Bonehead Alert: How Washington’s Latest “Brainwave” Could Crush Our Prosperity

by David Fessler, Investment U’s Energy and Infrastructure Expert
Tuesday, September 14, 2010: Issue #1344

As the old adage goes, there are only two certain things in life: Death and taxes.

Actually, make that three. Toss Congressional stupidity into the mix, too.

In recent years, we’ve had war and the healthcare reform bill hotly debated within the Capitol. And right now, we’ve got another highly controversial Congressional debate in full swing.

The Bush tax cuts.

With the federal government looking to raise additional revenue (read: higher taxes) in order to fund even more stimulus programs, one of the easiest ways to do so is to let the Bush tax cuts expire. That’s set to happen on January 1, 2011.

President Obama wants to extend them, but only for the middle-class. Many of his fellow House Democrats agree, but want the extensions to last for just one or two years. Republicans and a few center-leaning Democrats are talking about extending all of them.

I’ll leave the political posturing and bickering on this argument to others. Besides, I’m keeping tabs on another legislative push in Washington – one that’s much more onerous than the Bush tax cuts…

The Energy Sector’s “Big Three”

Buzzing behind the scenes, away from the mainstream media and the public eye, Washington is working on the elimination of an obscure tax deduction.

But it’s a decision that could absolutely devastate the oil and gas industry. I’ll get to the specifics in a moment, but let me first explain why this area is so important.

I’ll cut right to the chase: In order to avoid a global gap between supply and demand, we’re going to need all forms of energy for the foreseeable future. And like it or not, oil, natural gas and coal are going to be America’s big three energy sources for a long time to come. They play a crucial role in meeting the world’s insatiable demand for energy.

Natural Gas: America’s Fuel for the Future

As I’ve said here before, America has an abundant supply of cheap natural gas. In fact, it’s widely accepted that we have a 100-year supply.

And it doesn’t take a genius to conclude that if we develop it properly as a transportation fuel, it could quickly lessen our dependence on foreign oil.

I’ve banged the drum on this for about 18 months now. And I’ve got good company, too, in the shape of famous oilman, T. Boone Pickens. Natural gas would provide a cheap, sustainable, domestic energy source that we need to underpin economic growth.

Not only that, natural gas makes for an ideal transition fuel as we develop other more sustainable sources over the next 50-100 years.

As you may know, Congress is trying to put together some form of energy bill. But much to the frustration of many Americans, the politicians haven’t made much headway. (What else is new?) But they are making headway on a terrible idea…

The Critical Tax Deduction That No One Knows About

Right now, oil and gas production and exploration companies are able to deduct what are referred to as “intangible drilling costs” or IDCs.

The term is contradictory, however, as IDCs aren’t intangible at all. They’re real, actual costs associated with oil and gas drilling operations. This includes things like ground-clearing, surveying, fuel, supplies, repairs, cement and other equipment.

Because most of these IDCs have no salvageable value, companies have typically treated them as expenses. That means it’s absolutely crucial for them to be able to take the IDC tax deduction.

Quite simple, this is the financial “key” that unlocks the huge amounts of upfront capital required for big drilling projects. Deepwater drilling is a good example. Oil shale drilling is another.

These upfront capital costs are huge, as are the risks. The recovery of the capital may take years – or even decades – with some deepwater oil and natural gas wells.

But it’s these very projects that ultimately result in the production of oil and gas. And let’s face it, even with all the advances in 3-D seismic technology, the actual drilling of a well is the only sure-fire way of determining whether there’s oil and/or gas present.

So what would happen if this deduction were eliminated – as some members of Congress are proposing?

The U.S. Congress: Hanging a Millstone Around Uncle Sam’s Neck

Simply put, without favorable tax treatment, oil and gas exploration and production companies will just abandon many currently planned projects. And without the large amount of capital required, higher-risk drilling projects would come to a screeching halt altogether.

And with less oil and gas supply as a result, you don’t have to have a Nobel Prize in Economics to understand what would happen to prices. They’d go up. Way up.

What else would rise? The ranks of the unemployed, swelled by laid off oil and gas workers. And as for overall economic growth… that would head in the opposite direction.

The elimination of the IDC tax would have a crushing effect on some oil and gas companies in the short-term. But the real loser in this equation would be American citizens, not drilling companies.

These firms would simply pack up their land-based rigs, load them onto ships and send them to overseas locations with more favorable tax climates. They’d be able to boost productivity and achieve higher rates of return for their shareholders.

Driving American Business Away from America

The President of the American Petroleum Institute, Jack N. Gerard, sums up the situation pretty succinctly and accurately: “[It] indicates a fundamental rule of economics: Tax something more, get less of it.”

Companies like Devon Energy Corporation (NYSE: DVN), Chesapeake Energy Corporation (NYSE: CHK), Anadarko Petroleum Corporation (NYSE: APC) and a host of others will gradually decrease their operations here and increase them elsewhere. In fact, some are already doing so.

The end result? Lower oil and gas supplies, higher oil and gas prices, higher U.S. unemployment, lower U.S. economic growth and ironically, a net reduction in tax revenue that our misguided legislation is actually aiming to increase.

And all because of one simple tax deduction. Nice going, Congress! These guys should quit their day jobs and become punters in the NFL, as they seem so adept at booting the proverbial can further down the road.

Stifling profitable investment in U.S. oil and natural gas drilling simply doesn’t make any sense at a time when we’re striving towards increased energy independence. So forget the oft-mentioned Bush tax cuts… I, for one, hope the IDC is one tax deduction that isn’t eliminated.

Good investing,

David Fessler