How the oil industry saves $4.4B a year on taxes

NEW YORK - Motorists are paying nearly $4 for a gallon of gasoline as the oil industry reaps pre-tax profits that could hit $200 billion this year.

This makes another big number hard to take: $4.4 billion. That's how much the industry saves every year through special tax breaks intended to promote domestic drilling.

President Barack Obama is increasing pressure on Congress to eliminate these tax breaks - including one that is nearly a century old - at a time of record budget deficits. The President and congressional Democrats say eliminating the tax breaks will also lower gas prices by making alternative energy sources more competitive.

Oil industry advocates, a group that includes most Republicans in Congress, argue just the opposite. They say oil companies reinvest tax breaks into exploration and production, which ultimately generates more tax dollars and increases the supply of oil. They say eliminating tax breaks will raise the cost of doing business and lead to higher gas prices.

Executives from the five biggest oil companies were asked about these tax breaks at a Senate finance committee meeting Thursday. Senate Democrats accused the oil companies of not paying their share to help the country emerge from economic hard times. Republicans derided the hearing as a dog-and-pony show staged to score political points with angry drivers.

The industry executives said eliminating the tax breaks would reduce investment in the U.S. Exxon Mobil CEO Rex Tillerson said the tax proposal "Would discourage future investment in energy projects in the United States and therefore undercut job creation and economic growth." He said it would do nothing to reduce gasoline prices.

The 41 U.S. oil and gas companies that break out their federal taxes said they paid Uncle Sam $5.7 billion in 2010, according to data compiled by Compustat. That's more than any other industry. Exxon alone paid $1.3 billion. (The company's total tax bill was $21.5 billion, but most of that was paid to foreign governments and states.)

But at a time when motorists are fuming about $4 gas, Obama and Democrats sees a huge political opportunity.

"When you see profits that include the word billions, people automatically think someone is getting screwed," says Christine Tezak, Senior Energy and Environmental Policy Analyst at Robert W. Baird & Co. "The fact that the (oil industry) is getting any breaks at all has become a sore spot."

The price of oil is so high that removing these tax breaks would likely have little to no effect on domestic oil production. There are other factors that make the U.S. a highly attractive place to drill: it's politically stable, it has good roads and pipelines, and it's the world's biggest energy consumer. And the industry would remain hugely profitable even though eliminating the tax breaks would increase its U.S. tax bill by nearly 70 percent.

The tax breaks that Obama wants to eliminate will cost the U.S. Treasury $44 billion over the next decade. A Senate proposal targets many of the same rules, but would eliminate them only for the five biggest oil companies: ExxonMobil, Chevron, BP, Royal Dutch Shell and ConocoPhillips.

Here is a look at the main tax breaks:

- The biggest is what's called the Domestic Manufacturing Deduction. It's a 2004 tax change meant to encourage companies to manufacture in the U.S.

It allows companies of almost any type to deduct from their taxable income up to 9 percent of profits from domestic manufacturing. Under the rule, oil and gas companies were classified as manufacturers, but their deduction was capped at 6 percent.

This provision alone is expected to save the oil and gas industry $18.2 billion over the next ten years, or 42 percent of the $44 billion total.

The oil industry feels unfairly singled out. "It can't be good for some and not for others or it is just a punishment," says Stephen Comstock, the tax policy manager at the American Petroleum Institute, an oil industry lobbying group.

- Another subsidy, established in 1913 to encourage domestic drilling, allows oil companies to deduct more quickly all of the so-called intangible costs of preparing a site for drilling.

To accountants, intangible costs are costs for things that have no salvage value when the well runs dry, including clearing land and pouring concrete. Ordinarily, a business would have to deduct these costs over the life of the drilling site. Instead, small, independent drillers are allowed to deduct all of these expenses in the first year; major, so-called integrated companies like ExxonMobil can deduct 70 percent in the first year.

The break is worth $12.5 billion over the next ten years.

Comstock compares the oil industry's ability to write off the cost of preparing a well to other companies' ability to write off research and development costs. Other tax experts say this is clearly a subsidy.

- A rule dating from 1926 that establishes how oil companies can depreciate the value of their wells allows drillers to deduct 15 percent of the well's revenue from its taxable income per year. This is instead of a more traditional depreciation scheme in which the cost of the well is depreciated over the well's life.

The tax break was created in part to simplify accounting, so companies wouldn't have to guess how long an oil or gas field would produce in order to calculate how to depreciate it. It can be a boon: The total of the deductions over the life of the well can sometimes be bigger than what the company actually spent on the well.

This provision was eliminated for major oil companies in 1975, but it continues for independent producers. The break is worth $11 billion over 10 years.

- Royalties that companies pay foreign governments for the oil they extract are not deductible from U.S taxes. But often the industry is allowed to claim royalties as foreign taxes, which are deductible. Obama and Senate Democrats call this a loophole, and want to close it. Obama doesn't include this in his $44 billion proposal, but Whitney Stanco, an analyst at MF Global, calculates that removing this benefit could cost the industry $8.5 billion over ten years.

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Jonathan Fahey can be reached at http://www.facebook.com/Fahey.Jonathan.