OKLAHOMA CHEROKEE FORMATION STUDY SHOWS BENEFITS OF GAS TAX CREDITS

Brian J. Stanley
Scott B. Cline
Hefner Corp.
Oklahoma City

To no one's surprise, the administration's recently released energy initiative package does not advocate the use of tax incentives such as the Internal Revenue Code Sec. 29 (tight sand gas) credit that expired Dec. 31, 1992.

This is unfortunate since tax credits do stimulate drilling, as the authors' recent study of Oklahoma's Pennsylvanian age Cherokee formation demonstrates.

Within this 783,000 acre study area, more than 130 additional wells were drilled between 1991 92 because of tax credit incentives. And such tax credits also increase total federal tax revenues by causing wells to be drilled that would not have been drilled or accelerating the drilling of wells, thereby increasing taxable revenue.

In short, tax credits create a win win situation: They stimulate commerce, increase tax revenues, reduce the outflow of capital to foreign petroleum projects, and add to the nation's natural gas reserve, which is beneficial for national security, balance of payments, the environment, and gas market development.

STUDY ASSUMPTIONS

Common sense and an elementary understanding of economic behavior tell us that drilling credits should stimulate drilling.

However, we offer the following abridged discussion of our more detailed study showing how the recently expired Sec. 29 credit increased drilling in one fight gas sand designated area, the Pennsylvanian age Cherokee group in western Oklahoma.

Though no definitive extrapolation is possible based on this limited study, it is safe to assume that the credit had similar effects in most areas that qualified for the credits.

This study covered the Cherokee group tight gas sand area of Oklahoma (Fig. 1), an area that encompasses about 34 townships or 783,000 acres in the Anadarko basin in western Oklahoma. The study included wells spudded between January 1985 and June 1993.

Although the mechanics of the tax credit cannot be covered in detail in this short article, a tax credit can be viewed as net price increase to the producer. As such, tax credits can be merged with gas price for statistical purposes as long as all companies have roughly the same tax rate and all are able to use the credit.

Assuming 1,100 BTU gas the net tax credit is 57/Mcf which results in an effective taxable price increase of 87/Mcf to the producer if the corporate tax rate is 34%.

The study considered only price, as adjusted by the tax credit, and not other non-price factors like well costs, technological advancements, or a play's stage of maturity. Well cost variations were negligible in the area during the subject tim period, as the average well depth of 12,900 ft had a standard deviation of only 1,000 ft, and drilling costs were stable.

Though some operators in the area used limited 3D technology and new fracture stimulation techniques, such use was not extensive enough to materially affect drilling activity. Further, many of the effects of technology are subsumed in the price factor. As price increases cause the drilling of more wells, the additional drilling experience allows operators to use, create, and perfect new technologies.

STUDY RESULTS

The study shows a definite positive relationship between tax adjusted gas price and the number of wells drilled.

The total wells identified as drilled primarily for the Cherokee group for each year, the average yearly gas price,1 and equivalent gas price with tax incentives (Fig. 2).

In 1991, the first year that the credit was available, drilling activity increased by 25% despite a 7% decrease in gas prices (unadjusted by the tax credit) from the previous year. An even more dramatic 121% increase in drilling occurred in 1992.

A scatter plot with best fit regression lines (Fig. 3) using the number of wells drilled as the dependent variable versus tax credit adjusted gas price as the independent variable shows a definite positive relationship.

Statistical analysis (Table 1) indicates that the relationship between price and drilling activity is statistically significant at a 98% confidence level with a linear fit. A slight improvement is obtained with a curvilinear fit using the log base ten of wells versus linear gas price. The correlation coefficient is 0.81. A 4th order polynomial fit (not shown) had a very high correlation coefficient, but the F statistic was not significant at a 95% confidence level. Residual analysis indicates no problem with autocorrelation or heteroscedasticity.

Although causal inferences are dangerous, this correlation value might have been higher if tax incentives had not been phased out so quickly. The exceptionally high number of wells drilled in 1992 was probably the result of operators rushing to take advantage of the tax benefits before the expiration date.

Table 2 shows the actual and predicted wells drilled if incentives had not been in place using both regression and moving average (Fig. 4) analysis. The regression analysis predicts that an additional 100 plus wells were drilled between 1991 92 if gas price is assumed to be the only independent variable using the actual non-tax credit adjusted 1991 92 gas prices of $1.47 and $1.63, respectively. The result is a substantial increase in drilling at higher effective prices whether regression or moving average analysis is used.

The sustained effect of the tax credits, if they were a permanent feature of the tax code, is unclear. The effect of the tax credits was probably both one of accelerating the drilling of wells that may not have been drilled for a number of years until prices increased and also the stimulation of drilling that may never have occurred without tax benefits. The additional drilling during the tax incentives period was primarily "infill," or increased density drilling, within already established 640 acre units. This conclusion is based on both well classifications and increased drilling success rates during the tax credit period. Success rates averaged 78% for the six years prior to the tax incentives and increased to 91% during the tax credit period. This does not imply however, that the additional tax incentive induced drilling merely added reserves that would have been added in the future anyway. Certainly some of those wells would never have been drilled. Further, accelerating the drilling of wells is itself sufficient justification for the existence of credits like Sec. 29, as causing the drilling and hence production to occur sooner increases the present value of the tax revenues generated by the drilling.

TAX CREDIT POLICY

Previous and apparently current legislative policy has been based on the mistaken assumption that natural gas is in short supply. The total resource base consists of both the traditional proved reserves and unproved reserves in both conventional and unconventional reservoirs such as coal beds and shales. The total natural gas resource base has actually increased over time to a current record 1,300 tcf,2 or a 71 year life at current demand rates.

Though the domestic natural gas resource base continues to grow in spite of historically low drilling activity, the proved reserves - those available for deliverability on short notice are declining. Proved, deliverable gas reserves, as opposed to the total gas resource base, have declined 18% from 202 tcf to 163 tcf since 1982.3 Recent proved reserve declines have been moderated by tax incentive induced drilling and field extensions aided by the closely related technological advances. More rapid transfer of unproved natural gas resources to deliverable proved reserves can also be accomplished by the discovery, application, and dissemination of technology aided by tax incentives.

The long term natural gas resource base exists. The question is how to convert that resource base to proved, deliverable reserves at the time they are needed. Current prices alone will not stimulate enough drilling to replace the current reserve decline that will inevitably lead to future short term supply shortages.

These short term supply shortages will lead to higher short term price shocks but will in the end lead to less growth in the gas market. Tax credits, then, should be used to stimulate a higher level of gas drilling, which will have the positive side effect of increasing tax revenue and assuring consumers of adequate supplies of relatively clean burning natural gas. With the assurance of adequate proved reserves, additional gas markets can be developed by channeling some of the additional tax revenue generated from the tax credits into additional gas related research and development and toward stimulating conversion of vehicles to natural gas.

Though any tax credit is better than none at all, and the industry must take what it can get from Congress and the administration, there are some things about the mechanics of the Sec. 29 tax credit that Congress could improve should it see fit to pass credit bearing tax legislation. For example, why should the phaseout of the credit be tied to the price of oil as was the Sec. 29 credit? Obviously there is a relation between the price of oil and the price of natural gas, but the correlation between the price of one and the price of the other is certainly not perfect.

If the credit must be phased out and some sort of phaseout is reasonable - why not use the price of natural gas itself instead of the price of oil as the determining factor: Since the price of natural gas varies significantly from region to region in the U.S., using a national price as the phaseout price, as Sec. 29 did, would disadvantage those producers in the regions receiving the lower price, as their credit would be phased out as the national average price rises because of increases in other parts of the country. There is simply no reason to phase out a New Mexico producer's credit because the price of natural gas has risen in New York, for example. If the purpose of the credit is to stimulate drilling activity, the credit must be available to those who will do the drilling, regardless of what is happening in a different region of the country.

There is no doubt that a vast natural gas resource base exists, the estimated size of which is still growing. The question then is not whether we have an adequate natural gas resource base but how will it be developed in a manner that will meet demand needs without periodic deliverability shortages that ultimately result in a loss of confidence in gas as a long term reliable fuel. Expanded gas markets are desirable from both an environmental and trade deficit standpoint. Drilling credits, unlike import fees, will not increase the cost of energy to the consumer, And the continued emphasis on the very unpopular import fee merely distracts Congress and the administration from other energy related matters, like drilling tax credits, secondary recovery incentives, expansion of stripper well definition, and other more politically palatable proposals. An import fee, however, might be more politically and economically tenable ff used merely to set an oil price floor perhaps $15 to prevent OPEC from purposely driving oil prices low enough to destroy the domestic oil business and eliminate competition. Expanded.markets and the ability to supply those markets are possible with tax credits as the cornerstone of energy policy.

REFERENCES

Claxton, Larry, 1992 statistical abstrace for oil and gas, Oklahoma Corporation Commission, June 1993.
The outlook for natural gas, Enron Corp., Houston, March 1993.
U.S. crude oil, natural gas and natural gas liquids reserves, 1992 annual report, Energy Information Administration, Washington, D.C., Office of Oil & Gas, September 1993.