Monday, June 1, 2009

Mr. Obama's Energy Policy

I’ve got very mixed feelings about the Obama Administration’s approach to energy. First, I am very encouraged that he is taking on our problems head-on. We are facing a national emergency between our dependence on foreign oil (and oil in general) and our negative impacts on our planet, and I appreciate his bold and gutsy approach. But I’m concerned that his (and Congress’s) approach is throwing the proverbial baby out with the bath water.

Much has been written about the failings of the various draft energy policies, so I won’t go into much in this forum. I’m certainly not going to argue global warming or carbon cap and trade. My greatest concern is that he is trying to make too big of a step right out of the blocks and is forgetting the long-term nature of his quest. He has a grand vision but has to recognize that there will be many interim steps along the way.

My two greatest concerns are 1) some of his proposals are hostile to the domestic oil and gas drilling industries, and 2) the carbon legislation is too generous to coal-fired power generators at the expense of natural gas.

First, in his campaign, he vilified the ExxonMobils of the world because of the extraordinary profits they generate when commodity prices are high. Given the fact that oil and gas is a cyclical industry, I knew there would never be a fruitful discussion of a windfall profits tax. But we need these companies, big and small, to drill at home in our existing drilling basins. I’m not necessarily in favor of drilling in the Arctic National Wildlife Refuge or off the coast of California or Florida, but there are numerous basins across North America that are available for drilling.

Two of the proposals that have been floated are eliminating the tax deduction for depletion and eliminating the deduction for intangible drilling costs. Anyone who receives royalties knows about the depletion deduction, currently 15% of net royalties. An oil or gas reservoir is similar to any other asset in the fact that it is a declining asset. As oil and gas is pulled from the reservoir, the reservoir is inherently less valuable. Accounting has formal rules and mechanisms to allow for this, either depreciation or amortization of goodwill. Fifteen percent might not be the right number, but looking at the steep decline rates of Haynesville Shale wells, the right number might be higher! Treating an oil reservoir differently from another long-lived asset is not fair. That proposal doesn’t hurt ExxonMobil as much as it hurts individual land owners.

The other proposal, to eliminate the deduction for intangible drilling costs, will have several impacts. It will make more of a producer’s income taxable, but at the same time it will change the economics of individual drilling projects. A venture that was marginally profitable might be unprofitable if some of the drilling costs are not deductible. The “tax shield” of intangible drilling costs is a real number that directly impacts the bottom line. This is an especially big deal in the Haynesville Shale because the wells are so capital intensive on the front end. Anything that tilts the economics to the negative will result in fewer drilling projects.

Second, as a resident of planet earth I was encouraged by the Administration’s bold step to take a stand against carbon. I know the argument that China opens a new coal-fired plant every week, but the United States is a world leader, actually THE world leader. We need to lead by example. It’s a silly playground argument to say that I’m going to keep polluting because that kid is too. Lead by example – don’t wait for someone else to pick up the flag from the battlefield. We are a nation of ideals. We can’t be selective in their application.

It was my hope that the carbon legislation would encourage the use of natural gas rather than coal in power plants. Natural gas is a significantly cleaner fuel, but the legislation as it is currently written gives coal plants a huge pile of freebie carbon credits, while natural gas-fired power producers get a pittance. I believe this was done to “level the playing field” and not unduly harm coal producers in the very short term. This is admirable and it avoids too heavy of a legislative hand, but does it also allow the coal-fired guys to maintain the status quo? The opportunity to fix the coal polluting situation is now. It’s hardly a bold action to give coal-fired plants a pass.

What does encourage me is that Mr. Obama seems willing to listen and incorporate reasonable differing opinions. My observation of Mr. Obama’s Administration is that they come out of the gates with a policy that is fairly extreme with the thought that they will move towards the center as the issue is debated. To me it’s a typical negotiating move. At this point, I’m concerned, not absolutely scared.

What is clear to me is that the government simultaneously needs to encourage domestic industries and cleaner fuel. Alternative power sources might be the future, but that future is decades from being realized on the grand scale. The bridge to our energy future is natural gas. It is poised to be a huge industry that employs hundreds of thousands, it is relatively clean and it comes from underneath our own feet. This is what Washington needs to keep in consideration.

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