Pennsylvania's Tax Level for Shale Drilling Sparks Debate

Pittsburgh Post-Gazette
27 September 2010
By Sean D. Hamill,

The battle over what type of severance tax Pennsylvania should impose -- supposedly by Friday -- on the modern day Gold Rush that is the Marcellus Shale natural gas reserve, has become a duel of two ideals.

On the one side is the severance tax approved two years ago in Arkansas. That's a tiered system that the Marcellus Shale industry and Senate Republicans in Pennsylvania prefer because it allows for a lower, 1.5 percent tax on market value until drillers make a return on their investment, after which it rises to 5 percent three or four years after the well is opened.

On the other side is the structure used by West Virginia. Its two-tax approach is favored by Gov. Ed Rendell because it applies a flat, 5 percent tax on the market value of gas sold and a 4.7-cent tax on each 1,000 cubic feet of gas produced, which he believes the industry can more than afford.

To hear either side describe the other's approach, there would seem to be no bridging the gap.

"When you look at it, West Virginia is lagging so far behind Pennsylvania in [natural gas] development, and that's because it has one of the most primitive tax structure rates in the country," said Kathryn Klaber, executive director of the Marcellus Shale Coalition, which represents the industry in Pennsylvania.

In pitching his West Virginia model two weeks ago in Washington, Pa., Mr. Rendell told an audience that the Arkansas model that the industry prefers here was "ridiculous, and I won't sign legislation like that" because some in the industry have projected a 64 percent return on investment in drilling in the Marcellus Shale.

But both sides in Pennsylvania's debate leave out, or gloss over, some interesting, crucial details about what has happened in those states.

Mr. Rendell said that before he announced his tax proposal as part of his budget last year he called West Virginia Gov. Joe Manchin "and I asked him, 'Has your tax depressed shale drilling? He said 'Absolutely not. In the years following, permits and drilling went up significantly.' "

That's partially true. Permits and drilling went up after Mr. Manchin approved the 4.7-cent tax on production in 2005.

But West Virginia didn't even give out its first Marcellus Shale drilling permit until 2005. The industry was just beginning, so of course it dramatically increased -- rising from just two permits in 2005 to 400 or more each of the last two years, a figure the state expects to hit again this year.

Moreover, unlike Mr. Rendell's proposal for a permanent tax, the 4.7-cent tax is supposed to be temporary. It is dedicated -- along with other mineral taxes approved at the same time -- to paying off West Virginia's old worker's compensation debt after a change in structure of that program. Current projections have that occurring in 2019, though Mr. Manchin said in an interview that "the governor and the Legislature then" will have to decide to end the tax.

Mr. Manchin said when Mr. Rendell called him, "I said, 'Ed, I can assure you they'll tell you everything, that it'll destroy your market. And it never did destroy our market.' "

That 4.7-cent tax, though, was not imposed with the Marcellus Shale riches in mind.

In 2005, the year Mr. Manchin first took office, "I had never heard about the Marcellus; the tax went on shallow wells then."

The impact has been relatively small, only generating $10.5 million last year, up from $9.1 million the year before, about what the state projected.

Even so, Mr. Manchin said: "They said drillers would leave the state (if the new tax was imposed), and I offered to buy the leases back. We've never had to buy back one lease."

The other part of West Virginia's tax -- the 5 percent on market value -- has had a much bigger impact, generating $75.9 million in revenue. The state gets 90 percent of that revenue, and local governments receive the rest. The total was down $6 million from the year before, reflecting the change in the lower market value of natural gas.

But the 5 percent tax in West Virginia wasn't imposed in 2005. It has been in place at that rate since 1989, and the state has had some level of the tax for 90 years, as has nearly every state with natural gas production.

However, state data shows a slowdown in both new wells that have begun producing gas -- dropping from 358 such wells in 2008 to 117 last year -- and a flattening out of gas production, at the same time Pennsylvania's figures are rising fast.

State officials, gas companies and the state's gas association all say they don't believe the taxes are a major reason for the slowdown, if they have had any impact at all.

"I don't believe there's any preference for either state," said Kevin West, spokesman for EQT Corp., the large Pittsburgh-based natural gas producer that is drilling in both states.

Corky DeMarco, executive director of the West Virginia Oil and Natural Gas Association, said: "It's probably not as prolific as it is in Pennsylvania, but we're very active down here. But you have larger land tracts that are in the sweet spots there compared to West Virginia. If you're drilling gold mines, you're going to go where the big seams are."

Still, Mr. DeMarco said, taxes are "an influence."

"If you're a public company and you have investors to satisfy and your rate of return is lowered by taxes, you might look to Pennsylvania where there's no taxes," he said.

Like West Virginia, Arkansas has had a natural gas severance tax for decades.

It had been unchanged from its three-tenths of 1 percent of market value level for more than 50 years and was generating just $500,000 to $600,000 annually.

But, not coincidentally in 2008, Arkansas, like Pennsylvania, was just beginning to get into its own natural gas boom, thanks to what is called the Fayetteville Shale, a deep, natural gas deposit similar to the Marcellus Shale that is also now accessible thanks to horizontal drilling.

The idea to raise the tax came from a longtime Republican leader and utility executive in the state, Sheffield Nelson, who in November 2007 said he was going to call for a public referendum to push the tax to 7 percent.

"The tax was just too low and I had pushed it years ago and couldn't get it through," Mr. Nelson said. "But it's a big battle if you take on the natural gas industry in any state."

His argument was that the surrounding states -- Louisiana, Texas and Oklahoma -- "all have thriving oil and gas industries and their taxes were much higher than ours."

Louisiana charges 33 cents per 1,000 cubic feet of production of gas, generating $911 million last year. Texas charges 7.5 percent of market value on gas, generating $2.3 billion last year. And Oklahoma charges 7 percent of market value on gas, generating $1 billion last year.

But industry opponents and other Republican leaders, led by former Arkansas Congressman Asa Hutchinson, cried foul, claiming that any increase in the tax -- particularly one as large as Mr. Nelson's proposal -- would cripple the fledgling Fayetteville Shale business.

"You've got to look at all the taxes together," said Mr. Hutchinson, who is now a consultant. "We've already got a high income tax and sales tax, so, just because you're low in one tax doesn't mean you need to raise it."

A compromise was struck, led by Democratic Gov. Mike Beebe, who worked out a deal between the industry and legislators.

The tiered tax system is expected to raise about $50 million for state and local government roadwork this year. Overall gas production has continued to rise, even as fewer gas permits have been taken out in the state.

"The rate of increase in gas production has slowed," Mr. Hutchinson said. "Is that because of gas prices being lower? Or because of taxes and they're going somewhere else?"

From Mr. Nelson's point of view, the results show what he thought all along: "In hindsight, it appears we need another jump."

"My idea is to take it to the voters and let them decide," he said. "A state has to run on taxes of some sort, and it's either from the people who reside in your state or on the things you produce, like natural gas."

Sean D. Hamill: shamill@post-gazette.com or 412-263-2579.