Washington Eyes Oil Industry
Today, the US House of Representatives passed new energy legislation aimed at taking a larger chunk of oil and gas industry profits. In total, the bill looks to increase US Government revenues by $14 to 15 billion dollars over the next 10 years. This leap in revenues would be accomplished by means of several changes to existing laws, including:

• Most notably, the new legislation will stop oil and gas industry manufacturers from taking manufacturing deductions that were passed into law in 2004 to provide tax incentives to US manufacturers. This change singles out the oil and gas industry for exclusion from these tax breaks, and as such it is expected to raise $7 billion in new taxes over the next 10 years.
• The bill will remove tax breaks for certain oil exploration costs for majors
• It will repeal new royalty incentives that were created with the Energy Policy Act of 2005
• Most contentiously, the bill also aims to force operators owning GOM deepwater (200m+) leases to renegotiate leases that were issued in 1998-99 without price thresholds. Under the terms of the new law, operators will either have to renegotiate leases to include price thresholds or pay "conservation of resources" fees on those leases. If they do not, they will be barred from further leasing in the GOM.

Royalty Relief and Price Thresholds
With regard to price thresholds and royalty relief, a brief look at US energy policies over the last 12 years is in order. In 1995, Congress passed the Deep Water Royalty Relief Act that specified mandatory royalty-free production for all Western and Central GOM deepwater (200m+) leases to be issued between 1996 and the end of 2000, which meant that it applied to 10 Gulf of Mexico lease sales during those years. Depending on the water depth of the lease, the volume that could be produced royalty-free varied from 17.5 to 87.5 mmboe, but royalties would be required once that level of production had been reached.

This royalty relief was designed to encourage exploration of deepwater prospects that, at the time, were too high-risk to undertake. By removing the royalties on the first portion of production, the government gave companies a break during the difficult and expensive period of production startup so that they could recover some of the capital expenditures required to bring the field online.

Given the low oil prices that persisted through the 1990s, when this legislation was passed, there was little concern at the time that oil prices would reach levels at which royalty relief would seem unreasonable. At the same time, the government empowered the Department of the Interior to determine the price threshold at which royalty relief would no longer apply. This was initially set at $28.00 per barrel for oil (in 1994 dollars) for leases with mandatory relief. With yearly adjustments for inflation, the royalty relief level was $34.71/bbl of oil in 2005.

This arrangement would have worked well except that for all the leases issued in 1998 and 1999, a total of 1,100 deepwater leases subject to royalty relief, the MMS failed to include language setting the price threshold for those leases. As such, all of these leases are not subject to royalty payments (assuming they have not reached the royalty-free production threshold for their water depth) even with oil prices that have exceeded the price threshold for the last two years. These flawed leases have been the subject of much debate, and they are the target of the new energy bill.

Gulf of Mexico Leasing
Looking at the data from the MMS lease sales during the mid to late 1990s, it is plain to see that the Royalty Relief Act accomplished its intended effect of spurring more deepwater exploration. In 1995, the last year before the act was put into effect, only $306 million was paid for GOM leases. In 1996, once the new law had taken effect, a total of $863 million was spent on GOM leases. Part of that increase was fueled by rising oil prices, which had gone from a 1995 average of $16.75/bbl to a 1996 average of $20.46/bbl.

However, in 1998, when the average oil price dropped to $11.91, the amount spent on GOM leases still amounted to $1.3 billion, one of the highest sums for any year. Thus, it is clear that the current oil price plays a fairly small factor in operator's lease decisions and that the oil price the year before is a much larger factor. Given that, it is no surprise that the total lease value for 1999 dropped more than 80% to just $249 million, even though oil prices recovered to an average of $16.55 for the year.

Looking specifically at the years of 1998 and 1999, and Gulf of Mexico Lease Sales 169, 171, 172, and 174 which occurred during that time frame, a total of 1,556 blocks were leased, 1,100 of which were classified as deepwater leases in water depths of 200 meters or more. The vast majority of this activity occurred in 1998, when a total of 1,196 leases were purchased.

Putting the Numbers Together
As of last year, a total of 21 deepwater discoveries had been made on blocks leased during 1998-99 time period. Of these discoveries, eight were in the Mississippi Canyon area, five were in the Green Canyon area, four in Garden Banks, three in Ewing Banks, and one in Viosca Knoll. Seven of the plays are oil discoveries, while the other 14 are natural gas. The average water depth for these discoveries is just over 3,800 feet deep.

Given the water depths of these discoveries, all but four of them would qualify for the 87.5 million boe royalty relief. This means that the operators would be able to produce 87.5 million boe without being responsible for any taxes, and with no price thresholds in the contracts, that would apply even with oil prices over $50 per barrel as in today's market. In order for these discoveries to be of commercial quality, the fields would have to contain far beyond the royalty relief limit, so there is no questions that these quantities of oil and gas would be produced from these leases.

Just looking at the royalty-free amount that can be produced for each of the 17 fields that qualify for that level of relief, there are 17 leases multiplied by 87.5 mmboe per lease priced at $50/boe for a total value of $74 billion worth of oil and gas production that is royalty-free. Given a 12% royalty rate for these leases, the US government would be missing out on $8.9 billion in royalties on just these deepest fields.

Consider also that of the 1,100 leases purchased during the 1998-99 time frame, only about 7 percent of them have been drilled. With over 900 leases yet to be drilled, the potential for further discoveries is quite large. If only one percent of those leases yielded commercial discoveries, that would be a further nine leases and $39 billion worth of revenue on which the government is trying to begin collecting royalties.

As such it is easy to see why the government is eager to bring these contracts into line and start collecting revenues from them. At the same time, with Kerr McGee already filing suit to contest the government's setting of price thresholds for royalty relief, it may be a long time before this contest comes to an end.