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Taxing Debate

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In the debate about how to tax the state's emerging natural-gas industry, choices made in the next month may well shape the state's budget -- and its landscape -- for decades to come.

This summer, the state legislature passed a budget bill pledging that by Oct. 1, the state would have a severance tax on natural gas.

"It is absolutely essential that the severance tax we enact pay these host municipalities their fair share," Gov. Ed Rendell said when signing the budget bill that included the promise.

The state has no such tax now, and there's little agreement on what a "fair share" would be. Depending on how it's structured, the severance tax could either allow gas companies to take the money and run, or prohibit them from drilling here at all.

The stakes are huge: The gas in question, stored more than a mile below ground in a layer of rock known as the Marcellus Shale, could result in thousands of wells being drilled all across the state.

Rendell's proposal -- 5 percent on the value of the gas, plus an additional 4.7 cents on each thousand cubic feet removed -- is based on the severance tax charged in West Virginia. But as City Paper reported two weeks ago, the industry has its own ideas of fairness. A memo circulated by the Marcellus Shale Coalition, which represents drillers, supports the 5 percent rate -- but only for a fraction of a well's life.

Under the Coalition's proposal, drillers would pay a tax of just 1.5 percent for the first five years a well operates. Older wells -- those producing less than 150,000 cubic feet of gas a day -- would be deemed "marginal" wells, and taxed only at 1 percent. Wells producing less than 90,000 cubic feet a day would be exempt from the tax entirely.

The industry says that it needs to be able to recoup the cost of drilling its wells upfront -- while taxing low-production wells would make them unprofitable, forcing them to close with gas still in the ground. Some legislators are receptive.

"The cost of drilling a well is somewhere around $3 or $4 million. The idea they want to recoup that money a bit quicker is understandable," says state Sen. Gene Yaw (R-Williamsport).

Gas drillers have been active in Yaw's district, and he says the economic benefits could easily make up for the tax break. "Farmers who were struggling are much better off" after signing leases to allow drilling on their acreage, he says. Meanwhile, "You can take everybody from barbers to laundries who are seeing the benefits" of gas drilling. States like Texas already offer similar breaks, he notes: "We're not doing anything new here."

Such concessions would be a huge boon to the industry. How large? It's hard to say.

Gas wells are most lucrative early in their operation, with gas production dropping sharply in the first five years, and then ebbing far more slowly over the course of decades. The Coalition is looking for breaks on both ends of that curve -- during the short period when production is highest, and the much longer period when production dwindles.

Michael Wood, the research director at the Pennsylvania Budget and Policy Center, has tried crunching the numbers on just how much that would cost. Based on similar shale formations elsewhere, he estimates the average Pennsylvania well would produce a little less than 1 billion cubic feet of gas over 40 years. And it would be paying the full 5 percent tax for just eight years of that.

In years one through five, the industry would be paying the discount 1.5 percent rate. In year 14, he estimates, production would drop below the 150,000 cubic feet level, being taxed at 1 percent until year 19, when production would drop below the Coalition's proposed threshold for paying zero tax.

Once you factor in the exemptions, Wood says, "The effective tax rate ends up being a little less than 1 percent over the life of the well." That is, obviously, far less than the 5 percent Rendell has proposed. Multiply the discount by 30,000 wells the industry may drill, Wood says, and it could cost the state a total of $5 billion in revenue -- depending on the price of gas and other factors.

The Coalition declined to respond to Wood's projections. And he acknowledges that the real numbers could vary sharply from his estimates. If, for example, the average well contained 2.5 billion cubic feet of gas -- more than twice the size of his hypothetical well -- the effective tax rate would be 2.3 percent. That's because more gas will be produced in the years with a 5 percent rate.

Such variables are why state Rep. David Levdanksy (D-Elizabeth) favors a flat tax of 35 to 40 cents for every thousand cubic feet of gas removed. (The price could be adjusted if the price of gas changes.) Charging a flat rate on the amount of gas taken from the ground, he says, is much simpler than basing it on the sales price of the gas.

"How does the industry calculate the value of the gas?" asks Levdanksy. The Coalition memo, for example, argues that the cost of processing and transporting the gas should be deducted from the tax bill: Trying to factor in such considerations "adds a huge amount of complexity."

In fact, it's hard enough just estimating how much gas there is -- and how much has already been drilled out. Until recently, the industry has kept its production data under wraps.

Production levels "are pretty well shrouded," says Penn State geosciences professor Terry Engelder. The information has been proprietary. "It's like a gold rush," Engelder says. "When someone discovers gold, what ruins your play is telling someone who can pick it up before you can." But the secrecy means that researchers can only make educated guesses about how much gas there really is underfoot.

Engelder guesses there's a lot. In a 2009 paper, he predicted that "this gas shale bonanza" would reshape energy policy for "several decades." Still, he acknowledges that without better data, when he makes these estimates, "I'm a blind man" taking "shots in the dark."

Well production totals are slated to be made public this fall. A state law, originally sponsored by Yaw, requires gas companies to supply state officials with data on gas production at each of their wells. That information will then be published on the state Department of Environmental Protection website.

But such information probably won't come in time to inform the severance-tax debate. Yaw's legislation set a Nov. 1 deadline for posting the material online -- one month after the legislature has promised to pass its tax.

Yaw says having production information might help guide the debate, "but only indirectly." Production information right now won't give much sense of the industry's potential, he says; wells are producing below capacity because "the pipelines aren't here to service them yet."

"Some people think a severance tax is going to generate hundreds of millions of dollars right away," he says. "But it's not going to generate the megabucks they think it will. Maybe five or 10 years down the road -- but we're going to need a lot of pipeline-building in the meantime."

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