Charles A. Schliebs
Managing Director, Stone Pier Capital Advisors, LP
The following must read article, although rather lengthy, details the problems with Tom Wolf’s proposed severance tax in a way no one else has done.
Part I – Published February 23, 2015 in Stone Pier Capital Energy News & Opinion
Let’s be clear about a few things—as an Independent since my initial voter registration decades ago in Missouri:
- I like Tom Wolf. Full disclosure, I was on his Transition Team for the Dept. of Environmental Protection—it was a good experience.
- I like that he is not a politician by training or experience, the gubernatorial race being his first.
- I like that he spent his adult life running a substantial, successful business, selling it, and then buying it back and running it again; I expect business savvy and fiscal responsibility along with a liberal social philosophy.
- I like that a 35-year friend in the political world was one of Wolf’s earliest advisors, more for his character than for particular positions.
- I respect the fact that he did not spend his campaign period soliciting contributions, or even accepting contact from, various industries, including the oil and gas industry—in order to demonstrate his independence from big money interests. I get that.
- And finally, even when I do not agree with Governor Wolf, I expect to and generally can understand his perspective and his strategy.
At a Complete Loss
All that being said, and with all due respect, I am at a complete loss as to what the Wolf Administration’s thinking is with respect to the issue of a severance tax. Let’s review the history from my perspective:
- During the Democratic primary campaign, once Rob McCord got desperate, besides the political extortion attempts to which he recently plead guilty, he proposed a 10% severance tax that shocked the industry and most everyone else.
- Shortly thereafter, Tom Wolf proposed a 5% severance tax, appearing if anything to be reasonable and balanced compared to McCord.
- Throughout the primary and the general election campaign against Tom Corbett, Wolf understandably stuck to his 5% proposal. Until August 2014, he turned down all opportunities to meet with oil & gas representatives to hear their thinking.
- In August 2014, I was privileged to arrange and moderate a discussion among Tom Wolf and PA Marcellus E&P CEOs and their government relations heads. Various E&P companies, the Marcellus Shale Coalition and the American Petroleum Institute all had the opportunity to present their views on a severance tax and overall PA taxation.
- Among the many facts presented were (1) in parts of northeast Pennsylvania the actual price then being received for natural gas was as low as $1.00/Mcf (it has been even lower since—see January issue), and (2), when the industry-supported Impact Fee was introduced, the number of rigs in PA dropped sharply and then continued trending down, all as OH rig numbers trended up.
- The 5% proposal was part of Wolf’s campaign promise to his support base, especially because he promised that proceeds would largely support education. Even after learning key facts that the Wolf team had not (in my opinion) realized or focused on, Wolf could not stray from the 5% during the campaign. I get that—part of the election strategy was that Corbett was tied to the oil and gas industry and that Wolf would change the way business was done in Harrisburg.
As nearly everyone predicted, Tom Wolf won the election handily, but without the “mandate” one might have expected. Many voters cast their votes against Corbett, rather than for Wolf, and then continued and even increased GOP majorities in both the PA House and Senate. Before and after the election, many in the shale gas industry (including me), privately or publicly, weighed in as best they could with the new Administration with a number of questions including:
- With natural gas prices at dramatic lows (both benchmark and the even lower PA dynamic regional prices), and nearly all companies forced to retrench, announce layoffs and/or implement significant capital expenditure reductions, why choose this moment to further burden the industry with additional costs and reduce employment (highly paid jobs averaging $83,000 per year)? Historically, around the country, proposals to increase severance taxes have generally occurred when oil/gas prices are high, not low, and there was more flexibility in oil and gas company investment decisions. As I told then Candidate Wolf myself, when natural gas was $12 to $14/Mcf in mid-2008, the oil and gas companies were not complaining at the thought of any severance tax. It was in 2008, while Secretary of Revenue, that Wolf had his first discussions with anyone about a 5% severance tax.
- Unlike severance taxes, the current Impact Fee (roughly equivalent to a 3% severance tax) is minimally affected by the ups and downs of oil and gas pricing. Why would any Governor want to tie funding of a critically important function of the state—education of its children—to a tax where revenues could drop dramatically from one year to the next, thereby putting the state’s education budget in a crunch at unpredictable times?
- Before pushing a severance tax in horrendous market circumstances for the shale gas industry (right now—negative internal rates of return), why wouldn’t Pennsylvania first take some money off the table by becoming the last non-Mormon majority state to exit the retail liquor business, keeping state taxes on liquor, but profiting greatly from the sale of the Liquor Control Board stores? I could not believe this system existed when I first moved to PA to matriculate at Penn at the age of 17, and I cannot believe it now.
- Why wouldn’t Governor Wolf take away one of the biggest arguments against using a severance tax for education by first pushing pension reform for both teachers and state employees, providing defined contribution plans for new plan entrants, just like virtually everyone else starting work under a new pension plan?
The New Administration’s Severance Tax Proposal
On February 11, 2015, Governor Wolf rolled out a more defined severance tax proposal: 5% plus the surprise of an additional 4.7 cents/Mcf, ostensibly to mirror WV’s severance tax (why he determined mirroring WV was a good idea is puzzling—other than the progressive WV Promise program, WV is not known for leadership in smart legislation) .
But there was an additional surprise, of critical importance to local government around the Commonwealth: Gov. Wolf said his proposal would NOT guarantee that local governments would continue receiving the same level of funding under the Impact Fee. The monies that have flowed to local governments under the Impact Fee have been vital to those communities, not only to minimize the impact the gas industry has on local infrastructure and services, but also to cover other needs that were not being met in rural economies that were sluggish at best before the advent of shale gas. Without this source of funding at the local level, and with the Supreme Court overturning elements of Act 13 such that local governments can regulate drilling to some degree, the gas industry knows that it would be much more difficult, time consuming and expensive to expand drilling programs without the current level of Impact Fees being directed locally.
Finally, without citing any support and during a period where companies are already announcing huge reductions that will later show up in production, Governor Wolf estimated that the tax would bring in $1 billion per year, the unspecified bulk of which would go to education.
The Governor’s proposals have been met with a great deal of skepticism by the Republican-controlled legislature, and many of the more thoughtful Democrats, tempered only by the fact that legislators know that there does need to be an answer, or set of answers, to the Commonwealth’s projected budget deficits.
Ever since former state Treasurer McCord shined a light on the severance tax, anyone paying attention has been met with a range of arguments, from “The companies will pack up and leave,” to “There is nothing they can do; this is where the gas is.” Both extremes, of course, are absurd. The answers lie in between and are complex because each company is situated differently in terms of their cost structure, including their cost of capital, the other opportunities within their company competing for capital, the quality of their PA leased assets vs. their assets in other shale plays, their assets already “held by production,” their contractual commitments to everyone from partners to pipelines, and on and on. Some companies have already left the region without the threat of an additional tax, and more may, but most will simply factor in the additional tax and make business decisions to reduce accordingly. There won’t be much emotion about it except for those people losing their jobs (further layoffs on top of those already announced) at both E&P companies and across the shale gas supply chain.
Particularly offensive have been the constant statements that PA is the only significant gas producing state without a severance tax (ignoring the equivalence factor of the Impact Fee that should have been called a severance tax, and PA’s high tax environment that applies to all industries and consistently keeps the state near the bottom of the list for companies thinking about expanding). Accordingly, the industry has been skewered for “not paying its fair share,” despite the billions in taxes being generated including of course those paid by the highly-paid, hard-working people making the industry possible. Our state is not attracting other industries like many are, so are we supposed to put the squeeze on what we have?!!!
An Earlier Proposal
When Dan Onorato ran for governor against Corbett, Dan and I sat down and discussed his plan for a severance tax (this was of course pre-Impact Fee). As a balanced Democrat who had shown how to successfully run Allegheny County, Dan approached the issue in a businesslike manner:
(paraphrasing) “How can we best establish an extraction tax that can be used to intelligently supplement the state’s revenue by (1) providing for needs we would otherwise have to delay (like infrastructure), (2) setting aside funds for times when revenue is down [n.b., like North Dakota has done], and (3) encouraging additional use of gas in PA (transportation, distributed power generation, manufacturers needing lots of power or using gas as a feedstock, etc.)—all while setting a tax level that will not discourage materially the industry’s investments in our state?
Onorato and I talked about percentages, including WV’s tax, and agreed that not enough was known to knee-jerk select a percentage. Dan noted that overall tax and cost comparisons—not just what other states’ severance taxes were–are key in the analysis. We discussed the possibility of who could fund and commission an objective study by the RAND Corporation that would hone in on those issues. We also discussed working with industry and tax experts to design a tax structure that might increase tax levels when times were good for the industry, but give the industry flexibility to continue drilling when times were not as good. [Many severance taxes have a variety of adjustments.]
As we now know, most (not all) players in the industry chose to back Corbett over Onorato, but it may not be too late to rationally approach the crafting of a solution for managing the incredibly fortunate situation in which we find ourselves in terms of shale gas.
To my knowledge, since the August meeting with the shale gas industry, there has been no meaningful contact between the industry and Governor Wolf (except for discussions regarding proposed crackers). I think that is reflected in the Governor’s proposal.
Various people have advised the Wolf Administration that there are industry leaders who are far more flexible than simply saying “No severance tax, period.” A window was open to move things to a point whereby a rational tax policy as to shale gas could be developed, demonstrating to the world that PA is a great place to do business. Until February 11 I assumed that window would still be open, but then I was profoundly disappointed with a statement from Governor Wolf when he announced his tax proposal. ABC Harrisburg affiliate, WHTM-TV, reported as follows:
“Wolf also not-so-gently reminded complaining drillers that the business climate could always be worse. ‘The alternative is not really no tax,’ Wolf said in a very direct tone. ‘The alternative is no drilling, a ban as in the case of New York.’”
According to another report, Wolf added that the state was not a “partner” with the natural gas industry until his new tax was in place. Talk of a ban, and not being a partner, is not consistent with his oft-cited support for a vibrant industry. He later said that he was not threatening a ban or moratorium, but at best he is sending confusing signals, and I know it is making those who consider investing in this state nervous.
Respectfully, Gov. Wolf should start by making it clear the Impact Fee will stay in place, making it a credit against any severance tax. He would quickly take one huge issue off the table. Then, he should make it clear that shale gas is not expected to fund the black hole that is the nation’s second most expensive legislature to operate. (When I first went to the State Capitol Complex, I thought I was in the governmental center of a major nation.) He can do that by privatizing the LCB and driving pension reform. Next, he should engage a select group of industry leaders and tax experts, working with the studies that have already been done and supplementing them as needed, to create a severance tax that works to grow Pennsylvania short, medium and long term.
Tom Wolf is a seasoned businessman—he knows how to do this, and if he needs to shed anyone getting in the way, so be it.
Part II – July 1, 2015
Rather than the Wolf Administration reaching out to the industry to create a solution to the severance tax issue that can appropriately provide funding to the state and its future budgets in a fair and reasonable manner (as suggested in our last issue), for some inexplicable reason, the Wolf Administration not only failed to reach out in good faith but compounded its earlier missteps and is faced with getting nothing from its attempt to place additional taxes on the state’s oil and gas industry.
The Fatal Third Element of the Severance Tax Proposal
Many Harrisburg sources have told me that the Wolf Administration either did work backwards or must have worked backwards to add the third element of its proposed severance tax. At the time of our last issue, the Wolf Administration had added a second element since the initial flat 5% severance tax proposal used during the campaign wasn’t enough on its own to generate the Administration’s $1 billion target for education.
The second element, added on February 11, is a flat 4.7 cents per Mcf, effectively raising the tax percentage either a little or a lot depending on the price at which the gas is sold. Early on, and certainly during a good part of the campaign period, the Wolf Administration clearly had no understanding that the prices around the state at which the producers were able to sell their gas were dramatically lower than benchmark Henry Hub or NYMEX pricing. As pricing continued to remain low, the Wolf Administration realized that the billion dollar tax target was not feasible unless it added a third element, one that is completely unprecedented nationally in extraction taxes.
Recognizing that it made no sense to fund something as important as education with a tax that could vary significantly with gas prices, the third element, a floor price, declares that no matter what an E&P company is able to get for its gas, it will be taxed at a minimum $2.97 per Mcf! With prices over the last year going down as low as the 60 cents per Mcf range, this makes the effective tax rate in many cases much higher than any in the nation.
The third element of the proposed severance tax was the Wolf Administration’s biggest mistake, even bigger than (1) Governor Wolf earlier threatening a fracking ban, (2) declaring that the state was not a partner with the gas industry unless he got his tax, or (3) refusing to recognize that the Impact Fee is a tax on extraction by over and over and over again misrepresenting that Pennsylvania is the only state without an extraction tax. The reverse-calculated floor price, on top of the other positions noted, sent a message to the E&P companies across the Commonwealth that the Wolf Administration was so disconnected to the realities of the oil and gas industry and how capital decisions are made that it was no longer possible to sit down as partners in the state’s development and negotiate something that worked for Pennsylvania.
One suggestion that apologetic Democratic friends have made over and over again is that the Wolf Administration was simply posturing as politicians do in order to have things to give away in a negotiation. Indeed, the Administration has recently complained the opposition is being unreasonable in not negotiating since the Administration offered up the possibility of dropping the floor price provision. If the Wolf Administration believes adding outrageous positions to a stance is a good way to engender good faith negotiations, I should probably establish a negotiation course in Harrisburg for executive and legislative staffers.
The Wolf Administration has dug itself a very deep hole even with Democrats in the oil and gas industry, and it would take a significant personal effort by the Governor to reach out, in effect apologize and rebuild. Although I genuinely see many wonderful traits in our Governor in terms of caring for citizens of the Commonwealth, he himself told the industry gathering I arranged in August 2014 that he was “arrogant,” so unless he was kidding (and it did not seem so), I don’t see him making an apologetic personal outreach to rebuild his credibility with industry leadership. Instead, Administration spokespersons assert that “[w]e are ready to negotiate a serious severance tax.” Given all the history, unfortunately that does not ring true.
Secondary Elements of the Proposal—Also a Disaster
As discussed in Part 1, the Wolf Administration made sure it lost the support of most political leaders from areas benefiting from the Impact Fee by proposing to eliminate rather than continue the Impact Fee. The outcry from around the state was deafening.
Backtracking, the Wolf Administration said an amount ($225 million, approximately the current level of funding) would be set aside out of the severance tax for the communities, but it stated that the amount allocable would not increase even if drilling activity increased over current levels. Not smart on the part of the Wolf Administration, as the impact of gas drilling in a particular community could double or triple, leaving the community critically short of the funds needed to address issues. This galvanized even many Democrats with the industry and the Republican majority in the legislature. Who was advising the Governor on this one? The clean and easy answer, upsetting no one, was to leave the Impact Fee in place and have it be a credit against the severance tax.
It gets worse. Little attention is given to other aspects of the Wolf Administration’s proposal. For example, the Wolf Administration proposal disallows deductions for pre-production costs. Essentially, this is a backdoor way of increasing the effective tax rate over the stated rate compared to other jurisdictions with the same stated rate.
The IFO Report
Let’s see what the state government’s own Independent Fiscal Office (“IFO”) has to say about Governor Wolf’s claim that his tax is “right in the middle” of other states’ severance taxes. [The IFO is roughly analogous to the Federal Government’s nonpartisan Congressional Budget Office, providing nonpartisan analysis to the General Assembly as the CBO does to Congress.]
On June 1 IFO Director Matthew Knittel gave testimony in front of the Senate Environmental Resources and Energy Committee and the Senate Finance Committee. The result was far worse than anything the Wolf Administration could have imagined, although it was directly in line with the expectations of anyone with a math or financial background. “For 2016, the analysis projects an average tax rate of 17.3 percent under the proposed severance tax,“ comprised of four parts:
- 5% price-based tax
- 4% volume-based tax
- 3.5% tax, due to disallowance of post-production costs
- 4.8% tax, due to the price floor of $2.97/Mcf
Total: a 17.3% average effective tax rate!
If prices recover as the IFO expects over the coming years, the longer term average tax rate is expected to be 7.3%. Both numbers are significantly greater than the next highest effective tax rates, in Texas and WV, of 5%. How Governor Wolf could conceivably say we would be in the middle is unfathomable. On top of this, the IFO called the Impact Fee a tax, and asserted that in 2015 it would be equivalent to a 4.7% extraction tax. The Wolf Administration has now unofficially lost the battle.
What’s Next this Year?
The rigid, might I say arrogant, approach of the Wolf Administration has backfired. All the last minute indications that the Wolf Administration is so reasonable and willing to negotiate are falling on deaf ears. It is too late for that. The General Assembly passed a budget that does not include a severance tax, despite the fact that a 5% tax with a credit for the Impact Fee would have been well received if handled adroitly and would have allowed the Governor to legitimately assert that he fulfilled his campaign position of a 5% severance tax. Governor Wolf has vetoed this budget, but he will eventually sign a version of it and it still won’t include a severance tax.
At the end of the day, all people will remember from this year’s budget impasse is that the Administration lost due to its unwillingness to develop a rational tax and a committed plan for how it would be equitably allocated, as well as its failure to recognize the logical and financial imperatives of first getting out of the alcohol business and putting new state employees and teachers on defined benefit pension plans like the rest of the nation’s employees of larger organizations.
The Tie-In to Education
Everyone who watches politics in PA knows that Governor Wolf linked the severance tax to a billion dollar increase in funding for education, but few know that the severance tax proposal is dubbed the Pennsylvania Education Reinvestment Act. Sounds nice, and personally, I would have been happy for a portion of any severance tax to be dedicated to education.
But the approach was all wrong in this case, as even people like me who supported Governor Wolf advised his Administration (to completely deaf ears and no response or discussion). There was no believable groundwork laid for why $1 billion more was needed (PA is 10th among the states in terms of money spent per student), just as there was no credible research by the Administration to justify a particular level of severance tax and the effects it would have on investment and employment. Given that there was a refusal to even consider appropriate pension reform for new state employees and teachers, or to even consider getting out of the alcohol business like 48 other states, these refusals to lay groundwork for more taxation were even more offensive.
The ironic thing is that I personally believe that the education funding system of Pennsylvania needs to be completely overhauled. I wrote a senior thesis at Penn about the inexcusable inequities of our public primary and secondary educational systems, largely due to the principal method of funding school districts—the property tax. But, rather than apply a tax to the gas industry without analyzing its level and structure, I would rather pay higher state income and sales taxes so that we could ditch the property tax regime that provides wealthier kids with great facilities, resources and well-paid teachers, while providing less well-off students with a demonstrably inferior education.
I do not want a system that unnecessarily piles more taxes upon more taxes, and I certainly don’t want a tax that will damage the state’s economy like the ill-conceived version of a severance tax proposed by Gov. Wolf.
Let’s hope the Wolf Administration has learned a lesson and can reach out across the aisle over the next year to craft some legislative solutions that will put Pennsylvania in good financial status for years to come, while encouraging rather than discouraging investment. We are in an exciting time, indicated perhaps most dramatically by the June 2015 Harvard/BCG report concluding that US manufacturing will be cheaper than Chinese manufacturing by 2018—due to shale gas!
Even with Pennsylvania’s high tax environment for corporations, there will be room for a well-designed severance tax, and in conjunction with other restructurings of the state taxation system, a severance tax can be a valuable resource, fairly applied and crafted to support rather than minimize investment in Pennsylvania. When I practiced law, a Fortune World 50 company I represented told me the many reasons why they would never build a manufacturing operation in Pennsylvania. We can overcome that perception, but not with the misguided tax philosophy demonstrated by the Wolf Administration.
As I said in Part I, Tom Wolf is a seasoned businessman—he knows how to do this, and if he needs to shed anyone getting in the way, so be it.
Editor’s Note: We are indebted to our friend Jim Willis at Marcellus Drilling News (also must reading) for bringing this superb article to our attention.