By Joe Nichols

Summary

Governor Kasich proposed an increase to Ohio’s severance tax on horizontal oil and gas drilling in his fiscal year (FY) 2016-2017 executive budget. This report briefly corrects four commonly held misconceptions about the impact of the severance tax proposal, in order to guide policymakers toward a better policy for Ohio’s economy.

Myth #1: The burden of the tax hike would fall on out-of-state “Big Oil” companies.

Reality: A few “Big Oil” companies did indeed explore Ohio’s Utica shale, but moved to greener pastures after finding that the most attractive area would not produce crude oil profitably.[1] Ohio is mostly left with smaller, more entrepreneurial, and less financially stable producers.

Oil and gas are commodities that trade in highly competitive markets. This means that producers are “price takers” because they can only sell oil and gas at the market price. Producers cannot simply “pass along” the severance tax to consumers by raising their price, because their customers could easily buy an equivalent product at a lower price from a different supplier.

Instead of passing on costs, a higher severance tax will force producers to reduce output and investment at the margin. Producers may be able to soften these cuts to some degree by passing along the severance tax to Ohio landowners in the form of lower lease and royalty payments. Either way, the tax increase would translate to less drilling and natural gas production in Ohio, driving local prices higher. This would make Ohio businesses, families, and even governments worse off due to higher energy bills, weaker job growth, and lower economic activity. Trimming fat from the state budget would free up capacity to pay for income tax cuts without these undesirable economic side effects.

Myth #2: Any negative impacts of the severance tax increase would be outweighed by the benefits of helping to pay for the proposed state income tax cut.

Reality: Even if that assertion is true, the severance tax is a particularly unwise “pay-for” for two reasons. First, the Office of Budget and Management estimates that the additional severance tax revenue would only pay for 5% of the personal income tax rate cuts in FY 2016, and 8% of the personal income tax rate cuts in 2017. Rather than place an unfair burden on horizontal drilling, policymakers should make up the difference through judicious state spending cuts.[2] Second, relying on severance tax revenues to help fund the income tax cut places undue risk on taxpayers. Production volumes from horizontal wells decline by up to 80% in the first year alone, and low prices have dramatically reduced 2015 capital budgets to drill new wells.[3] This means that total horizontal shale production in Ohio is likely to drop off well before the end of the biennium. The drop will be more dramatic if the severance tax is increased. Since the proposed severance tax formula is a function of production volume, future production shortfalls would translate to deficits in expected severance tax revenue collections.

The fact that past severance tax revenue projections by the Kasich administration were significantly off target warrants extra caution. The administration projected a total production of 36.5 million barrels of oil and 730 billion cubic feet (Bcf) of natural gas in 2014.[4] Ohio’s horizontal wells actually only produced approximately 11 million barrels of oil and 450 Bcf of natural gas during 2014, a difference of 70% and 40% from the administration’s estimates, respectively.[5] Contrary to unpredictable severance tax revenues, prudent state budget cuts would provide a stable foundation for pro-growth income tax cuts.

Myth #3: The severance tax simply doesn’t matter to producers.

Reality: This myth has two distinct but equally erroneous variations. The first variation claims that since states like Alaska and Wyoming have both high severance taxes and high oil and gas production, raising Ohio’s severance tax will not reduce production in Ohio. The fact is that these other shale plays produce higher quality oil in far greater quantities, allowing producers to pro t despite the higher tax.[6] The Marcellus shale in Pennsylvania is also a gas play, like the Utica, but it produces even more natural gas and gas liquids. Plus, Pennsylvania has no severance tax at all, merely a small “impact fee.”[7]

The other variation claims that producers will not be able to avoid the severance tax by leaving Ohio because they have already leased land and drilled wells in the state. The truth is that exploration, leasing, and drilling expenses are “sunk costs” that cannot be recovered, and so they would not affect future investment decisions.[8] Further, producers typically operate in several states, and can easily re-focus future investment according to where they will get the best returns. Simply put, it is foolish to think that these profit-seeking producers will not respond to tax increases that harm their bottom line.

Myth #4: The severance tax increase is a good policy because local governments need help fixing roads.

Reality: More than 60% of local governments have “Road Use Maintenance Agreements” that oblige producers to maintain and repair local roads.[9] Even without these agreements, in the same shale region, local governments that must pay to fix roads have also enjoyed growing tax revenues. The severance tax increase would reverse this positive trend and ultimately harm the very localities it seeks to help. Further, the state would only share 20% of the projected severance tax revenues with local governments.

To summarize, the General Assembly needs to recognize the reality of Ohio’s position in the universe of shale drilling, rather than succumb to misinformed myths and populist rhetoric. Ohio’s Utica shale has tremendous potential to boost the state economy. However, enacting the proposed severance tax would be akin to killing the goose that lays the golden eggs. Ohio policymakers should remove the severance tax increase from the budget in its entirety, and instead seek to reduce government spending.

1. Edward McAllister and Selam Gebrekidan, “Insight: Is Ohio’s “secret” energy boom going bust?” Reuters, October 22, 2012, http://www.reuters.com/article/2012/10/22/us-ohio-shale-idUSBRE89L04H20121022

2. Rea S. Hederman, Jr., Tom Lampman, Greg R. Lawson, and Joe Nichols, “Tax Reform Principles for Ohio,” The Buckeye Institute, February 2, 2015, http://www.buckeyeinstitute.org/uploads/files/Tax_Reform_Principles_for_Ohio(FINAL).pdf

3. For example, see Bob Downing, “Gulfport Energy cutting back on Utica drilling, reducing capital budget for 2015,” Akron Beacon Journal, February 26, 2015, http://www.ohio.com/news/local/gulfport-energy-cutting-back-on-utica-drilling-reducing-capital-budget-for-2015-1.570146; and also “Antero Resources Announces 2015 Capital Budget and Guidance,” Antero Resources Corporation, January 20, 2015, http://investors.anteroresources.com/investors-relations/press-releases/press-release-details/2015/Antero-Resources-Announces-2015-Capital-Budget-and-Guidance/default.aspx

4. FY 2014-2015 Taxation Budget Testimony, 130th General Assembly (February 28, 2013) (testimony of Joe Testa, Tax Commissioner), http://www.gongwer-oh.com/public/130/testa.2.28.pdf

5. The Buckeye Institute analysis of Ohio Department of Natural Resources, Division of Oil and Gas Resources, 2014 Quarterly Horizontal Shale Production, http://oilandgas.ohiodnr.gov/shale#ARCH1

6. Unlike shale plays in high severance tax states and the Marcellus, the Utica shale is not a top 100 U.S. oil and gas field. See U.S. Department of Energy, Energy Information Administration, “Top 100 U.S. Oil and Gas Fields,” March 2015, http://www.eia.gov/naturalgas/crudeoilreserves/top100/pdf/top100.pdf

7. Elizabeth Stelle, “Dangers of a severance tax,” Commonwealth Foundation, May 7, 2014, http://www.commonwealthfoundation.org/issues/detail/dangers-of-a-severance-tax

8. N. Gregory Mankiw, Principles of Economics, 7th ed. (Mason, OH: South-Western College Publishing, 2014).

9. “Ohio Shale Development Community Impact Survey,” Ohio University, Voinovich School of Leadership and Public Affairs, February 2014, http://www.ohio.edu/ce3/research/shale/upload/Ohio-Shale-Development-Community-Impact-Survey- Report-Final-Feb-2014-posted.pdf