The 50% drop in crude oil prices that took place between June 2014 and January 2015 was as unexpected as it was precipitous. It
certainly came as a surprise to participants in the Grant Thornton LLP and Hart Energy 2014 survey of U.S. oil and gas companies, conducted last summer. Of the 375 respondents who shared their guess regarding the average cost of West Texas Intermediate (WTI) crude oil in 2015, most saw prices at around $100 per barrel, with only one doomsdayer dipping as low as $75 — a level that now seems optimistic, given that prices were hovering around $43 in mid-March.
At the same time, the downturn in prices should not obscure the fundamental strength and flexibility of the U.S. oil and gas sector. “The structure and integration of the U.S. oil industry is so robust among its players — producers, investors, service companies — that it can very quickly adjust to challenges in the supply/demand equation,” says Kevin Schroeder
, national managing partner of Grant Thornton’s Energy practice
. The number of working rigs has dropped significantly from its October 2014 peak, which should be reflected in a decline in production around the third quarter. Coupled with increased forecasts for oil demand, the pricing picture could brighten later in the year. That said, lackluster industry conditions could persist for a while, perhaps several years, due to other geopolitical issues.
Federal policy on oil and gas presents a mixed picture
The Obama administration’s stance on oil and gas will have a varied impact on the industry. The president vetoed a bill authorizing construction of the Keystone XL pipeline, and the administration announced measures that would bar drilling in most of the Arctic National Wildlife Refuge and much of Alaska’s coast. These restrictions continue policies that have resulted in an overall decline in energy production on federal lands at the same time that energy and power companies have achieved an extraordinary rise in output on nonfederal properties.
On a more positive note, the administration has announced its intention to allow drilling in parts of the Atlantic Coast, ending a decades-long moratorium. The president’s plan also calls for leasing additional areas in the Gulf of Mexico.
However, the impact of these measures at the federal level won’t be felt for years. For now, the U.S. upstream energy sector is in a slump. Capital budgets have been sliced, staff is being shed, and liquidity concerns loom for some firms.
Mid-tier and smaller producers, which often carry large debt burdens in this capital-intensive industry, are finding themselves strapped for cash. Service companies are feeling the pain as well, as customers delay purchases and payments.
Cash flow and the SALT function
As companies seek avenues to manage liquidity, state and local tax (SALT) is an area that can be easily overlooked. SALT presents both opportunities and risks that producers must consider as they work to maintain adequate cash flow in difficult times.
Reductions in tax staff are usually unwise
To shore up their cash position, some companies have started to lay off employees. Staff positions, such as those in accounting and taxes, are often first on the chopping block. Public companies know they can’t cut deeply into resources dedicated to financial reporting and still fulfill SEC requirements. But in the tax area, some producers think the function can withstand cuts in staffing, compensation or both.
Such moves are rarely cost-effective. Skilled tax professionals are always in short supply in the energy industry, and underpaid employees head for the exit. These staffs are usually small to begin with, so any cuts quickly affect essential tax functions. Potential savings from layoffs are often outstripped by the higher risk of exposure or missed opportunities for savings or refunds. For smaller companies, cutting the tax staff often means eliminating the only person who knows anything about the company’s SALT function — which can leave management facing a tax administration nightmare.
The industry’s doldrums are having a devastating impact on the budgets of some energy-rich states (see sidebar). Look for them to step up tax-boosting measures like audits, which can require hours of effort from companies’ tax employees.
Other cost-cutting alternatives
Producers have options when it comes to staff reductions. One often-used method for cash savings is automation, although this doesn’t work for SALT purposes. The technology carries a high price tag, and companies aren’t prepared to make the necessary investment when they are already short on cash.
A more viable option may be outsourcing. Some producers are already outsourcing many or most of their staff functions, and SALT is an area where external staffing can work. Companies may also want to look to external providers for assistance in finding overpayments, identifying significant exposures, improving tax processes, and advising on audits and representations in administrative hearings.
The impact of lower oil prices on state budgets
Just like oil company accountants, the controllers of energy-rich states were mostly unprepared for the sharp decline in crude oil prices. While the price drop is affecting tax collection in all oil-producing areas, the overall impact varies by state.
North Dakota is among the most affected. It has cut its projected oil and tax revenue for the 2015-2017 budget cycle from $8.3 billion to $4.2 billion, reflecting both lower severance taxes from cheaper oil and fewer high-paying jobs as a result of less drilling activity. The state’s original estimate was based on oil prices of $74 to $82 per barrel between 2015 and 2017; the new forecast assumes prices of $45 to $65.1
Texas is projecting a 14% drop, to $5.7 billion, in oil-related taxes in fiscal 2016 and 2017.2 Luckily, oil revenue represents only 6.4% of the operating budget of this economically diverse state, so its total revenue is expected to rise 6% this year.3 In contrast, tax revenues from oil- and gas-related activity represent as much as 15% of Louisiana’s budget, 31% of Wyoming’s, and a whopping 89% of Alaska’s.4 Whether it’s tapping into rainy day surplus funds, cutting spending or raising tax rates to cover projected deficits, oil-producing states are using different strategies to deal with the current crisis.5
The impact of the November elections can be seen in changes in state energy policies. Newly elected Pennsylvania Governor Tom Wolf, a Democrat, has proposed a 5% severance tax on natural gas.6 (The arguments both for and against the tax are discussed in this article by Grant Thornton’s Vito Cosmo Jr. and Matthew Melinson.) Wolf has also instituted a moratorium on new leases for oil and gas drilling under state-owned forests and parks.7 But the presence of a Republican governor does not necessarily mean a better tax environment for oil and gas producers: Ohio’s John Kasich is seeking to substantially increase taxes on oil and natural gas extracted from the state’s shale fields to make up for the shortfall that would be created by his proposal to cut state income taxes.8
Finding savings and efficiencies in SALT
One cash-boosting alternative may lie in better execution in each area of the SALT function: sales and use, property, severance and income/franchise taxes.
Sales and use taxes
Companies often develop projects to recover cash from overpayment of sales and use taxes. In boom times, these plans sometimes get shelved because the anticipated payback isn’t large enough to offset the effort or capture the attention of senior management. When companies are short on funds, however, these projects can be a valuable source of cash.
Companies in the energy industry, especially service companies, should also make sure they have all required resale and exemption certificates. While that’s always good advice, it’s even more important in tough economic conditions, when some customers may go out of business or be acquired. “If a state audit finds that a company hasn’t been charging tax to some customers, the company can usually bill their customers and recover the funds,” says David Rohlmeier
, Grant Thornton’s managing director, Indirect Tax Services. “But if the customer is out of business or has been acquired, the company may simply be out of luck.” Energy companies would be well-advised to reach out to their customers and get updated certificates.
Property tax overpayments often entail an excessive valuation of assets. “In challenging economic times, energy companies should focus on identifying assets that are obsolete or have fallen in value to find potential savings,” says John LaBorde
, Grant Thornton partner and leader of the firm’s Texoma SALT practice. Levies are typically based on the value of a property as of Jan. 1 — e.g., for 2015, taxes are based on the property’s value as of Jan. 1, 2015. If values have declined from the previous year, companies should start discussions with tax authorities to seek lower assessed values.
Most companies don’t have severance tax specialists, so the focus has often been on making sure payments are made on time and penalties are avoided. Companies should carefully review whether all possible exemptions are being taken.
Income and franchise taxes
Because of the nature of taxation within the energy industry, producers don’t always receive large income tax bills. That’s not necessarily true of service companies, which may have made substantial income tax payments in more profitable years. It could be worthwhile for companies to review previous tax returns for refund opportunities.
General tax issues
One of the most important issues for mid-tier companies — especially service companies — is whether they are filing in all the required states. It would be easy for a company to start doing business outside of their home state without fulfilling all the tax responsibilities in these new locations. It’s critical for operations to inform the accounting/tax function of all the states where the company is doing business so that additional taxes and filing requirements can be handled correctly, and tax penalties can be avoided.
Another strategy that companies should consider is simplifying their entity structure and streamlining their administrative and tax functions. Over time, the number of legal entities under which a company does business can mushroom. For organizations operating under several entities and filing in numerous states, the number of tax returns can climb into the hundreds. Besides reduced administrative costs, combining entities may offer tax benefits, such as the immediate offset of profits and losses as opposed to the buildup of net operating losses.
A smart SALT strategy may ease the pain of dismal pricing
The sharp decline in oil prices presents energy companies with substantial operating challenges. The fundamentals of the U.S. oil and gas industry remain strong, and pricing should firm as demand increases and production declines. As they work to shore up cash positions, energy companies should avoid making hasty layoffs in the SALT area that could cost the company more in administrative errors than it would save in compensation. Indeed, SALT presents companies with opportunities for generating cash through the recovery of overpayments. In managing the SALT function, producers may seek out external tax providers for help in reducing their tax bills, identifying areas of underpayment with significant exposure, and negotiating with state auditors.