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Try, try again

The politics aren't favorable, but the facts say a 2008 compromise didn't put a big enough severance tax on natural gas production.



Remember when the legislature and Governor Beebe, in the spring of 2008, solved a big part of Arkansas's highway funding problems by enacting the first serious tax on natural gas production in 60 years?

How did that turn out?

Not so well, obviously. The state Highway Commission and its good-roads constituents are back lobbying for a big road-building program when the legislature convenes in January — either new motor fuel taxes, the reassignment of some existing sales taxes to the highways or a new sales tax, any of them pledged to back highway bonds.

Receipts from the gas severance tax, 95 percent of which go to highways, roads and streets, are running barely more than half the amounts that were forecast in 2008, and there is a fresh recognition that while natural gas production has exceeded the forecast, the tax receipts will probably never come close to matching the forecast. Wellhead prices for gas have slumped the past 18 months because the recession has reduced demand and because drilling in other shale plays besides the Fayetteville shale from the Adirondacks to the Rockies have filled pipelines and storage with an overabundance of gas.

But the depressed market and prices are not the only reasons that tax revenues for the highways have fallen so far short of the predictions of that fall, when Governor Beebe told highway advocates that the severance tax would produce far more than the $100 million-plus a year that had been predicted.

The tax law, which was written by gas industry lawyers and rushed through the legislature in three days, is full of holes. Not much gas is actually taxed at the law's stated rate of 5 percent of the wellhead price but at 1.5 percent or even less. The tax bill was drafted to exempt most gas from the 5 percent tax and also to bluff the legislature from ever trying to amend the provisions to make the tax more productive. The act says three-fourths of the both houses of the legislature will have to vote to increase the tax on any gas, although that plainly violates the state Constitution. The tax can be raised to 2.6 percent of the market price by a simple majority vote. That was the tax rate when the Constitution was amended to require a three-fourths vote to raise any tax rate above its 1934 level.

So the Highway Commission is back seeking another big source of money for road building and maintenance. Revenues from motor-fuel taxes, the main highway-funding source, have been flat or declining for six years.

The Blue Ribbon Committee on Highway Finance, which has recommended a big highway program to the governor and legislature, has floundered in its search for some plan that Governor Beebe would embrace or that might eke through the more conservatively entrenched legislature. Its members have talked about raiding general revenues, levying a new sales tax or increasing the gallonage tax on motor fuels in some way that would not trigger the Constitution's three-fourths vote requirement to pass most tax increases.

The reactionary political climate, put in stark relief in the general election this month, makes all of those options remote. With a legislature dominated by freshmen, most of them pledged to vote against all taxes, the prospect of passing a tax program of any size, much less one of the magnitude the Highway Department says it needs, seems preposterous.

Could the natural gas severance tax still be the solution?

Sheffield Nelson thinks so. Nelson, the former president of the state's largest gas distribution company, engineered the severance tax law in 2008 by starting a petition drive to put an initiated act on the ballot that would tax natural gas production at the rate of 7 percent of the wellhead price, the same rate as Texas, the nation's No. 1 producer of gas. When Beebe, at the urging of the gas industry and business interests, called a special session to levy a smaller tax, Nelson dropped his initiative effort and supported the Beebe and industry bill.

But Nelson says it is time to make a stab at a real severance tax.

The state needs a big infusion of road revenues, Nelson said this month, and the need is magnified by the immense destruction of roads in the swath of counties in the shale play. Gas producers who are reaping healthy profits from shale exploration, not everyday road users, are the ones who should pay in Nelson's estimation.

Unlike most other business taxes, a production tax cannot be passed on to consumers because it is not sold directly to the distributor. The tax has to be borne by the producer and, to a small extent, by royalty owners.

But no matter if the tax wouldn't raise consumer prices, the legislature is not apt to pass a severance tax, even one calibrated to pass with a simple majority in both houses. The General Assembly will include 44 Republican House members and 15 Republican senators, nearly all committed to vote against taxes. In that case, Nelson said, he might push again for an initiated act that would produce a better stream of revenue.

He did not regret striking a deal with Beebe to withdraw his initiative petition, and he said the governor deserved credit for passing even the anemic act that taxes gas at a rate far below that of nearly every other gas-producing state. But the state must do better, he said.

If Nelson starts an initiative petition calling for a flat tax of 5 or 7 percent it might produce a reprise of Beebe's 2008 campaign to raise a smaller tax. But he almost certainly could not corral 75 votes in the House and 27 in the Senate in the new legislature.

From 1947 until 2008 Arkansas left natural gas production virtually untaxed. While other energy-rich states like Texas, Oklahoma and Louisiana were taxing production at rates of 5 to 7 percent of market prices, with some exclusions, Arkansas taxed it at the rate of three-tenths of a penny per thousand cubic feet (mcf). In 1996, when Arkansas gas production peaked at 225 billion cubic feet, the state reaped only $673,000 from the severance tax. At Texas's rate and at 1996 gas prices, it would have produced nearly 100 times that amount that year — about $60 million.

Arkansas had not always taxed gas production so weakly. The first tax on the harvest of natural resources in 1923 taxed most minerals, including gas, at the rate of 2.5 percent of their cash value, and that was raised in 1927 to 2.6 percent.

Why the legislature nearly abolished the tax on gas in 1947 is not clear. Gov. Ben T. Laney wanted to raise revenues in his second term by increasing taxes on liquor, cigarettes, incomes and minerals. Taxes on most minerals were raised — he lifted the tax on oil, the source of his personal wealth, from 2.6 percent to 4 percent — but when the bill exited the legislature the price-based tax on natural gas had not been increased but repealed altogether and replaced by the invisible rate of 3/20ths of a penny per mcf. (It was raised to 3/10ths of a penny 10 years later.)

More than likely the gas tax cut was the work of W. R. "Witt" Stephens, who had acquired Arkansas Oklahoma Gas Co. two years earlier and was about to embark on acquisition of a dominant interest in gas exploration and distribution in the region. He had already invested heavily in political influence. Stephens would thereafter squelch every effort to raise the tax, except the little increase that he permitted in Gov. Orval Faubus's modest tax program in 1957 from 3/20ths to 3/10ths of a penny per thousand cubic feet. Stephens considered any attempt to raise the tax on gas a personal affront.

If the tax had not been slashed just as gas exploration in South Arkansas and the Arkoma Basin in western Arkansas burgeoned, it would have provided a huge source of revenue the last half of the century, as it did in Louisiana, Texas, Oklahoma and Kansas.

From 1976 through 2008, the last year of the tiny tax, it produced a grand total of $16 million. If the tax had remained at the 1947 rate, 2.6 percent of market value, which was lower than other states in the region, it would have produced $546 million over that 33-year period. If the rate had been 5 percent, the average of other states, it would have produced $1 billion. At Texas's rate, it would have produced $1.4 billion.

Nelson, who succeeded Stephens as president of Arkansas Louisiana Gas Co. in 1972, defied the rest of the gas industry in 1983 by campaigning to increase the severance tax, but an effort by Governor Clinton, with Nelson's help, to raise the tax never made it out of a committee. Rep. Jodie Mahony of El Dorado, who sponsored the bill although his family had gas interests, later said he detected little effort by Clinton to pass the bill. It would have helped pay for school reforms.

When the new technology of horizontal drilling opened the Fayetteville shale play to exploration and high-production wells in the last decade, Nelson announced that he would direct a petition drive to put a 7 percent tax on the ballot in 2008. The prospect of the voters levying a stiff tax softened industry opposition to any increase. Gov. Beebe said he would call the legislature into special session to enact a more modest tax, one that still would require the three-fourths vote of both houses that had eluded Clinton. Nelson acceded and said he would abandon the petition drive if the legislature passed the bill.

A few legislators wanted to look at the bill before the session but were told that it was being touched up in downtown law offices. Beebe wanted a quick session and the bill was introduced on Monday and enacted on Wednesday, the shortest period allowed by the Constitution for enacting a law.

When the bill surfaced the first day of the session, it was a little more complicated than the explanations. The tax rate was to be 5 percent of the market price, minus the cost of dehydrating, treating, compressing and delivering the gas to the hub, but producers would not have to pay that tax on "high-cost" wells (all of those in the shale play) for three years so that they could recover the cost of drilling the wells and operating them. The tax rate would be 1.5 percent of market price for that period and even longer if a company said its drilling costs still had not been recovered after three years. The gas from new "discovery" wells also is taxed at 1.5 percent for two years.

For "marginal" gas, the tax rate is even lower: 1.25 percent of the market price after deducting the costs of treating and distributing the gas. Marginal gas is from a well that produces no more than 100,000 cubic feet a day in shale plays and 250,000 cubic feet a day in conventional vertical wells like those in South Arkansas and the Arkoma Basin of west Arkansas. (There are a few wells in South Arkansas that lie in the Haynesville shale play of Louisiana and Texas.)

Shale wells generally produce far more gas, at least in the first couple of years, than conventional wells, often more than 100 million cubic feet a month in the first year. A high-volume well may recoup the producer's investment in a matter of months, but the low tax rate will remain in effect for three years.

Production usually declines sharply over a well's first two years. A well that begins producing 106,000 mcf a month may be producing only 56,000 mcf a year later. When the 5 percent tax finally kicks in after three years, the volume of the state's tax receipts is usually pretty low. Before long, a well may slip below 3 million cubic feet a month and become marginal, in which case the tax drops to 1.25 percent. Most conventional gas wells are categorized as marginal.

The legislature could have raised the severance tax to a flat 2.6 percent of wellhead value and passed it with a simple majority of both houses, 51 votes in the House and 18 in the Senate, although it was never considered. It would not have required the deal making with production companies and lawmakers to reach the three-fourths majority needed to raise the rate to 5 percent, which did exceed the 1934 levy. And the flat 2.6 percent rate would produce far more revenue for the state than the 5-percent-law because it would not excuse most wells from the 2.6 percent tax.

The General Assembly this winter could amend the law to raise the tax on marginal gas from 1.5 and 1.25 percent to 2.6 percent by a simple majority of both houses, which would increase the severance revenues for the highways by half or more. The lawyers who drafted the 2008 bill anticipated such a prospect and inserted a provision saying that it would require a three-fourths vote to raise the tax on any category of gas. But it would have no effect. The legislature cannot change the Constitution by adopting a simple statute that says the Constitution doesn't mean what it says.

But it would take an earnest effort by Mike Beebe to get those 51 and 18 votes, and then he probably couldn't in the new legislature.

When Beebe told highway backers that the severance tax would produce far more than $100 million a year after that initial year, gas had been marketed at more than $11 an mcf.

But when he spoke, prices were already beginning to tumble as the national recession deepened in the last half of 2008. Commercial and industrial usage slackened. Adding to the price squeeze was the roaring production from new shale fields. Despite widening alarm over the environmental destruction from hydraulic fracturing, the process that penetrates shale to the gas, production was nearly doubling owing to exploration in the vast Marcellus shale play in the Appalachians and shale plays in Arkansas, Louisiana and Texas and in the Rocky Mountain states of Utah, Colorado, Wyoming and Montana.

Gas prices averaged $9.12 per mcf in 2008, but fell in 2009 to an average of $4.06 an mcf at the Henry Hub in Louisiana, the pricing point for natural gas contracts traded on the New York Mercantile Exchange. But the lower prices also made gas a far better value for electricity generation. Natural gas became cheaper than coal for many generators, and the demand by utilities partially offset the slack in commercial and industrial demand. Natural gas fired the generators for almost a fourth of the electricity produced in 2009.

So while a few production companies scaled back their budgets for shale exploration, drilling kept apace in 2009 and again in 2010 although prices often slumped even farther. Southwestern Energy Co. of Houston, Texas, which has an interest in 2,300 of the 7,400 gas wells producing in Arkansas, had an investment budget of $1.6 billion this year, most of it in Arkansas.

Gas production has continued to climb sharply even after prices fell off the cliff. Partly, it is because companies need to lock in the terms of mineral leases they signed in the boom days of 2006-2008, but production also remains highly profitable. In the first three months after the severance tax took effect in January 2009, gas production in Arkansas totaled 148 billion cubic feet. In the second quarter of this year it had climbed to 227 billion.

But the public's recovery from the vanishing resource was flat, and it isn't likely to improve.

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