Shale gas development in India: What fiscal model should India adopt to prevent this asset from becoming a burden?

By Pooja Chatterjee

A few years back if a company went looking for oil and found gas instead it would be considered as bad luck! There was hardly any market for natural gas. But the circumstances have changed with supply of fossil fuels dwindling, climate change and green-house gas (GHG) emission concerns and demand for energy rising steadily. With oil prices being high (for now), marginal fields and deep offshore fields are increasingly being explored. When companies become prepared to go into difficult geographical locations to extract energy, developing gas (or even oil) from shale no longer seems likes mission impossible. Even when the costs of exploration are high, profits are marginal and risks to the environment and people are phenomenal, the demand for fossil fuels tends to silence the naysayers. That is not to say that unconventional energy should be explored with abandon. There should be several red flags in place to ensure that the benefits outweigh the burdens being placed on the environment. With the BP-Macondo disaster in the Gulf of Mexico, there is a greater awareness of protection of environment and consequences of exploration and consumption of fossil fuels on the environment. These interests have to be balanced with the need for investments in the shale gas sector. Technological advancements in hydraulic fracturing and horizontal drilling have made shale gas profitable in the past decade. There is no doubt of the scale of domestic markets available to shale gas, bridging the energy deficit in India.

Several basins in India have been identified as holding shale gas resources, such as Cambay (in Gujarat), Assam-Arakan (in the Northeast), Gondwana (in central India), Damodar and the Gangetic plain. In January 2011, Oil and Natural Gas Corporation (ONGC) discovered the country's and Asia’s first shale gas reserve, considered the world’s third shale gas find, at Durgapur, India . There is considerable excitement about shale gas in India - shale gas is being hailed as the next big thing. Unconventional gas has tremendous potential to significantly contribute to the demand for energy provided certain barriers to its assimilation are removed. One of the barriers which this paper seeks to address is the absence of a fiscal policy regulating the industry. A lack of legal framework is acting as a major hindrance to any developmental activities: a successful exploitation of shale gas will be a function of the policy.

The US shale gas industry flourished under good geological conditions, tax breaks, existence of a mature service industry and the landowners, instead of the Government profiting from the use of their land. Whether these favourable conditions can be replicated elsewhere is a moot point.

1. Fiscal models regulating the shale gas sector in the US and Canada

1.1. United States

Currently, 28 states impose a severance tax on natural gas using both a percentage and a fixed fee per mcf. The States examined for the purposes of this paper are Louisiana, Texas, Pennsylvania, Arkansas and New York. Arkansas is considered to be one of the best examples for study of shale gas fiscal regime. Natural gas production is taxed throughout the life of a well. “High cost gas (deep shale) and new discovery gas are taxed at a lower rate of 1.5 percent for the first 36 and 24 months respectively. If they still have not recovered their investment on the well at the end of the phase-in period, they can file for an extension.” All real and personal property (including movable drilling equipment) is subject to property tax.

Louisiana has a fairly stable fiscal regime: the severance tax structure was established in 1990 and remains largely the same. “It incorporates a base tax rate of $0.07/Mcf that is adjusted each year by an annual rate adjustment factor that incorporates the ratio of current price levels to prices in 1990.” There are some benefits as well for the producers; for any gas produced from horizontally drilled wells after July 30, 1994, there will be a tax holiday for 24 months or until the payout of well cost realized, whichever comes first. Tax holiday are periods in the early stages of a project when the defined tax or set of taxes are not payable.

Texas has a stable severance tax regime as well from 1990. However, “the applicable severance tax is defined as 7.5% of the market value of the gas produced.” The gas produced from high-cost gas wells is eligible under the special provisions for severance tax reduction until 50% of the drilling costs are recovered. This reduction is based upon “drilling and completion costs and ranges from 0.0% to 7.4%”.

*Tax codes vary across states. As such, deductions, exemptions, and other unique rules, which alter the base that the tax rate is measured against, are not reflected on this table. Therefore, the effective rate may differ from the primary rates on this table. Estimated severance tax burden was calculated by converting per mcf taxes to percentage based on the price of natural gas at the wellhead using the EIA data (November 2008 - $5.97.)[1]

[1] Supra note 3

Pennsylvania and New York, however, have no severance tax structures in place for natural gas production. While whether New York imposes any tax or not may not significantly impact the Marcellus shale developers as majority of the resources lies in Pennsylvania , the latter state is losing out on millions of dollars of revenue from lack of severance tax on production. In 2010, Marcellus Shale turned out to be a battleground in Pennsylvania with calls for imposition of severance tax to improve the budget deficit while the producers resisting any such attempts. Some of these attempts included: “1) The initial proposal by Governor Ed Rendell would impose a 5% severance tax plus $0.047/Mcf on natural gas production from Marcellus shale. 2) The Pennsylvania House of Representatives passed the bill S.B. 1155 on September 29, 2010 approving a $0.39/Mcf severance tax on natural gas production from Marcellus shale at the wellhead, a minimum floor price that would be adjusted annually if the price of natural gas rises. 3) An alternate proposal touted by Senate Republicans would impose a 5% tax rate that is reduced to 1.5% during the initial five years of production to allow producers to recover their drilling costs faster.” The following graph explains how the proposed exemptions would have affected the Government revenues by removingtaxes for most of typical Marcellus Shale well’s lifetime.

 Source: Author’s calculations adapting Pickering Energy’s production curve for the Barnett Shale.[1]

[1]Supra note 5

The battle in Pennsylvania also extended to several proposed tax exemptions. Tax holidays for the first three years of well production were demanded to recover development costs. This ‘front-end’ exemption would be in addition to the ‘back-end’ exemption being offered to low producing wells, reducing the revenue earned by the Government. The shale gas producers (and the oil and gas industry in general) turned out to be the winners with the Senate and the House of Republicans failing to negotiate in good faith on the terms of the proposed bill.

The key taxes on non-renewable resource development levied by state and local governments in the U.S. can be divided into three main groups: taxes on production, property and income.” Severance taxes and royalty are the backbone of the US shale gas fiscal regime. A severance tax is a tax imposed on the extraction of natural resources which could either be natural gas, coal or even timber and salt. In the case of natural gas, the State taxes the production at the wellhead, that is, when the gas comes out of the ground. The tax is paid both by the well operator and anyone else with a working or royalty interest in the natural gas.

Severance taxes, like royalty tax, are based on either the volume or value of gas extracted or a combination of the two. Severance tax, based on the volume of the gas extracted, is the simplest method to charge flat rates per thousand cubic feet (Mcf). The gas is metered as it is extracted from the well and the tax is paid on the amount of gas extracted. Volume based tax is, however, not sensitive to price fluctuations of natural gas. If the price is high, the gas producers would make windfall profits whereas a price crash would make production prohibitively uneconomic. A regime of tax on value of gas extracted at the point of extraction (well-head) tackles the problem or price sensitivity but is more difficult to administer and costly to enforce. Instead of monitoring the well meter, the gas sales have to be monitored. A combination of both can be incorporated in tax regimes: the tax authority can charge a minimum flat-volume tax and then charge an additional tax on the value of the extracted gas. However, it is extremely difficult and expensive to administer this form of taxation. The country opting for such a regime would need to have adequate resources and man-power in place to implement it successfully.

Tax exemptions are of two types, front-end and back-end exemptions. Front-end exemptions reduce or eliminate the tax liability in the initial years when there is cash-flow from well production which is then adjusted against the development costs. Whereas back-end exemptions are for wells with low productivity rate due to being in operation for a long time. Back-end exemptions incentivize drillers to continue operating the older, low-producing wells rather than go digging for new wells.

State and local governments also levy property taxes on the assessed (quasi market) value of the equipment above the ground and of the resources below the ground. Income taxes are levied against the accounting net income of extraction firms.

NUTSHELL:

Even with the issues surrounding the fracking technology, shale gas is still an attractive asset on a country’s balance sheet because of the need to take care of energy security issues and to shirk volatility of oil prices. Pooja has tried to identify the ideal fiscal model for the shale gas industry in India by identifying the lessons to be learnt from the fiscal regimes available in the United States and Canada and then giving recommendations to ensure the fiscal model in India avoids similar pitfalls or emulates their successes. This is the first of two parts of this interesting article. Stay tuned to learn more! To view Pooja's professional profile and for more information on this article please click here: -->