laying off workers or using technology to drill more efficiently and cheaply, for instance.

Producers in Texas can pursue another option: start calling their oil wells gas wells. 

Reclassification — the legal term for it — doesn’t happen with the wave of a magic wand. Regulators at the Texas Railroad Commission have to sign off on it. By shifting oil wells to gas wells, producers can often claim a generous state tax credit targeting “high cost” natural gas.

Meant to spur more drilling, the policy can shave several percentage points off the state’s 7.5 percent severance tax on natural gas production. The tax credit is good for 10 years, or until the credits total half the cost to drill and complete a well.

But a surge in oil-to-gas reclassifications may put taxpayers on the hook for hundreds of millions of dollars in incentives for oil wells drilled during boom times, including reimbursement for taxes paid years ago.

Now, key lawmakers say the natural gas credit — considered a giveaway by some, an essential economic tool by others — deserves a new round of scrutiny.

“I am very familiar with the high-cost gas exemption and its original purpose," Senate Finance Chairwoman Jane Nelson, R-Flower Mound, told The Texas Tribune in a statement. “This is a concerning trend that warrants review."

House Appropriations Chairman John Otto, R-Dayton, and House Energy Chairman Drew Darby also say parts of the policy could use a fresh look after the measure shaved more than $8 billion off operators’ tax bills from 2008 through 2014, according to a report last year from former Comptroller Susan Combs.

Of particular interest is whether the state should retroactively apply the credit for years when the state called the wells oil wells.

“I think we need to look at that,” said Darby, R-San Angelo. “Is it doing what it’s designed to do — to encourage production in marginal wells? Or is it just a windfall, so to speak, for playing a game?”

But any attempt to change the policy would likely face fierce pushback from an industry beset by sinking oil prices that hit an 11-year low on Monday.

Oil or gas?

Operators commonly free up oil and gas from the same well. But Texas law defines wells as either oil or gas — not both. The highly technical job of categorizing each falls to the Texas Railroad Commission, the state’s curiously named oil and gas regulator. 

A well’s classification depends on a host of factors, including how much gas is coming out of the ground. Sometimes, after looking at new data from a well, the commission discovers it misclassified a well in the first place.  

“What the Railroad Commission does, is really a science and fact sort of finding,” said John Tintera, the agency’s former executive director, now an industry consultant. 

The agency reclassified 844 oil wells as natural gas wells during the 2015 budget year. That more than tripled the switches from the previous year and was nearly six times the number in 2013. 

Gas-to-oil switches also surged during that period, but on a much smaller scale —from 68 to 239.

The trend has drawn attention from Texas Comptroller Glenn Hegar.

His rough estimate suggests eligible wells in just the Eagle Ford Shale — home to most of the switches — could cost the state up to $250 million in tax revenue during the 2016-2017 budget cycle and more than $200 million over the following two years.

“The reclassification of wells is one of many issues we are tracking at the Comptroller’s Office that could impact the state’s bottom line,” said Lauren Willis, a spokesman for Hegar.

A company might seek reclassification for a number of reasons. Producers, for instance, can typically hold twice as many acres around a gas well, compared to an oil well. And as geology can change over time, so can a well’s production.

The Railroad Commission can also initiate a reclassification itself, if production data shows a change is appropriate.

But the tax credit can make reclassification particularly attractive for operators.

A big incentive

The policy has sparked debate in Austin for years, with proponents arguing that it keeps drillers in Texas, where the standard severance tax rate is higher than in most states. Critics say the incentive needlessly pads companies’ bottom lines without encouraging more production.  

The recent oil-to-gas shift has fine-tuned the questions lawmakers and others are asking. Should reclassified wells be eligible for credits just once they are switched, or should the credits apply to every year since they were drilled — as current policy allows?

To answer that question, officials should look at whether the provision keeps wells — oil or gas — pumping across Texas, Darby said. 

“As oil prices continue to decline, you’re going to have the struggle every day,” he said. “If it leads to continued production, then overall, that it is a positive impact to the state.”

James LeBas, an economist with the Texas Oil and Gas Association and a former chief revenue estimator in the comptroller’s office, said it makes sense that companies could claim credits from years past. That’s because a successful reclassification essentially acknowledges that the original category was incorrect.

Operators drilled some wells in spots originally thought to be richer in oil, he said, but additional geological study and production data later proved otherwise.

“The wells that are being reclassified were never oil wells to begin with. They may have been misclassified as oil wells,” he said. “The wells we’re talking about were gas wells all along.”

Others say that retroactively awarding the credit to reclassified wells hardly fit the policy’s original intent.

“It is just a complete give away, in my opinion,” said Jim Bradbury, a Fort Worth-based lawyer who focuses on environmental and energy issues. “The whole theory was that we needed to incentivize risky production.”

A Railroad Commission debate

These questions come as the Railroad Commission weighs a pair of cases that could arguably make it easier for companies to ask for oil-to-gas switches.

Usually, operators submit such requests by filling out individual forms for each well.

But Oklahoma City-based Devon Energy wants to simultaneously reclassify hundreds of its wells. That comes through a broader application to change drilling rules on two Eagle Ford fields. 

The request specifically lists more than 200 wells that the company wants permanently switched. It also asks the commission to drastically lower the gas-to-oil ratio needed to categorize a well as a gas well. That would only add to the number.

Ramona Nye, a commission spokeswoman said, it would be “premature” to speculate how many wells would be affected.

A final decision could take months, following a hearing that was held in November. Agency hearing examiners must make a recommendation to the agency’s three commissioners, who will ultimately vote on it.

Devon did not respond to repeated requests for comment.

Meanwhile, Pioneer Natural Resources is asking the commission to classify all 11 wells on one of its Eagle Ford units as natural gas. That includes two wells that the agency says don’t fit the requirements.

In an October report, agency hearing examiners called on the commissioners to reject the application, criticizing the Irving-based company’s methodology for testing the wells — and its argument that some should be considered gas wells simply because of their proximity to other gas wells.

Approving the application would “deviate from longstanding commission practice,” examiners wrote, adding that an “unstated rationale behind Pioneer’s application,” appeared to be the generous tax credit.

The company disagreed with the examiners’ report, and said its request would benefit mineral owners, too.

“Pioneer feels the data developed in the Eagle Ford supports its position,” Robert Bobo, a spokesman, said in an email.

At an open meeting last week, the commission delayed a final vote on the Pioneer case, saying that evidence to be submitted in the Devon case could ultimately inform their decision.

“This is an extremely technical question, and it’s an extremely important question,” said Chairman David Porter. 

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Economy Energy Environment Politics Drew Darby Jane Nelson Texas Railroad Commission