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The oil and gas industry generates both jobs and wealth in Texas. The last several decades have seen continued growth in this industry, first through the development and production of resources from the Barnett Shale, a gas rich geological formation lying beneath several counties in north Texas, and more recently in the Eagle Ford Shale in south Texas. The continuing economic development potential of natural gas production led Texas to develop a severance tax policy that provides financial benefits to natural gas producers, specifically those who choose to undertake non-traditional forms of gas production. Natural gas production in the state is taxed at 7.5 percent of market value; however, deductions, exemptions, and rate reductions have reduced many producers tax liabilities to zero and reduced the overall effective rate in recent years. In fiscal year 2011, 7.7 billion thousand cubic feet (Mcf ) of natural gas was produced in Texas, resulting in tax collections of $1.1 billion or 2.9 percent of total state tax collections. This was an increase from a low of $725.5 million in fiscal year 2010. This amount is a fraction of the total amount that would be collected at the full tax rate. The high-cost gas taxrate reduction reduced tax-payer liabilities for the natural gas production tax by $984 million in fiscal year 2011. year 2008, and averaged $1.17 billion during fiscal years 2004 to 2011. Since fiscal year 2004, the value of high-cost gas tax-rate reductions has totaled $9.4 billion in forgone state revenue.
 Drilling

and completion costs for the 2,355 highcost gas wells approved for high-cost gas tax-rate reductions during fiscal year 2011 totaled $10.9 billion, resulting in the potential for state revenue losses of $5.4 billion through 2021 from the wells drilled in 2011.

CONCERNS
 Relatively

inexpensive recompletions are defined by statute and classified by the Railroad Commission of Texas as high-cost wells. These wells reduce the median drilling and completion costs used to calculate the tax benefit. Using median drilling and completion costs rather than mean drilling and completion costs resulted in larger rate reductions for 93 percent of the wells in the sample of fiscal year 2009 completions provided by the Comptroller of Public Accounts. Comptroller of Public Accounts is required by statute to report on the effect of exemptions, discounts, and exclusions of sales, excise, and use; franchise; school district property taxes; motor vehicle; and any other tax generating in excess of 5 percent of state collections in the prior fiscal year. The Tax Exemptions and Tax Incidence report does not include information on taxes that would otherwise meet the minimum threshold for inclusion in the report if the value of the exemptions were considered. This results in a lack of public information regarding some state programs, including the high-cost gas-rate reduction. gas production tax is in doubt. Production trends are toward methods that are currently defined as highcost and subject to reduced tax rates. No analysis has been done to determine the market price at which the high-cost gas-rate reduction is an incentive for producers to drill new wells.

 The

FACTS AND FINDINGS

 High-cost

gas tax-rate reductions are based on production definitions established in the late 1970s, which allow drilling operations to be certified as high-cost regardless of the actual production cost. These definitions rely on the type of gas produced and manner of production. In fiscal year 2009, this resulted in the certification of a $24,000 gas well as a high-cost operation when the median drilling cost was $2.3 million. high-cost gas-rate reduction changes the natural gas production market by giving preferential tax treatment to one form of production versus another, regardless of the actual cost of extraction. In fiscal year 2011, high-cost gas wells represented 55 percent of total gas production in the state. cost to the state of high-cost gas tax-rate reductions reached a high of $1.97 billion in fiscal

 The

 The future revenue generating capability of the natural

 The

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RECOMMENDATIONS
 Recommendation

1: Amend statute to use mean drilling and completion costs instead of median drilling and completion costs in the calculation of the high-cost gas tax benefit. 2: Amend statute to require the Comptroller of Public Accounts to include the estimated value of exemptions, discounts, and exclusions, when identifying taxes for inclusion in the biennial Tax Exemptions and Tax Incidence report. 201415 General Appropriations Bill to require the Comptroller of Public Accounts to conduct a study to determine at what natural gas prices, if any, the high-cost gas-rate reduction incentivizes production. The Texas Legislature could amend statute in the next legislative session to make the rate reduction effective only at natural gas prices at which the Comptroller of Public Accounts has determined that the rate reduction incentivizes production. This program would be administered in a similar manner to the low producing well exemption.

FIGURE 1 NATURAL GAS PRODUCTION IN TEXAS FISCAL YEARS 2004 TO 2011

9 8 7 6 5 4 3 2 1 0 2004 2005 2006 2007 2008 2009 2010 2011 MCF IN BILLIONS

 Recommendation

 Recommendation 3: Include a rider in the introduced

SOURCE: Comptroller of Public Accounts.

DISCUSSION
The oil and gas industry is a significant contributor to the Texas economy and state revenue. While traditional gas production positioned Texas as a leader in world energy markets, continuous experimentation with new methods of natural gas production has contributed to industrial development within the state. During the last decade, increased development of the Barnett Shale in north Texas has helped the states gas industry grow. The relatively recent development of the Eagle Ford Shale in south-central Texas has also provided an economic boost and grown the states oil and gas industry. As shown in Figure 1, data from the Comptroller of Public Accounts (CPA) shows that from fiscal years 2004 to 2011 natural gas production in the state rose from 5.3 billion Mcf to 7.7 billion Mcf, with a peak of 7.9 billion Mcf in 2009. (Mcf is a thousand cubic feet.) This level of production was made possible in large part by a 41 percent increase in the number of active wells during that time, reaching 101,831 in 2011. During this period, average production per well actually decreased by 14 percent to 69,248 Mcf per year. From fiscal years 2004 to 2011, Texas producers were responsible for 29.6 percent of all domestic natural gas

production and 21.6 percent of all crude oil production. In 2011, the industry extracted an estimated $75.5 billion in oil and natural gas, which is a 70.1 percent increase from 2004 production. This increase was driven largely by modest increases in oil production and a dramatic increase in the price of oil. According to an analysis of Railroad Commission of Texas (RRC) and U.S. Energy Information Administration data, the value of Texas production peaked in 2008 at $104.2 billion. Figure 2 shows the estimated value of oil and gas production in Texas from fiscal years 2004 to 2011.

FIGURE 2 ESTIMATED VALUE OF OIL AND NATURAL GAS WELL PRODUCTION, FISCAL YEARS 2004 TO 2011
IN BILLIONS $120 $100 $80 $60 $40 $20 $0 2004 Oil 2005 2006 2007 2008 Gas Well Gas 2009 2010 2011 Casinghead Gas Condensate

SOURCES: Railroad Commission of Texas; U.S. Energy Information Administration.

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In the last two decades, the energy industry has sought opportunities to develop non-traditional domestic sources of energy, including oil-sand, coal-beds, and shale deposits. Traditional natural gas wells seek out gas stored in geological reservoirs where it has become trapped. Shale production bypasses storage areas and instead drills straight into the source, the natural rock from which the gas will eventually be released. One shale drilling process, fracturing, releases gas stored in solid rock by pumping a mixture of sand and water through a well to cause fractures, releasing pent-up gas. Fracturing processes have achieved such success that shale gas production has grown from 1 percent of natural gas production in the U.S. to almost 10 percent during the last decade. Shale gas wells can be drilled in the conventional vertical model, or in a horizontal model that seeks to maximize initial production. Horizontal wells carry an average increased cost of 2.5 times a standard vertical well. Horizontal wells are more productive on average than vertical wells; however, that advantage has been shrinking. In the sample of wells provided by CPA drilled in 1996, horizontal wells were 143 percent more productive than vertical wells. By 2006, however, horizontal wells were only 63 percent more productive than vertical wells. Several other large shale fields are now being developed throughout the U.S. and Canada; the largest of the new fields is the Marcellus Shale, lying under Pennsylvania, West Virginia, and New York. The Marcellus Shale is larger than Barnett, by 90,000 square miles, and is estimated to have 10 times the gas production potential as Barnett. Pennsylvania

recently enacted a price sensitive Marcellus Shale impact fee that imposes a fee on unconventional wells in each of the first 15 years of production. At current prices, the fee is $50,000 for each horizontal well and $10,000 for each vertical well in the first year of production and the fee decreases each year. In fiscal year 2012, the fee generated $204.2 million in revenue to be split between the state and local governments. Geologists believe the Marcellus formation could contain sufficient gas deposits to power the U.S. for the next two decades. Because of these predictions, and other factors related to gas production processes such as lease timing and proximity of the gas to end consumers, many of the largest natural gas producers have begun to focus their attention to the east, although it is still unclear what impact the shift has had, or will have, on gas production in Texas. Such conditions, if persistent, could lead to slower rates of new well development in Texas. Figure 3 shows the number of natural gas wells operating in Texas from fiscal years 1997 to 2011. TEXAS SEVERANCE TAXES Oil and natural gas production in Texas is taxed as part of the states severance tax structure, which taxes the removal of natural resources from Texas land. Severance taxes are defined as taxes on extracting, or severing, natural resources such as oil, gas, sulphur, or coal, from the earth. Natural gas production taxes are statutorily set at 7.5 percent of the market value of gas produced within the state borders, while oil and condensate are taxed at 4.6 percent of market value. For many drilling operations, the tax rate on natural gas

FIGURE 3 NUMBER OF NATURAL GAS WELLS OPERATING IN TEXAS, 1997 TO 2011

120,000 100,000 80,000 60,000 40,000 20,000 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

SOURCE: Railroad Commission of Texas.

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production is reduced to 0 percent during the first 120 months of production or until the site recovers 50 percent of its drilling and completion costs due to the high-cost gas-rate reduction. For taxation purposes, the market value of natural gas is determined by its value at the site of the producing well, a price that can be highly volatile due to both national and international economic factors. The average wellhead price of gas declined from a high of $10.79 per Mcf in July 2008 to a low of $1.89 per Mcf in April 2012, before rebounding slightly to $2.59 in July 2012. The amount of gas that will be subject to the tax is determined by meters placed at the well site with data collected before the resource leaves the lease property boundary, either by entering a pipeline or through delivery to a processing plant. The data is then reported to the state by the operator. Severance tax on gas production has proven to be an important revenue source for the state. In 2011, natural gas tax collections were $1.1 billion, making up 2.9 percent of total state tax collections. This is an increase of 53 percent from $725.5 million in 2010. During the last four biennia, the state has collected $13.2 billion in natural gas production taxes, an average of $1.65 billion per year. Because natural gas production taxes are classified as occupations taxes, 25 percent of total collections are deposited for the benefit of public schools. Figure 4 shows the natural gas tax collection totals and the related percentage of total state tax collections for fiscal years 2004 to 2011. When oil production and regulation taxes are included, 6.6 percent of state tax collections came from the state severance taxes in 2011. Sales tax revenue related to oil and gas extraction generated the state an additional $489.1 million or 2.3 percent of all sales tax revenue in 2011.
FIGURE 4 NATURAL GAS PRODUCTION TAX COLLECTIONS FISCAL YEARS 2004 TO 2011
IN BILLIONS $4.0 $3.5 $3.0 $2.5 $2.0 $1.5 $1.0 $0.5 $0.0 2004 2005 2006 Gas Tax Collections 2007 2008 2009 2010 2011 Gas Percentage of Total Tax Collections PERCENTAGE OF STATE COLLECTIONS 8% 7% 6% 5% 4% 3% 2% 1% 0%

ECONOMIC STABILIZATION FUND The growth of the states Economic Stabilization Fund (ESF)also referred to as the Rainy Day Fundbears a direct relationship to natural gas tax collections. Constitutionally, an amount of General Revenue Funds equal to 75 percent of natural gas tax collections in excess of 1987 revenue, $599.8 million, is deposited to the ESF after the end of each fiscal year. Historically, natural gas taxrevenue-related deposits are the largest component of the ESF, representing 65.5 percent of deposits from 1990 to 2012. The largest gas tax-related deposit to the ESF, $1.6 billion, occurred in September 2008, based on tax collections received for fiscal year 2008. Gas tax-related deposits to the ESF dropped to $382 million in September 2011. LOCAL GOVERNMENT REVENUE In addition to providing revenue to the state, the oil and gas industry also contributes to local government revenue. The primary direct impact is by increasing the property tax base through increases to the mineral related property value. Mineral-related property accounts for approximately 5 percent of total property value in Texas. From fiscal years 2004 to 2011, mineral-related property value grew significantly, increasing from $51.6 billion to $106.7 billion. This rate of growth far outstrips the rate of growth for nonmineral-related property of 53 percent during the same period. The growth of mineral-related property value was most striking in the counties located over the Barnett Shale, which increased by 316.8 percent. The Barnett Shale counties accounted for 20.5 percent of the total growth in mineral related property value in the state. This increase in property value provides a funding source from which local governments can generate revenue to help offset costs for infrastructure demands placed on them by the oil and gas extraction-related development. PUBLIC EDUCATION FINANCES One impact of this newfound property wealth for school districts located in shale production areas is that, in addition to having the ability to generate more revenue at similar tax rates, some school districts that had been historically property poor are now sufficiently property wealthy to have their added revenue subject to recapture. Recapture is the mechanism through which the state seeks to equalize revenue between property wealthy and property poor school districts such that school districts have access to similar revenue at similar tax rates regardless of property wealth. From 2000 to 2004, the recapture from the school districts of the core

SOURCE: Comptroller of Public Accounts.

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counties of the Barnett Shale increased from $11.1 million to $70.2 million and was $73 million in 2011. From fiscal years 2004 to 2011, the school districts over the Eagle Ford Shale experienced similar growth in recapture to what the Barnett Shale area school districts experienced in the early part of the decade, increasing from $15.2 million to $41.5 million during that time. Total recapture payments in 2011 were down almost 2 percent from 2004. HIGH-COST GAS TAX-RATE REDUCTION The state provides a number of deductions, exemptions, rate reductions, and allowances to the natural gas tax that reduce total state collections. These adjustments are primarily related to the method of production involved in drilling or transporting natural gas. The largest tax liability adjustment available to natural gas producers is the high-cost gas tax-rate reduction program. The program applies to qualifying wells completed after August 1996 and reduces the tax rate applicable to gas produced from the well. High-cost wells must first be certified by RRC, after which time the operator can apply to CPA for the applicable tax-rate reduction. Texas statute cites federal law to define high-cost gas wells, specifically Title 15, United States Code, Section 3317, as it existed on January 1, 1989 (created by the Natural Gas Policy Act of 1978). Section 3317 was repealed by Congress on July 26, 1989, with the repeal effective January 1, 1993; however, the definition remains part of the Texas Tax Code. Before its repeal, the federal statute defined high-cost gas based on specific types of geological formations or the processes used to produce the gas, including: well completion locations greater than 15,000 feet; geo-pressured brine operations; occluded natural gas from coal seams; gas produced from Devonian shale deposits; and other conditions determined to be high-cost by the Federal Energy Regulatory Commission. RRC uses this definition to define specific geographic areas from which gas operations can be certified as high-cost. Each area must be anchored by at least one well that conforms to the statutory definition of high-cost gas production; areas larger than 12,500 acres must contain multiple certified wells. The effect of this definition is that all wells drilled within the Barnett Shale and the Eagle Ford Shale qualify as high-cost gas wells regardless of the actual drilling costs. During fiscal year 2009, drilling and completion costs for approved high-cost gas wells ranged from a high of $14.7 million to a low of $24,000. As shown in Figure 5, since fiscal year 2007, production from high-cost natural gas operations has eclipsed traditional

FIGURE 5 NATURAL GAS PRODUCTION IN TEXAS BY TYPE FISCAL YEARS 2004 TO 2011
MCF IN BILLIONS 6 5 4 3 2 1 0 2004 2005 2006 2007 2008 2009 2010 2011 High-cost Production
SOURCE: Comptroller of Public Accounts.

Traditional Production

gas production in Texas. High-cost wells are located in 134 of the states 254 counties. Nearly one-quarter of the high-cost wells identified by CPA are located in the four counties identified by RRC as the core counties of the Barnett Shale Denton, Johnson, Tarrant, and Wise counties. When the non-core counties are included, the Barnett Shale accounts for 30.3 percent of the states active high-cost wells. Those counties in turn accounted for 30 percent of total natural gas production in fiscal year 2011. Well certification by RRC allows a producer to obtain a reduction in the effective tax rate applied to natural gas produced from the specific well. Statute sets the reduction based on the drilling and completion cost of the well relative to twice the median cost of drilling and completion for certified high-cost Texas wells during the previous year. The reduction is allowed for 120 consecutive calendar months (10 years), beginning on the first day of production, or until the total value of the reduction equals 50 percent of the actual drilling and completion costs of the certified well, whichever occurs first. As an example, consider the case of a new shale gas well site operating in the Barnett Shale, drilled during fiscal year 2011, which incurs total drilling and completion costs of $3.0 million. The fiscal year 2010 median drilling and completion cost for certified high-cost gas wells in Texas was $2.6 million. Based on the statutory-rate reduction calculation, this well, when certified as a high-cost operation by RRC, would be eligible for a rate reduction from the

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statutory 7.5 percent to 3.2 percent. Figure 6 shows the ratereduction calculation for the certified high-cost gas well in this example. If, instead of the median, the mean drilling and completion costs of $3.3 million were used as the basis for calculating the reduction, the same well would be taxed at a rate of 4.1 percent. Production from the well would be subject to the reduced tax rate for a period of 120 consecutive months, or until the value of the reduction equals $1.5 million, half the total drilling and completion cost of the well. However, wells drilled at costs far less than the median cost would also qualify for some level of tax-rate reduction.
FIGURE 6 TAX-RATE REDUCTION EXAMPLE CALCULATION FOR HIGH-COST GAS WELL, 2011
Tax Rate [ Tax Rate ( Actual Drilling Cost / ( 2 * Previous Fiscal Year Median Drilling Cost)) ] .075 [ .075 ( $3,000,000 / ( 2 * $2,615,268)) ] .075 [ .075 ( $3,000,000 / $5,230,536) ] .075 [ .075 ( .5736) ] .075 [ .043 ] 0.032 or 3.2 percent
NOTE: This example is based on a natural gas well drilled for $3,000,000 for which the operator applied to CPA for a rate reduction during scal year 2011. SOURCE: Legislative Budget Board.

FIGURE 7 DISTRIBUTION OF EFFECTIVE TAX RATES FOR HIGH-COST GAS WELLS APPROVED DURING FISCAL YEAR 2009
GAS WELLS 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 0% 0-.9% 1-1.9% 2-2.9% 3-3.9% 4-4.9% 5-5.9% 6-6.9% 7%+ Median Completion Cost Base Mean Completion Cost Base

SOURCES: Legislative Budget Board; Comptroller of Public Accounts.

During fiscal year 2011, the effective tax rate for all high-cost natural gas production was 1.8 percent. Figure 7 shows the distribution of effective tax rates for high-cost gas wells approved during fiscal year 2009 and the distribution of effective tax rates if the mean drilling and completion costs were used instead of the median drilling and completion costs currently specified in statute. Drilling costs for the 2,355 high-cost gas wells approved for rate reductions during fiscal year 2011 totaled $10.9 billion, creating the potential for lost state revenue of $5.4 billion through 2021. The impact of such losses is largest during initial years because of steep decline in production experienced by high-cost wells in later years. Based on an analysis of CPA data, approximately half of a typical wells first 120-month production occurs in the first two years, indicating that if price were constant for the 120-month period for which the well is eligible for the rate reduction then half of the tax benefit would occur in the first two years. Actual revenue losses could be below potential estimates depending on the ability of each completed well to reach sustainable production volumes. In practice, operators have

tended to recover closer to 15 percent of drilling and completion costs through the high-cost gas rate reduction. Wells completed from 1997 to 2002 recovered from 13.4 percent to 19.2 percent of drilling and completion costs during their 120-month period of rate reduction eligibility on average. Only 2.5 percent of the 14,211 high-cost wells completed from 1997 to 2002 received the full 50 percent reduction. Recommendation 1 would amend the Texas Tax Code to require that the high-cost gas-rate reduction would be calculated by using mean drilling and completion costs from the previous fiscal year instead of median drilling and completion costs. Analysis of the sample of wells provided by CPA indicates that the low drilling and completion costs of some reduced rate eligible wells reduce the median and increase the tax benefit to many high-cost wells. This increases the revenue loss to the state. VALUE OF THE RATE REDUCTION The actual value of the rate reduction to any one operator is very difficult to predict. While the tax-rate reduction is dependent on the fixed costs associated with the drilling and completion of the well compared to the median fixed costs from the prior year and is therefore very predictable, the actual monetary value of the reduction is highly dependent upon the price of natural gas at any given time. Figure 8 shows the monthly value of the rate reduction at the average effective tax rate of high-cost wells for each year, as well as the

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FIGURE 8 VALUE OF THE HIGH-COST GAS-RATE REDUCTION (PER MCF), FISCAL YEARS 2004 TO 2011
$1.00 $0.90 $0.80 $0.70 $0.60 $0.50 $0.40 $0.30 $0.20 $0.10 $0.00 SEP-03 MAR-04 SEP-04 MAR-05 SEP-05 MAR-06 SEP-06 MAR-07 SEP-07 MAR-08 SEP-08 MAR-09 SEP-09 MAR-10 SEP-10 MAR-11 Value at Average Effective Tax Rate Value at Effective Tax Rate of 0 Percent

SOURCES: Legislative Budget Board; Energy Information Administration; Comptroller of Public Accounts.

value of the rate reduction for wells with an effective tax rate of 0 percent. From fiscal years 2004 to 2011, the maximum value of the rate reduction at the average effective tax rate was $0.67 per Mcf in July 2008 when the price of gas was at historic highs and was at its lowest point in September 2009 at $0.17 per Mcf when gas prices were at their lowest point. The maximum benefit for wells taxed at an effective rate of 0 percent was $0.81 in July 2008 and the low was $0.22 in September 2009. In fiscal year 2012, the value of the rate reduction for wells taxed at an effective rate of 0 percent has ranged from $0.14 per Mcf to $0.29 per Mcf.

Not only is the value of the rate reduction highest to the operator when the price of gas is highest, as Figure 9 shows, the level of forgone state revenue is also the greatest when gas prices are highest. When the price of gas peaked at an average of $10.79 in July 2008, the cost to the state of the rate reduction also peakedcosting the state $280.8 million in the same month. The average monthly price of natural gas exceeded $10.00 per Mcf three times from 2004 to 2012, in October 2005, June 2008 and July 2008. In those three months, the high-cost gas-rate reduction cost the state an average of $228.7 million per month in foregone revenue.

FIGURE 9 HIGH-COST GAS-RATE REDUCTION COST TO THE STATE BY PRICE OF NATURAL GAS, FISCAL YEARS 2004 TO 2012
TOTAL COST OF HIGH-COST RATE REDUCTION (IN MILLIONS) $56.5 200.2 963.1 1,840.9 2,091.8 2,557.6 152.4 997.0 498.2 686.2 $10,043.9 AVERAGE MONTHLY COST TO THE STATE DUE TO RATE REDUCTION (IN MILLIONS) $28.2 40.0 68.8 76.7 80.5 106.6 152.4 166.2 166.1 228.7 $93.0

PRICE OF NATURAL GAS (PER MCF) $1.00 to $1.99 $2.00 to $2.99 $3.00 to $3.99 $4.00 to $4.99 $5.00 to $5.99 $6.00 to $6.99 $7.00 to $7.99 $8.00 to $8.99 $9.00 to $9.99 $10.00 and above Total

MONTHS 2 5 14 24 26 24 1 6 3 3 108

PERCENTAGE OF TOTAL 0.6% 2.0 9.6 18.3 20.8 25.5 1.5 9.9 5.0 6.8 100.0%

SOURCE: Comptroller of Public Accounts.

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By continuing to rely on definitions from the late 1970s for high-cost gas production, all production operations in the Barnett Shale and in the Eagle Ford Shale are classified as high-cost regardless of the actual costs incurred by producers and operators. High-cost natural gas production in Texas increased 93.0 percent from 2004 to 2011. High-cost gas production expanded from 41.2 percent of total state production in fiscal year 2004 to 55.0 percent of total gas production in fiscal year 2011. However, high-cost wells completed more recently are less productive on average than those completed only 10 years prior. As Figure 10 shows, wells are most productive in the first year of production and annual output declines significantly thereafter. Historically, production in year two is approximately half of production in the first year. Within two years, high-cost wells completed in 1996 had 44.3 percent of their total production to date. High-cost wells completed in 2001 had 52 percent of their total production within two years. High-cost wells completed in 2006 had 65.2 of their production in the first two years. Because production is so heavily concentrated in the first years of operation, it is reasonable to assume that the current price of gas and price expectations heavily affects the decision to drill or not to drill. This is the point at which the high-cost tax rate reduction could encourage a producer to drill at a price slightly lower than they otherwise would in the absence of the tax benefit. Figure 11 shows that the number of new gas well permits tends to increase and decrease as the price of gas changes.

COST TO THE STATE In fiscal year 2004, the revenue loss from high-cost gas taxrate reductions topped $595 million. By fiscal year 2008, during a price spike in natural gas commodities, the loss to high-cost gas tax-rate reductions had grown to $1.97 billion. Essentially, the state did not collect 42 percent of total potential natural gas tax revenue during fiscal year 2008. Although rate reduction revenue losses decreased with commodity prices during fiscal year 2009, the value of the reductions remained above $1.0 billion. In fiscal years 2010 and 2011, the value of the rate reduction was worth close to $1.0 billion in each year and represented a loss of 51.0 percent of potential total natural gas production tax revenue. Figure 12 shows that when the cost of the high-cost rate reduction is included, the potential total value of the natural gas production tax would have been 5.4 percent of total state tax collections in fiscal year 2011. By statute, when a particular tax exceeds 5 percent of total collections, CPA is required to include that tax in the biennial Tax Exemptions and Tax Incidence report. In this report, CPA details the cost to the state of any exemptions associated with the tax and projects the value of the exemptions going forward. Due to the size of the high-cost rate reduction the natural gas production tax was not included in the 2011 edition of a report examining, at least in part, the cost of exemptions to the state. As a result, there have not been any published projections of the cost of the high-cost rate reduction to the state since February 2009 when the natural gas production tax met the requirements for inclusion in the 2009 edition of

FIGURE 10 TYPICAL HIGH-COST WELL ANNUAL PRODUCTION, BY YEAR OF COMPLETION

PRODUCTION IN MCF 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 Year 1 Year 2 Year 3 Year 4 1996 Well Year 5 Year 6 Year 7 Year 8 2001 Well Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15

2006 Well

SOURCE: Comptroller of Public Accounts.

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FIGURE 11 NEW GAS WELL PERMITS BY MONTH, JANUARY 2004 TO JULY 2012
PERMITS 700 600 500 400 300 200 100 0 JAN-04 JUL-04 JAN-05 JUL-05 JAN-06 JUL-06 JAN-07 JUL-07 JAN-08 JUL-08 JAN-09 JUL-09 JAN-10 JUL-10 JAN-11 JUL-11 JAN-12 JUL-12 New Gas Well Permits
SOURCES: Railroad Commission of Texas; U.S. Energy Information Administration.

PRICE

$14 $12 $10 $8 $6 $4 $2 $0

Price of Natural Gas

FIGURE 12 TOTAL POTENTIAL NATURAL GAS PRODUCTION TAX COLLECTIONS, FISCAL YEARS 2004 TO 2011
IN BILLIONS $6 $5 $4 $3 $2 $1 $0 2004 2005 2006 2007 2008 2009 2010 2011 Gas Tax Collections High-Cost Rate Reduction Potential Natural Gas as a Percentage of Total Taxes 12% 10% 8% 6% 4% 2% 0%

from being excluded from the report due to associated exemptions, discounts, and exclusions being sufficiently large to push the tax below the 5 percent threshold. Figure 13 shows natural gas production tax revenue by source (including foregone revenue due to the high-cost gas rate reduction) as a percentage of total possible revenue for fiscal years 2004 to 2011. The combination of low natural gas prices, high crude oil prices, and increasing condensate production in the Eagle Ford Shale may reduce the relative importance of the high-cost rate reduction to potential natural gas revenue. Despite being priced and taxed similarly to crude oil, the revenue from the tax on condensate production is included as part of the natural gas production
FIGURE 13 PERCENTAGE OF POTENTIAL NATURAL GAS PRODUCTION TAX REVENUE BY TYPE OF GAS FISCAL YEARS 2004 TO 2011
100% 80% 60% 40% 20% 0% 2004 Condensate 2005 2006 2007 2008 High Cost Gas 2009 2010 2011

SOURCE: Comptroller of Public Accounts.

the report. In addition, because the same taxes are not always included in each report it is not always possible to review previous reports to gain context for current trends and projections. Recommendation 2 would amend the Texas Government Code to require CPA to include the estimated value of exemptions, discounts, and exclusions, when identifying taxes for inclusion in the biennial Tax Exemptions and Tax Incidence report. Recommendation 2 would also require that CPA include any tax that has met the criteria for inclusion in the Tax Exemptions and Tax Incidence report in a previous fiscal year. This recommendation increases transparency related to the states use of tax exemptions and prevents a tax

Conventional Natural Gas

High Cost Gas Exemption

SOURCE: Comptroller of Public Accounts.

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MODIFY THE HIGH-COST GAS TAX-RATE REDUCTION TO INCREASE ITS COST TRANSPARENCY AND EFFECTIVENESS

tax. Condensate production is not eligible for a high-cost rate reduction. ECONOMIC DEVELOPMENT INCENTIVE The high-cost gas rate reduction clearly reduces costs for some natural gas producers. However, it is not clear whether or not this cost reduction leads to increased natural gas production or increased secondary economic activity. Legislative Budget Board staff used the REMI PI+ simulation model to model the impacts of eliminating the rate reduction at current prices and increasing government spending on education with the increased revenue and found that eliminating the rate reduction is associated with reduced employment in the mineral extraction sector and increased employment in the education sector. The model found a small negative impact on short-term total employment and a small positive impact on long-term employment. Unlike many industries in which businesses have great flexibility as to where they locate operations, natural gas extraction, like any resource extraction, is highly dependent upon the physical location of the resource. Because the tax benefit is administered as a tax-rate reduction, the benefit is most valuable when the price of natural gas is highest and in those situations a high market price, absent increases in the cost of production, is likely sufficient to incentivize production. Conversely, when the price of natural gas is lowest, the value of the rate reduction is also lowest. There may be some natural gas prices at which the high-cost gas-rate reduction incentivizes the production of natural gas that would not otherwise exist but we are unable to determine at what prices, if any, that this occurs. More information on the break-even price of natural gas production in the state is needed before that determination can occur. Recommendation 3 would include a rider in the in the introduced 201415 General Appropriations Bill to require CPA to conduct a study to determine at what natural gas prices, if any, the high-cost gas-rate reduction incentivizes production. The study would consider the economic costs and benefits to the state of any increased production that is due to the rate reduction. Historically the cost of the rate reduction to the state has been highest in the months in which the average price of gas has been highest. It is likely that high natural gas prices would be sufficient to incentivize production without the assistance of an additional tax benefit. It is also likely that at very low gas prices the rate reduction would not be sufficient to incentivize added production. Additionally, if the rate reduction is an incentive to produce at low prices, the induced production would add
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to supply and likely further depress prices. Contingent upon the results of the study, the Legislature could amend statute to make the high-cost gas-rate reduction effective only at natural gas prices at which CPA has determined that the rate reduction incentivizes production that is economically beneficial to the state. CPA already administers the low producing well exemption, which is a price sensitive natural gas production tax benefit. LESSONS FROM OUTSIDE TEXAS Neighboring states Pennsylvania and West Virginia provide a case study in the importance of location in determining natural gas production. In 2004, Pennsylvania and West Virginia each produced close to 200,000 Mcf of natural gas, ranking 13th out of the 32 natural gas producing states. From 2004 to 2009, production in the two states increased at approximately the same rateincreasing by 34 percent in West Virginia and 39 percent in Pennsylvania. Production increased at a similar rate despite the fact that during this time, Pennsylvania did not have a severance tax on natural gas production and West Virginia taxed production at 5 percent of gross value. Due primarily to increased production in the Marcellus Shale play both states saw rapid production increases from 2009 to 2011, though Pennsylvania saw much more dramatic growth due to being located over more productive portions of the play. Natural gas production increased by 379 percent in Pennsylvania and increased by 49 percent in West Virginia. Both states expect record production again in 2012. Pennsylvania responded to the growth in natural gas production by instituting a Marcellus Shale impact fee of $50,000 for each horizontal well and $10,000 for each vertical well drilled each year at current natural gas prices, which generated $204.2 million in revenue.

FISCAL IMPACT OF THE RECOMMENDATIONS

These recommendations would increase the transparency regarding the cost of the high-cost gas-rate reduction and provide the Legislature with better information in the future to assess its efficacy. Recommendation 1 would require the use of mean drilling and completion costs instead of median drilling and completion costs to calculate the high-cost gas tax benefit. Because this would reduce the impact that low-cost wells have on the calculation, this recommendation would result in a revenue gain to the State, but the fiscal impact cannot be estimated. Analysis of the sample of wells provided by CPA indicates that the low drilling and completion costs of some
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MODIFY THE HIGH-COST GAS TAX-RATE REDUCTION TO INCREASE ITS COST TRANSPARENCY AND EFFECTIVENESS

reduced rate eligible wells reduce the median and significantly increase the tax benefit to many high-cost wells. In 2009, 14 percent of completed wells had drilling and completions costs that were above the median but below the mean. Using mean drilling and completions costs would have generated an additional $77.3 million from production in 2009 of wells completed in that year, of which $19.3 million would have been available as General Revenue Funds and $57.9 million would have been deposited into the Economic Stabilization Fund at the beginning of the next fiscal year. Recommendations 2 and 3 would require CPA to perform additional analysis and administrative duties. This analysis assumes these duties could be completed using existing resources. The introduced 201415 General Appropriations Bill includes a rider to implement Recommendation 3.

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