ICF: CHANGE SECTION 29 TAX CREDITS

Federal tax credits for producing U.S. unconventional gas should be changed to restore original energy objectives of Congress, says ICF Resources Inc., Fairfax, Va.

ICF suggests how Section 29 tax credits might be changed in an analysis drawing on a confidential survey of 60 producers of unconventional gas resources (UGRS) and two earlier ICF Section 29 studies.

The analysis comes at a time when Section 29 incentives are stirring debate in Congress and controversy in the U.S. gas industry.

WHAT CONGRESS INTENDED

ICF says Section 29 credits for developing and producing UGRs no longer provide the incentives Congress intended because, despite sweeping changes in the U.S. gas industry, the credit's scope and mechanism have not changed since its inception in 1980.

The company says Congress implemented Section 29 to speed development and production of unconventional gas, mostly in marginal or otherwise uneconomic tight sand, coal seam, and Devonian shale reservoirs.

U.S. UGRs in place in the three reservoir types are estimated to exceed 7.4 quadrillion cu ft, with an estimated 204-463 tcf recoverable under today's technology and wellhead prices.

But most incremental UGRs production claiming Section 29 credits so far has been developed using conventional technology in the most geologically favorable eligible areas, ICF says. This has been true especially in the past 2 years, when UGRs wells accounted for most Natural Gas Policy Act well determinations and the value of the credit rose to more than 60% of the average U.S. gas wellhead price.

Section 29 credit proponents say the credit has helped stimulate gas production and maintain reserves in a low price market, thereby helping assure adequate long term supplies - one of its stated purposes.

On the other hand, critics contend the credit is contributing to low wellhead prices during a period of surplus supply and subsidizing production from inefficient wells or wells that would be uneconomic without the credit.

UGRs wells drilled in qualified reservoirs before the year-end 1992 deadline will be allowed tax credits totaling 520/Mcf for tight sands and 94/Mcf for coalbed methane and Devonian shale production. The credits are available for gas produced from eligible wells through Dec. 31, 2002.

EFFECT OF INCENTIVE

ICF data show UGRs production in the past 5 years has increased almost 50%, while production from conventional gas reservoirs has grown less than 5%. At the same time, average U.S. wellhead prices have plunged more than 30% in real terms, and the size of the Section 29 credit compared with average wellhead prices jumped in 1991 to 62% from 40% in 1986.

Yet, the company says, it is unlikely that UGRs production alone significantly affected U.S. gas prices. Rather, other gas market fundamentals - growing conventional supplies, flat demand, improved pipeline transportation, and market competition in UGRs-prone U.S. basins-far outweighed the effect of incremental UGRs supplies.

But even if Section 29 credits haven't depressed U.S. gas prices, ICF says, questions persist about the existence and structure of the incentives.

"It is appropriate that any future incentives be altered to reestablish original congressional intent to improve technology and lower risks only for UGRs prospects that would not be economic without incentives," ICF said.

Specifically, ICF said, alternate credit designs should address the:

Inefficiency of subsidizing production of any wells in a surplus market.
Equity of providing incentives for otherwise economic, low risk wells.
Value of the incentive relative to average gas wellhead prices.
Uncertainty about usefulness of the credit because of other tax provisions.
Potential cost of the credit to the U.S. Treasury.

PRODUCER SURVEY

Responses to ICF's UGRs producer survey analyzed in light of well distributions in five major basins-Appalachian, Black Warrior, Cotton Valley, Michigan, and San Juan-and four Section 29 proposals most widely debated in Congress show how the credit could be changed.

But ICF said, "The optimum structure of any economic incentive cannot be specified without clear policy objectives."

Weighing the effect of the incentives is complicated because producers of gas from eligible UGRs reservoirs can't use Section 29 credits to offset current year alternative minimum tax (AMT) liabilities. Among respondents to ICF's UGRs operator survey, up to 50% of majors and 70% of independents said they could not use Section 29 credits because of their AMT status.

Still, ICF said, its analysis of operator survey responses concludes an annual rate cap allowing credits to only high cost, low rate wells is the most effective means to provide incentives to marginal wells while limiting credits to highly productive wells.

The company said a cumulative production cap limiting credit payments on each eligible well would be less efficient because most prolific gas wells would receive the maximum credit early in their productive life.

A time cap limiting credit payments to traditional payout periods would be inequitable because production curtailments could reduce incentive benefits. In addition, because methane production increases as coal seams are dewatered, much coalbed methane production might occur after the end of eligibility.

CONGRESSIONAL PROPOSALS

Debate in Congress about how to alter Section 29 has focused on four options:

Allowing Section 29 credits to expire at the end of 1992 under current law.
HR 4190, a bill by Rep. Robert E. Wise (D-W.Y.), that would extend Section 29 credits permanently and allow incentives to be credited against AMT but would limit eligible production to 55 MMcf/year.
A 2 year extension of Section 29 in its current form.
A permanent extension of Section 29 in its current form.

In its analysis, ICF estimated the effect of each option in 1993-97 on total and incremental UGRs drilling, reserve additions, production gains, and potential credit claims on the U.S. Treasury:

If Section 29 expires at yearend 1992, 12,800 UGRs wells could be drilled, adding 19.1 tcf of reserves and 13 tcf of production from all UGRs wells, with credit claims of as much as $4.8 billion if AMT restrictions do not limit credit use. Some wells would be drilled that would be economic without the credit. In addition, operators' survey responses indicate if Section 29 incentives were allowed to expire at the end of 1992 credit use likely would be little more than half the potential amount.
Under HR 4190, 18,400 UGRs wells could be drilled, 23.4 tcf of reserves added, 13.9 tcf of unconventional gas produced, with credit claims of as much as $6.2 billion. The Wise bill would add the smallest volume of incremental reserves and production and the lowest possible credit claims among options compared. Incremental reserves would be added at a claims cost of 38/Mcf.
If Section 29 is extended for 2 years in its current form, 18,800 UGRs wells could be drilled, 27.8 tcf of reserves added, 15.8 tcf of unconventional gas produced, and $8 billion of credit claimed. Producers likely would step up development as the deadline approaches, resulting in lower average well quality than if the same number of wells were developed during a longer time. The cost of incremental reserve additions for this option is 38/Mcf, highest of the modification options analyzed.
If Section 29 were extended permanently in its current form, 23,300 UGRs wells could be drilled, 36.2 tcf of reserves added, 15.8 tcf of unconventional gas produced, with tax credit claims of $8.4 billion. Incremental production during the 5 year period would be no greater under a permanent extension than a 2 year extension. But 17.1 tcf of incremental reserves would be added at a cost of 21/Mcf, the lowest among the three modification options.

However, although the marginal cost per Mcf of reserves added is lowest with a permanent extension of current Section 29 credits, ICF said, "the aggregate cost to the U.S. Treasury is far in excess of what is realistic under current federal budget constraints. Furthermore, it does little to address many concerns credit opponents have raised,"

FURTHER CHANGES

ICF said further changes of Section 29 should be considered to better focus incentives on original congressional objectives while minimizing costs to the federal Treasury.

The company recommends:

Setting a rate cap that restricts credits to wells uneconomic without an incentive, possibly at a lower level than the 55 MMcf/year proposed by HR 4190.
Tying incentive value more closely to prevailing wellhead prices rather than the price of oil as under the current credit.
Restricting eligibility of formations and areas based on new assessments of geology, technology, and project economics to assure that only formations uneconomic without the credit qualify for incentives.
Establishing drilling eligibility periods long enough to allow efficient development planning.
Ending production eligibility shortly after drilling eligibility to gradually phase out the effective credit value, thus minimizing drilling and market distortions as the credit ends.