Will North Dakota tax incentives boost crude output?

Sandy Fielden, RBN Energy

Data from the North Dakota Industrial Commission (NDIC) indicate that production in January 2015 slowed by 37 Mb/d from record levels over 1.2 MMb/d in December. The number of new well completions also slowed in January – leading to a large backlog of wells drilled and waiting to start producing. Lower production and completions are in part due to producer caution following the crude price crash last year but producers waiting for a North Dakota state tax break and the usual impact of winter weather could also be responsible. Today we describe how new state tax incentives could boost summer output back to record levels.

Even at recent lower crude prices, oil production generates huge economic benefits for those states like North Dakota that are lucky enough to sit on top of prolific shale formations. States generally impose various taxes on oil and gas production at the wellhead and vigorously regulate drilling and production activity. As we described recently, North Dakota has been pro-active in trying to reduce the quantity of gas that is flared at the wellhead (see Fewer “Candles In the Wind”). Among many other regulatory requirements, they also require monthly reporting of well production and are involved in downstream regulations such as the rules for the conditioning of crude for rail transportation that came into effect this month (April 2015).

On the revenue side, North Dakota applies two taxes to most of the State’s oil production. The first is a 5% Gross Production Tax (GPT) applied to the gross value of all oil produced except for certain publically held or American Indian holdings. The second is a 6.5% Extraction Tax that is also applied to the gross value of oil produced at the well. Over time, the GPT has been applied consistently but the North Dakota legislature has implemented a couple of incentive schemes to encourage oil production by waiving or reducing the 6.5% extraction tax when crude prices are low. Low crude prices since last Summer led to the first of these incentives – known as the Small Trigger – coming into effect on February 1, 2015 and the second – known as the Large Trigger – looking increasingly likely to be tripped should average crude prices stay below $55/Bbl during April and May of this year.

Small trigger
The North Dakota Legislature enacted the small trigger tax break in 2009 to incentivize new drilling of horizontal wells and encourage production through periods of low oil prices. The trigger comes into effect when the monthly average price of West Texas Intermediate (WTI) crude (the U.S. domestic benchmark) falls below $57.50/Bbl (see the purple line in Figure #1). In January 2015 the WTI average was about $47/Bbl meaning that the extraction tax incentive came into effect for new wells drilled after February 1, 2015. The small trigger incentive lowers the oil extraction tax from 6.5% to 2% on the first 75 MBbl produced or the first $4.5 million of gross value (whichever comes first) for up to 18 months following well completion. The small trigger only applies to wells completed after the incentive is triggered and is only effective through June 30, 2015 when its enacting legislation sunsets. The small trigger incentive is also disabled if average WTI prices exceed $72.50/Bbl during any month after the trigger. Effectively this means the 4.5% tax break will apply to all new horizontal wells completed between February and June in North Dakota unless there is a sudden oil price recovery above $72.50/Bbl – pretty unlikely.

Figure 1:

Source: North Dakota Oil & Gas Division, CME NYMEXX Data from Morningstar and RBN Energy

Large trigger
The second, large trigger tax incentive is based on state legislation dating back to 1987 – again to encourage oil production during periods of low prices. In 2001 lawmakers set a trigger mechanism in place that causes the 6.5% extraction tax to be waived if oil prices fall below a threshold initially set at $35.50/Bbl and indexed to inflation. The trigger threshold is set in advance every year based on various cost of living indicators. The inflation adjusted trigger price for 2014 was set at the WTI equivalent of $54.56/Bbl and in 2015 it is $55.09/Bbl (green line in Figure 1). To trigger the tax break, monthly average WTI prices (red line on the chart) must stay below the threshold for 5 months in a row. The chart shows that the WTI average has been below the target for three months so far this year. If prices stay under about $55/Bbl during April and May then the tax incentive will kick in starting June 1, 2015. If the monthly average price increases above the threshold this month or next then the clock is reset until the threshold is met for 5 months in a row. Once the conditions are met, the large trigger stays in force until average prices increase above the target for another complete 5-month period. In other words, once set in place, the incentive is only removed by a sustained oil price recovery.

The impact of the large trigger is far more significant for both oil producers and North Dakota oil tax coffers than the small trigger. The larger incentive removes the full 6.5% extraction tax for a 24 month period after the price trigger for all producing wells (old and new) and then (after 24 months) reinstates only a reduced 4% extraction tax. Given that the “normal” full tax rate on production in North Dakota (5% production plus 6.5% extraction) is 11.5%, the large trigger tax incentive more than halves the State’s oil tax revenues. Research by Heikkinen Energy Advisors estimates that the tax break represents the equivalent of a 3.5% increase in producer internal rates of return (IRRs – see It Don’t Come Easy for more on producer rates of return). In other words this is a big deal for producers looking to cut costs and increase drilling returns as well as representing a significant commitment from the State of North Dakota to encourage continued drilling.

Sitting on the sidelines?
The prospect of the large trigger tax incentive kicking in on June 1, 2015 is one factor that might explain a recent increase in the number of wells that have been drilled and are awaiting completion in North Dakota (the State defines completion to mean when the first oil is produced through wellhead equipment into tanks). The chart in Figure #2 shows well completion data from the NDIC. The red line shows that the number of wells waiting on completion increased from just over 400 in January 2013 to more than 800 in January 2015.  No doubt that some of these wells have been held up because producers are waiting to complete their wells when the large trigger tax incentive kicks in during June.  But there is more to it than that. 

Wells can be waiting on completion for a number of other reasons.  These include the absence of infrastructure – as could be the case for North Dakota producers trying to comply with regulations to reduce flaring or needing to set up equipment to condition their crude for rail loading. In a low price environment, producers can also delay well completions as a form of storage – waiting for crude prices to recover. In North Dakota winter weather can also be reason enough to delay completions. The blue line in Figure #2 is the number of completions each month since January 2013 and although there were just 47 completions in January 2015 compared to 183 in December 2014, the numbers do not appear to be outside the normal range so some portion of the lower number of completions in January is likely just usual impact of the North Dakota winter.  Generally speaking, smaller producers are incented to complete wells sooner rather than later in order to generate cash to repay finance costs so that lengthy completion delays are not common. In any case, North Dakota drilling permits only last for a year – by which time producers have to drill and complete their wells - meaning that any backlog will only last for a limited time.

Figure 2:

Source: North Dakota Oil & Gas Division, RBN Energy

One thing is sure in North Dakota this year. Whatever the reason for the January slow down in production and the build up in wells awaiting completions this winter, the consequence is almost certain to be a boost in output by the summer. That is because, in the first instance, the one-year drilling permit time limit will require producers to complete some delayed wells. And then if prices stay low and the large trigger tax incentive kicks in during June producers will have extra incentive to complete wells before prices increase above the threshold. The tax incentive can also be expected to improve IRR’s on marginal wells enough to justify some increased drilling later this year. In the meantime, the small trigger incentive – reducing the oil extraction tax to 2% - may result in increased completions between now and June this year – boosting production in the short term.

About the author
Sandy Fielden serves as Director Energy Analytics for RBN Energy LLC and is an internationally accomplished professional with 25 years of management and communication experience in the European and North American energy industry, including ten years as a vice president at industry leading firms. He is a widely recognized expert at analyzing, processing, and communicating the value of a wide range of information in the energy industry.

 

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