• Energy Tax Facts
  • 15 Jan 14

Percentage Depletion: Save a Stripper Well

By Jessica Sena
In 1926, Congress passed an accounting standard to address the closure of oil and gas businesses across the country, and to spur investment in the robust development of American natural resources. Prior to this, the only deduction for mineral resources wascost depletion, which did not provide sufficient opportunity for smaller, independent businesses to retain revenues to keep up with well costs. What Congress created was in essence “value depletion”, known today as the Percentage Depletion deduction.Percentage depletion is a tax allowance that honors the recovery of monetary investment over time. Not a subsidy or a tax credit, this cost recovery mechanism extends beyond oil companies as a deduction for investors and royalty owners to incentivize capital formation. Similar to depreciation, percentage depletion allows an owner or operator to account for the reduction of a product’s reserves. Like a cup of coffee, wherein with each sip the drink becomes less valuable, a well too depreciates as fluid minerals are extracted.

The costs associated with maintaining wells is high, including maintenance, disposal of water, and electricity costs to run pumping units. The revenue retained by the percentage depletion deduction is essential to meeting costs. For larger wells, percentage depletion provides more revenue to be used on exploration and development of new wells.

The recovery standard is figured using a rate of 15% of the gross income from the property based on average daily production of domestic crude oil or natural gas up to the depletable quanitity; generally 1,000 barrels of oil, or 6,000 mcf of natural gas multiplied by the number of barrels of depletable oil quantity. To claim depletion on both oil and natural gas, depletable oil quantity (1,000 barrels) must be reduced by the number of barrels used to figure depletable natural gas quantity.

The depletion deduction is limited to 65% of net taxable income. Taxable income from the property is gross income from the property minus all allowable deductions (except any deduction for depletion or domestic production activities). Gross income from the property does not include lease bonuses, advance royalties, or other amounts payable without regard to production from the property. Percentage depletion in excess of the 65% limit may be carried over to future years until it is fully utilized. The net income limitation requires percentage depletion to be calculated on a property-by-property basis, and prohibits percentage depletion to the extent it exceeds the net income from a particular property.

Anyone with an economic interest in mineral property, either through an investment in mineral deposits, a contractual relationship, or by legal right to income from extraction, can take a deduction for depletion. A production payment retained on the sale of mineral property does not qualify as an economic interest. More than one person can have an interest in the same mineral deposit, and this is nearly always the case. The depletion deduction is divided between the lessor and the lessee (mineral owner and producer). It may be taken only by independent producers and royalty owners, and not by integrated oil companies.

Integrated companies are engaged in many facets of the industry, including exploration, production, refinement and distribution of oil and gas. Integrated companies typically have global operations. Many of the largest oil and gas companies are integrated.

Nearly all of America’s oil and natural gas wells (90%) are developed by independent petroleum producers like those keeping Montana’s Hi-line energized in the North Central part of the state. The majority of America’s oil wells produce less that 15 barrels per day, classifying them as marginal wells or “stripper” wells. Yet these wells account for a fifth of total American oil production. Nearly 75% percent of American natural gas wells are marginal wells, producing approximately 12% of domestic natural gas.

While other countries shut down smaller operations, marginal wells make up a unique and prominent sector of the oil and gas industry in Montana and the rest of America. In total, there are over 300,000 stripper gas wells, and 300,000 stripper oil wells in production.

Marginal (stripper) wells are economic multipliers for local and state budgets. For every $1 million directly generated by stripper well production, more than $2 million in economic activity is generated elsewhere. Each additional $1 million of stripper well production employs 10 workers directly and indirectly, with some producers employing as many as 15 workers. If all marginal wells were abandoned, 292,374 individuals would lose their jobs. In the oil and gas industry alone, the effect of abandonments is $5.3 billion in lost worker earnings and 83,000 potential jobs lost, according to the National Stripper Well Association.

Historically, independent producers invest more than their cash flow back into projects. And despite limitations, percentage depletion plays a significant role in keeping America’s marginal wells producing, and is a vital accounting mechanism for the country’s independent petroleum companies, investors, and mineral owners alike.