A hydraulic fracturing well looms large over the Ohio countryside (courtesy of Ideastream).
In March 2012, the Ohio House of Representatives introduced HB 487, a bill which included changes to the way that Ohio taxes oil and gas extraction in the state. Ohio’s current system of regulating oil and gas production was implemented in 1972. Almost everything about the energy sector in the United States has changed drastically in the last 40-plus years; I wish I could say these regulations were included.
Ohio’s existing severance tax
Ernst & Young analyzed Ohio’s existing severance tax and Governor Kasich’s proposed changes (PDF) in 2012. E&Y compared Ohio’s tax policy to that of seven other oil and gas producing states. Of the eight states, Ohio has by far the lowest effective tax rate (ETR). The state’s combined ETR of 1.8% is 80% lower than the average in the seven other states. Based on a 2011 analysis from Policy Matters Ohio, this tax rate has cost the state millions in foregone tax revenues. From 2001-2010, the value of the oil and natural gas extracted within the state was $8.38 billion. But Ohio collected a mere $26,017,858 in taxes – equal to 0.31% of the market value. That’s not at typo. Using these numbers, Policy Matters projected the amount of severance taxes that Ohio would collect from shale gas production from 2012-2015, compared to five surrounding states. Of the $10.77 billion in estimated value, Ohio will capture just $39.8 million in taxes. Compare this number to West Virginia and Michigan, whose 5% tax would bring in $538.4 million.
The Kasich proposal
Clearly, Ohio’s current severance tax sucks. Governor Kasich’s plan was supposedly introduced to rectify this issue. The proposal would have doubled severance taxes on oil from conventional, vertical wells to $0.20 per barrel and altered the tax on natural gas from vertical wells to the lessor of 1% of the market value of the gas or $0.03 per thousand cubic feet (mcf). It would have also priced oil and gas from horizontal wells, which is produced using the controversial hydraulic fracturing method, separately. This oil would have been taxed at 1.5% of the market value for one year, then at 4% for the lifetime of the well. Natural gas from fracking wells would have been taxed at 1% across the board. E&Y’s analysis found that this proposal would have increased the effective severance tax rate from just 1.8% to 2.7% overall; however, Ohio would still have the lowest tax rate in the region. Under Kasich’s proposal, Ohio’s ETR for an average oil/gas well would be just 40% lower. What a relief.
Ohio Republicans strike back, introduce HB 375
And yet, Ohio Republicans balked at Kasich’s plan. During budget deliberations, the plan was completely stripped out of the bill. Recently, Ohio Republicans finally offered up their alternative to Kasich’s proposal. State Rep. Matt Hoffman (R-Lima) introduced HB 375 on December 5. Shockingly, the bill has overwhelming support from the oil & gas industry.
Thomas Stewart, head of the Ohio Oil & Gas Association, issued a statement saying the bill “includes a sensible modification of the severance tax based on actual well economics.”I’m not sure what energy economics textbook Mr. Stewart is reading from, but suffice it to say he’s just a tad off the mark. Headwaters Economics issued a report in 2012 that included a list of 12 recommendations for crafting fiscal policies for the oil and gas sector. HB 375 goes against every single recommendation. So let’s compare the bill to just three of these recommendations.
1. Maintain a high effective tax rate
Headwaters argues that it is essential for states to keep a high ETR on their mineral deposits, because it provides additional resources to mitigate the impacts of drilling and allows them to invest in long-term economic development.
Even 1980s Kevin Bacon knows that the oil & gas industry isn’t footloose (courtesy of People Magazine).
Contrary to fear-mongering from industry reps and the Ohio GOP, the oil & gas industry is not going to flee the state and give up concessions just because the state increases slightly its pathetically low severance tax. As Headwaters notes, Montana had an ETR of 4.6% for oil and gas in 2011. Neighboring North Dakota, in contrast, keeps its rate at 9.9%. Despite this, North Dakota has seen significantly more drilling activity, and Montana’s poorly-designed tax policy cost the state $60 million in foregone tax receipts in 2010 alone.
The minerals sector is not directly comparable to other economic activities, like the service sector. Oil and gas producers migrate to where the oil and gas deposits are, not where taxes are lowest. The industry is not, in economics parlance, particularly footloose. If it were, then Texas and Alaska, where tax rates are 8.2% and 25%, respectively, would not be leading producers. There is simply no valid evidence to suggest that slightly higher severance tax rates will keep companies from drilling here.
Yet, HB 375 institutes tax rates even lower than Kasich’s proposal. It would lower the tax on conventional gas from $0.025 per mcf to $0.015 per mcf. It also repeals the regulatory cost recovery assessment fee passed in 2010 to offset the costs of land reclamation. And, for horizontal wells, it introduces a severance tax of 1% of the value of net proceeds from oil/gas sales for 20 months; this tax then increases to 2%.
2.Remove “holiday” incentives
Several states have production tax “holidays” during the early days of oil and gas production. The logic behind these tax holidays is based on the fact that, for conventional wells, there is a lengthy gap between the drilling phase and the production phase (when the oil/gas is actually flowing). This gap can be upwards of two years for vertical wells.
But this model does not apply to horizontal wells. The drilling phase for a horizontal well is compressed, and the production phase typically jump starts thereafter. The majority of oil/gas from horizontal wells is extracted during the the first two years, after which production drops precipitously – by more than 60% in just one year in most cases.
This image from the EIA charts the production cycles of shale wells across five different shale plays.
By providing a five-year tax holiday, HB 375 effectively ensures that Ohio will forfeit the overwhelming majority of tax revenues from its oil and gas deposits. By the time that the tax rate increased to 2% in year six, it’s entirely likely that drillers may have simply moved onto the next well.
3. Guarantee adequate local share in revenue collections
A central tenet of good oil/gas policy is to guarantee that the benefits of the fuels are adequately shared with communities on the front lines of extraction. As I’ve written before, the US isn’t somehow immune to the impacts of the natural resource curse. Far from it. One can find evidence of the resource curse from horrifically high mortality rates (PDF) in Appalachia to skyrocketing crime rates in North Dakota to groundwater pollution from fracking in multiple states to increased damage to infrastructure in Texas.
HB 375 does nothing to support front line communities. Ohio’s past two biennial budgets have taken a toll on local governments. Ohio Republicans balanced the state budget by holding onto tax revenues that should have been returned to local governments. The 2014-2015 budget reduces the amount of money local governments will receive by $1.4 billion. HB 375 simply exacerbates the issue further. Under the proposal, the funds raised would go to the Ohio Department of Natural Resources to cover the costs regulating the industry, remediating abandoned wells, and conducting geological surveys for the industry. Any additional funds would go to reduce personal income taxes. This policy would disproportionately benefit the wealthy and leave those directly affected by drilling on the outside looking in.
HB 375: Great for the industry, terrible for Ohio
All told, Policy Matters Ohio found that HB 375 would cost the state $620-800 million over the next decade, compared to the Kasich proposal (which is far from ideal policy). The bill amounts to little more than a giant handout to the oil & gas industry. Ohio’s current oil/gas severance tax is a 40-year old relic of terrible policymaking. It would be a challenge to make a policy that’s worse.
Somehow, Ohio Republicans have crafted a bill so terrible that it gives existing law a run for its money. If you were looking to develop a policy that took the full advantage of our natural resource endowment and benefited ordinary Ohioans, you could hardly do worse than HB 375. But, on the other hand, if your goal was to benefit the wealthy, well-connected, and your political benefactors, you would be pressed to outdo HB 375.
This bill is egregiously bad policy. Naturally, I expect it will be on Kasich’s desk by the spring.