Michael Filloon: Failing To Reform The Oil Tax May Have Cost North Dakota A Billion Dollars

The recent failure to adopt a flat oil production tax in North Dakota may have cost the state a minimum of a billion dollars.

Initially shot down and sold as a tax cut to oil producers, the same oil price based system exists using triggers to decrease taxes. Oil producers benefit from a lower tax environment when oil prices decrease. A flat tax does not need to be a tax break for oil and gas as it could be set at any percentage. Removing the current tax triggers would decrease risk to state tax revenues, and could provide equal revenues when oil prices are high.

I am no expert on tax policy, but would like to provide some data as to the problems North Dakota faces in 2015 because a flat tax was not implemented. Oil is a volatile commodity (as all commodities are), affected by anything from demand to currency values. These variables create large price swings over short periods of time. The trigger tax adds to this volatility, as it decreases tax revenues further. This reason alone helps support that importance of security in the way we tax crude.

Currently, North Dakota has an oil extraction tax of 6.5% and gross production tax of 5%. The extraction tax has a built-in tax break if oil drops below an inflation adjusted limit set at $55.09/bbl. for 2015. If the realized price of WTI is below that number for 5 consecutive months, then the 6.5% tax is dropped for the first 24 months of the well’s life. After the 24 months are up, the tax is reinstated, but at a 4% rate for the well’s life, not 6.5%.

Keep in mind, a well will produce for 35 to 40 years, so the effective tax break would cover that period of time. The 5% gross production tax is not affected, and will continue throughout the period regardless of oil price. This tax trigger may not be relevant today, as it was implemented in 1987 after the last oil boom went bust. Legislators had hoped that this tax reduction would bring vertical development back to the state. At the time, this mattered little as oil prices and technology didn’t provide the economics needed. This law was also predicated on vertical production, which is relatively consistent throughout well life, where current horizontally fracced wells produce 19% of total resource in the first year.

Half of all production occurs in the first 5 years, so we essentially provide a break on more resource than the trigger had initially envisioned. So, this front heavy production is hit especially hard by the tax break. Also, crude prices generally crash quickly and recover long before 24 months are up, so North Dakota’s break reaches too far into the future. On 12/29/14, the NYMEX price for WTI closed at $54.15/bbl. So, if we see an oil price at or below $55.09/bbl. through May, all wells completed after that will not see the 6.5% tax for at least 5 months.

If this trigger is initiated, Bakken operators could receive at a minimum, a $1 billion tax break. In this article, I have not only highlighted how this tax break affect producers, but on a per well basis. It is also very important to note that this trigger could cost the state of North Dakota much more than $1 billion. This depends on US inland crude storage and how long it will take to work through the vast inventories built over the past year. Every barrel stored will work to keep realized oil prices down. This may provide a low oil price environment through the better part of 2015, which would significantly increase the overall tax break to oil producers.

If we look at how other states tax crude production, we see that North Dakota has one of the highest in the country.

This does not mean that I think we should lower taxes, as I think our current rates are supported by North Dakota’s superior well results in and around the Nesson Anticline. Because of this, operators pay the higher tax which is offset by better producing wells. EOG Resources recently drilled a well that backs this assertion. Its Antelope well reached payback in one year at $37/bbl Bakken light price realizations. This well is obviously an outperformer, but it provides a glimpse of wells to produce in northeast McKenzie County. If the tax was too high, operators would have stopped developing acreage a long time ago.

Obviously this wouldn’t be the case if oil prices were to stay below $50 per barrel, but longer term we are looking at $60 to $70 per barrel for WTI. This supports development in southwest Mountrail, northeast McKenzie, northern Dunn and southeastern Williams counties.

The current 52 week low is $44.37/bbl set on 1/29/15. Over the past week, oil prices are re-testing this level. This is an important level of support and when looking at the chart it is important to note oil prices could go lower if we break below the 52 week low. It is possible we could see those prices fall to $35/bbl if this occurs, and much lower if these levels are breached.

This shouldn’t scare anyone, but to provide an idea of how low oil may fall and how long this oil price environment can last. More importantly, how long oil will stay below the $55.09/bbl level where the tax break is triggered.

It is easy to be bearish oil prices currently. The strength of the dollar doesn’t look to abate. Most don’t know the importance of currency when valuing commodities. Basically a strong dollar can buy more, and because of this provides for cheaper oil. QE in Europe and Japan will continue to support the dollar, and should continue to in the long term. The strength in the dollar will continue to put downward pressures on the price of oil in the United States. Demand also remains weak for refined products. As long as countries continue to economic woes, we will not see the demand needed to support prices. Most importantly, we must consider global production and oil storage.

As you can see, most of global storage has been filled. The US is one of the few areas with unused capacity. This is filling up, and because of it, costs for storage are headed higher. Tank storage is up 50% and ship storage has almost doubled. Costs will increase unless major change occurs. Inland storage capacity is 521 million barrels and we have already stored 468 million barrels. On average, we have seen US storage additions of over 1 million barrels per day. At this rate storage will be filled in 53 days. This provides a situation that the United States hasn’t seen, at least since we started documenting crude inventory levels. With no ability to store oil at Cushing, in the Permian or Gulf Coast the only option is to load ships or set the crude loose. When the crude has to go directly to market, an operator would have to accept what the market is paying. This should push prices dramatically lower.

This creates what may be a very interesting issue for oil prices going forward, and could prolong the time it takes for a rebound. Not only is production continuing to grow, but we are entering refinery maintenance, which will decrease demand for crude as US refineries. The need for OPEC crude will decrease to 28.5 million barrels per day, compared to the current output of 30.22 million barrels per day in February. This will add an additional 1.7 million barrels to inventory per day.

So even if production in the US does decrease, it will be difficult to offset lower refinery throughput. Many operators still have large volumes of crude hedged at prices around $90/bbl. This encourages those operators to continue to produce. Most operators had around 50% of production hedged in the first half of this year. Many of those operators have high debt levels, and to make those payments must keep production levels high. Because of this, expectations are that production will remain strong through the first half of the year. If this is the case, we could be through most of 2015 without seeing WTI realized prices above $55.09/bbl.

North Dakota tax revenues will immediately take a $1 billion dollar hit if this price is not exceeded by 5/29/15. This is only direct taxes on oil and natural gas. It does not include taxes lost to lower oil price realizations outside of production, only those lost due to the trigger tax, and not initiating the flat tax proposed earlier. These lost revenues will double every five months after. It is possible the trigger isn’t met, but this is something to watch as it may cost North Dakota a billion dollars.