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Nailing Down the Numbers on Impacts of Oil and Gas Subsidy Reform

Peter Erickson's picture
Stockholm Environment Institute (U.S. Center)

Peter Erickson is a senior scientist in the Seattle office of the Stockholm Environment Institute. His research focuses on climate change mitigation policy, with special interests in the role of...

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By Peter Erickson and Michael Lazarus.

Many U.S. taxpayers would probably be surprised to learn they subsidize oil and gas production by at least $4 billion each year. Indeed, given federal budget concerns, not to mention the urgency of climate change, President Obama tried to cut back subsidies during his first term. Working with Democrats and some Republicans in Congress, he tried several times to repeal the industry’s three biggest tax breaks: the expensing of intangible drilling costs, percentage depletion, and the manufacturing deduction. Congressional proposals in 2011 and 2012 drew a majority of Senators’ support, but came only votes shy of reaching a filibuster-proof 60 votes.

Now, as pressure mounts globally for countries to end fossil fuel subsidies, a study from the Council on Foreign Relations adds fresh insights that could help reinvigorate the debate.

Authored by Tufts University economist Gilbert Metcalf, it finds that repeal of these three tax preferences would reduce U.S. oil and gas production by less than 5%, and global oil demand by about 0.5% – impacts he considers relatively small. Like other researchers before him, Metcalf argues for repeal on the basis that it offers a fiscal benefit without significant or “material” repercussions.

In contrast, research sponsored by the industry has found the effects of subsidy reform on U.S. oil production to be much higher, on the order of 15%. But unlike industry studies, the Metcalf analysis uses transparent methods and assumptions, which inspires greater confidence and enables more rational, fact-based debate.

Unlike most academic studies, Metcalf’s analysis also models the effects of subsidies on cash flow, which is the cornerstone of project decision-making in the oil industry. As a result, it clearly shows the extent to which tax preferences can move unprofitable projects from the red into the black, leading them to go forward. And it also illuminates the extent to which, for the many projects already in the black, tax breaks just add to oil company profits, with little or no impact on production or investment.

In terms of greenhouse gas emissions, Metcalf suggests that the direct impact would be negligible. But he adds that removing subsidies at home could give the U.S. added leverage in prodding other countries to reform their own, often more significant fossil fuel subsidies. Indeed, major economies have committed to a G20 pledge to remove “inefficient” fossil fuels subsidies.

Some of our own work, to be published shortly, takes a similar approach as Metcalf’s, but with additional refinements that we think are important. For example, we use detailed field-by-field data, rather than more generalized groupings of field types. We are also evaluating a broader suite of state and federal subsidies than were assessed in the Metcalf paper.

Still, there are commonalities in our findings. For example, for many producers, the subsidies do not seem to affect the decision on whether to develop a field – though, not surprisingly, this conclusion is sensitive to what one assumes for the price of oil. Metcalf uses the U.S. Energy Information Administration (EIA) reference case, which assumes prices will return to about $100/barrel. In this case, fields tend to be profitable and would thus be developed even without subsidies. Like Metcalf, we find only modest effects on U.S. oil production and global oil demand.

In contrast, if oil prices stay closer to current levels ($50/barrel) – an outcome that becomes likelier as major economies take actions to achieve the goals of the Paris Agreement (to limit global warming to well below 2°C), our analysis suggests that the impacts on production and global emissions from subsidy reform could be much more significant.

Simply put, there is a lot more potential U.S. oil production with break-even costs around $50/bbl than around $100/bbl. As a result, changes in project economics – for example, a bump in internal rates of return (IRR) of 5 percentage points resulting from subsidies – can affect the go/no-go decision of many more fields at $50 than at $100 per barrel. (Many of the projects most likely to be affected are in shale basins with high numbers of independent producers, such as the Permian of Texas and the Williston of North Dakota.)

Such findings appear to suggest an even stronger case for subsidy reform. Not only would removing federal and state support (such as the extensive rural road maintenance costs borne by the Texas Department of Transportation) provide a fiscal benefit and demonstrate U.S. leadership, but the climate benefits could be substantial as well. These benefits come through lower oil production, oil consumption, and global CO2 emissions, and continue to expand as other countries take similar steps to live up to their commitments in Paris.

With a change in U.S. political leadership in the next few months, now is a good time to revisit oil and gas subsidies. As Metcalf notes, a clear sense of the impacts of subsidy reform is essential to choosing the best path forward. With stronger evidence, the next President and Congress may be able to make progress where the current ones could not.

Photo Credit: Richard Masoner / Cyclelicious

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