Rendell signals flexibility on tax

Facing stiff resistance from the natural gas industry, Gov. Rendell has expressed a willingness to make concessions on his proposal to tax the Marcellus Shale gas bonanza.

Rendell, in a recent talk in Texas, encouraged the industry to accept a "modest and reasonable severance tax" and singled out the 5 percent levy on gas production in Arkansas.

The governor's mention of Arkansas is significant because the Razorback State cuts the tax rate for shale-gas wells to 1.5 percent during the first three years of production. The tax relief allows operators to speed up recovery of their drilling costs, which typically amount to about $4 million a well.

The tax break can be substantial because wells generate as much as half their production in the first three years of operation. (Though a well might produce gas for decades, production typically declines in a steady downward curve as well pressure is lost.)

Rendell's spokesman, Gary Tuma, said the governor stood by his initial proposal to model Pennsylvania's severance tax after the rigid West Virginia levy, which offers no abatement and assesses a straight 5 percent fee on sales, plus an additional 4.7 cents for each thousand cubic feet (Mcf) of gas produced. At current gas prices, the effective tax rate in West Virginia is about 6.2 percent.

"The governor is open to a fair severance tax, regardless of the model, that benefits the commonwealth for the long term," Tuma said. "He is always willing to look at alternatives, but at this point is still supporting his own original proposal."

Rendell's suggestion on March 25 during a roundtable discussion in Dallas that he might be amendable to an Arkansas-style tax was regarded as a positive step by some in the industry.

"If you put a tax in the right way, that's the foundation for success," said Matt Pitzarella, a spokesman for Range Resources Corp. He noted that two other big shale-gas producing states - Texas and Louisiana - also offer tax breaks on deep-well drilling during the initial production years.

Pitzarella and the Marcellus Shale Coalition, an industry trade group, say they are willing to discuss a severance tax as one component of a revamp of Pennsylvania's gas regulations and taxes, which were designed for a much smaller industry than the one that is emerging to exploit the Marcellus.

Rendell withdrew a severance-tax proposal last year after the industry complained it would retard growth, but he renewed his call in this year's budget. The tax would generate $161 million in its first year - less than 1 percent of the state's $29 billion budget - but likely would grow as more gas is produced.

Only one industry leader, Murry Gerber, the chairman of EQT Corp., of Pittsburgh, has voiced public support of a severance tax.

The Pennsylvania Independent Oil and Gas Association, noting the renewed discussions about a tax, wrote to Rendell and legislators last week to restate the organization's "nonnegotiable" opposition.

"We are not willing to exchange legislative or regulatory remedies or relief for a severance tax," Louis D. D'Amico, president of organization, wrote.

He complained that gas operators are being unfairly singled out for a tax that has never been imposed on other extractive industries, such as coal.

Rendell's call for a compromise is also unlikely to win many friends among conservationists and severance-tax advocates.

Sharon Ward, director of the Pennsylvania Budget and Policy Center in Harrisburg, dismissed the industry's argument that a severance tax would drive away drillers. She said a tax abatement for new wells would only deprive the treasury of revenue.

"It's just unnecessary to give the industry a break," said Ward, who said the experience in other states indicated severance taxes were not a disincentive to gas production.

Ward argues that Pennsylvania is the only major gas-producing state without a production tax, and that the levy is needed to compensate local governments in gas-drilling regions that are suffering from the growth and traffic caused by the industry. Natural gas and coal are also exempt from local property tax.

Some financial analysts agree that the severance tax would do little to drive away drillers.

Taxes are only one cost that gas operators take into account when they decide where to drill, said Subash Chandra, who follows the oil and gas industry for Jefferies & Co. Inc., of New York.

"The industry will probably hate me for saying this, but as far it goes in my world of spreadsheets, the severance tax is not a deal-breaker," he said. "I don't believe it will have a huge impact on drilling. It's not that large."

The principal incentive to drill is the price of natural gas. (The current wholesale price of gas is about $4 a thousand cubic feet, or Mcf. A typical home-heating customer in the Philadelphia area consumes about 16 Mcf a month in the winter.)

But, despite a dramatic fall in natural gas prices since the market crash in 2008, gas operators have flocked to Pennsylvania, suggesting there is more at play here than the commodity price. There are currently 77 drilling rigs operating in Pennsylvania, compared with 16 in April 2008.

The chief attraction to Pennsylvania's Marcellus is the novelty of the play.

Gas operators have leased millions of acres in Pennsylvania in recent years at comparatively low costs, but to maintain the lease, they must drill at least one well during the term of the agreement, typically five years. The lease then becomes "held by production" in perpetuity.

Gas operators have a strong incentive to defend the older leases because the current rate for leases has increased dramatically. It may be cheaper for an operator to drill a well even at a loss, than to sign new leases that pay bigger royalties to landowners.

"From our own company's perspective, half of our drilling is kind of nonvoluntary in the sense that we're drilling to hold leases, not drilling because we think $4 is a great gas price," Aubrey K. McClendon, chief executive officer of Chesapeake Energy Corp., said at a recent industry conference.

McClendon, whose company is a big player in the Marcellus, said the glut in undrilled acreage inventories would last until 2012.

"We're trying to cram about 50 years' worth of ordinary development into about three years," he told the Developing Unconventional Gas Conference in Fort Worth, Texas, in March.