Subsidies really do matter to the US oil & gas industry -- one in particular

Fossil fuel subsidies are a vexed and peculiar topic. On one
hand, everyone seems to agree they’re bad and should be
eliminated (it’s in Biden’s jobs bill, for instance). On the
other hand, they never go anywhere.


In part, it’s because we lack a clear understanding of what
constitutes a subsidy and what impact they have. Analysts are
forever arguing over exactly what counts, trying to tally up the
total subsidies fossil fuels receive, but there are very few
bottom-up attempts to document the concrete effects of subsidies
on the economics of oil and gas projects.


That’s why I was interested in this new paper in Environmental
Research Letters, by Ploy Achakulwisut and Peter Erickson of the
Stockholm Environment Institute and Doug Koplow of Earth Track.
It breaks down the effect of 16 specific, direct US fossil fuel
subsidies on the profitability and emissions of US oil and gas
production.


As for those subsidies, there are three basic categories:
“forgone government revenues through tax exemptions and
preferences; transfer of financial liability to the public; and
below-market provision of government goods or services.” (Note
that this study does not get into unpriced environmental
externalities like air pollution and greenhouse gases, which are
themselves a kind of subsidy.)


Subsidies either enrich oil & gas investors or spur new oil
& gas projects


One reason there aren’t many bottom-up analyses like this is that
it’s devilishly difficult to pin down the economic effect of a
subsidy. Doing so always involves a counterfactual baseline —
what would have happened absent the subsidy. Anytime
counterfactuals are involved, there lots of assumptions to make
and variables to account for.


To take just a couple of examples, the effect a subsidy will have
on the decision whether to invest in a new oil and gas project
will depend on oil and gas prices and the hurdle rate. (The
hurdle rate is the rate of return investors require to fully
cover risks; more aggressive decarbonization efforts will
presumably mean more risk and thus a higher hurdle rate.) The
study actually runs several different scenarios based on
different values for those variables, producing a cost curve for
each region of the US. It gets complicated.


For clarity, they chose to highlight two scenarios: 2019’s higher
oil and gas prices with a 10 percent hurdle rate and 2020’s lower
prices with a 20 percent hurdle rate. Here are the results:


We find that, at 2019 average market prices of oil and gas, the
16 subsidies could increase the average rates of return of
yet-to-be-developed oil and gas fields by 55% and 68% over
unsubsidized levels, respectively, with over 96% of subsidy value
flowing to excess profits under a 10% hurdle rate. At lower 2020
prices, the subsidies could increase the average rates of return
of new oil and gas fields by 63% and 78% over unsubsidized
levels, respectively, with more than 60% of oil and gas resources
being dependent on subsidies to be profitable under a 20% hurdle
rate. 


The way to think about this is, subsidies can have one of two
negative effects, depending on market circumstances.


With higher prices and a lower hurdle rate, “only 4 percent of
new oil and 22 percent of new gas resources would be
subsidy-dependent, pushed into making profits,” Achakulwisut told
me. That means most of the projects didn’t really need subsidies
and the extra money is all going to bigger profit margins for oil
and gas investors.


With lower prices and a higher hurdle rate, “subsidies would
matter a lot,” she says, “and 61 percent of new oil and 74
percent of new gas would be subsidy-dependent.” The subsidies
would directly lead to more production.


Achakulwisut summarizes: “In one case, it's going to profit,
amplifying the incumbent status of the oil and gas industry. In
another, under more aggressive decarbonization policy and low oil
and gas prices, it's actively working against the climate goal by
spurring additional production.”


Either of those effects is bad. In 2021, we don’t want bigger
profit margins for oil and gas companies and we don’t want more
oil and gas production.


One subsidy to rule them all


What’s interesting is that the benefits to oil and gas are not
spread evenly over different subsidies. In fact, one in
particular dwarfs the others: the expensing of intangible
exploration and development costs (“intangible drilling costs,”
or IDC), a policy that’s been around for over a century.


The chart below shows the “average effect of each subsidy on the
internal rate of return (IRR) of new, not-yet-producing oil and
gas fields, at average 2019 prices of USD2019 64/barrel of oil
and USD2019 2.6/mmbtu of gas.”


As you can see, in every region, the IDC deduction is the
dominant subsidy. It “increases US-wide average IRR by 11 and 8
percentage points for oil and gas fields respectively.”


The IDC deduction has been the subject of controversy for ages.
The Committee for a Responsible Federal Budget (CRFB) has a good
breakdown here. A definition:


Intangible drilling costs are defined as costs related to
drilling and necessary for the preparation of wells for
production, but that have no salvageable value. These include
costs for wages, fuel, supplies, repairs, survey work, and ground
clearing. They compose roughly 60 to 80 percent of
total drilling costs. 


Since the dawn of the federal income tax code in 1912, US law has
allowed oil and gas companies to deduct all these costs up front,
rather than as they are incurred. The idea is to defray the risk
that an exploration project will come up dry; in practice, it’s a
fat financial reward at the front end of every project.


The industry and its defenders offer an array of arguments in
favor of the deduction, which CRFB adeptly summarizes:


Supporters of the deduction argue that oil and gas and
exploration and development is a high-cost industry, and allowing
expenses to be recovered immediately encourages companies to
invest. They explain that altering the deduction could
result in job losses, since wages are included in the deduction.


More broadly, supporters point out that the oil and gas
industry receives the same treatment that other manufacturing or
extractive industries receive, and are merely a target because of
the now-controversial nature of reliance on fossil fuels.
Finally, supporters of energy
independence often support the IDC deduction, as
it promotes further exploration and development of wells within
the United States.


The thing is, all those arguments are true. But the subsidy is
still bad.


Yes, deducting IDCs encourages investment in new oil and gas
projects and creates new jobs. That’s what subsidies do! It just
happens that we no longer want to encourage investment in oil and
gas.


Yes, other manufacturing and extractive industries get similar
deductions. The difference is that we want to encourage
investment in those other industries and we no longer want to
encourage investment in oil and gas. That’s the whole point.


The issue is not whether the subsidy does what it’s designed to
do. It does. The question is whether we still want to do the
thing it does. We do not.


People have been calling for removal of this subsidy for decades.
It’s still a good idea.


Oil and gas also benefits from offloading its environmental
regulatory costs onto the public


The other subsidies that substantially boost oil and gas profit
margins are “regulatory exemptions that lower [oil and gas]
production costs at the expense of the health and safety of
workers and the public.” Two such exemptions shift financial
liability for well closure and reclamation from companies to
state governments, which saddles places with lots of abandoned
wells — Texas, Pennsylvania, and Oklahoma, for example — with an
average of $10 billion a piece in remediation costs, which well
exceeds what those states have set aside in cleanup funds.


Another allows oil and gas to treat solid wastes from extraction
as non-hazardous, despite the fact that they frequently contain
toxic chemicals or radioactive materials. This reduces per-well
operational costs an average of $60,000.


Keep in mind, this study didn’t try to tally up the public health
benefits of removing these subsidies. Others have done so, like a
recent study from Yale’s Matthew Kotchen that tried to tally up
the “implicit subsidies” to US fossil fuel producers represented
by “externalized environmental damages, public health effects,
and transportation-related costs.” His conclusion:


The producer benefits of the existing policy regime in the United
States are estimated at $62 billion annually during normal
economic conditions. This translates into large amounts for
individual companies due to the relatively small number of fossil
fuel producers. 


Those implicit subsidies are far larger than any direct
subsidies. In 2017, the International Monetary Fund tried to
tally up implicit subsidies across the globe and came up with an
eye-popping $5.2 trillion.


Like much climate policy, removing fossil fuel subsidies requires
directly confronting fossil fuels


I take three things from this research. One, fossil fuel
subsidies really do strengthen the economics of US oil and gas
companies and accelerate investment and exploration. That’s what
they’re designed to do, and they do it. Two, the oil and gas
industry really does materially benefit from being allowed to
offload its environmental risks onto the public.


And three, the deduction for intangible drilling costs is the
main fight. It is the big subsidy, the one that’s actually
pushing new oil and gas projects over the line into
profitability, and it is a much more specific target than “fossil
fuel subsidies.” It seems like something some clever group ought
to be able to build a campaign around.


It’s worth noting that Joe Biden’s proposed 2021 budget would
eliminate the IDC deduction, along with a host of other fossil
fuel subsidies. Then again, Obama included the same kinds of
provisions in virtually every one of his budgets, and Congress
never complied. Like I said, fossil fuel subsidies just hang
around.


In this way, they represent the sad reality of federal climate
policy in the US, which involves a lot of heady talk and future
targets, but very little that would confront fossil fuel
industries head-on over the next decade. (I wrote about this the
other day.)


The problem is that the benefits of fossil fuel exploration and
production are concentrated in a few regions and communities and
the members of Congress who represent those communities are
hyper-motivated to preserve existing advantages. In contrast, the
benefits of ramping down fossil fuel production are spread out,
geographically and temporally, so few members of Congress will
champion it with the same vigor.


That’s how climate policy runs aground in the US — in the
translation from high-flown rhetoric to policies that will
materially affect the bottom lines of fossil fuel companies.


This study offers us a marker of serious commitment: repealing
the deduction for IDCs. When Congress actually gets around to
addressing that age-old subsidy, we’ll know we’re finally getting
somewhere.


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