Marginal and stripper wells: What tax breaks are available to low production oil and gas companies?

The fluctuations that occur in oil & gas prices can pose a large challenge for many oil and gas companies. After rising to near $120 per barrel in 2013, crude oil dropped sharply from 2014 through 2016, bottoming out below $30 a barrel in January 2016. Oil finally began to see an upward turn as 2016 continued, with a sharp rise to $50 a barrel in just a few months. In the last two years the price of oil has continued to gradually rebound to approximately $68 a barrel, where it rests today.

While the market dictates the price oil can be sold at, the costs to produce oil are largely constant, causing price fluctuations to massively affect upstream oil companies. Upstream refers to the companies that extract and produce oil and natural gas (E&P), as opposed to downstream companies, which buy crude oil from the upstream companies, refine it and sell it, and hence suffer little from fluctuating prices.

Many oil wells were hit hard by the low oil prices, especially small rigs and stripper or marginal wells. NWSA estimates there are over 770,000 stripper wells operating that contribute 11.3 percent of the U.S. oil production and 8.3 percent of U.S. gas production. The government has created incentives for these types of companies to keep operations running smoothly.

What is a “stripper well” or a “marginal well?”

The term “stripper well” is sometimes confused with the term marginal well, although they are technically different. A stripper well is, simply put, a well that produces a very low amount of oil or gas - see tax definitions in the paragraph below. A marginal well, on the other hand, is a well whose production costs are higher than the cost the business earns from selling the gas/oil at its critical point. Because of this, the well can only earn a profit when the price for oil rises above the critical break-even level.

Despite the difference, the terms are often used interchangeably by the government for tax purposes.

For tax purposes in Texas, an upstream oil or gas production company may generally qualify as a stripper well if it is:

• An oil well that produces a daily average of 15 barrels of oil or less over 365 days
• A natural gas well that produces a daily average gas level of 90 thousand cubic feet or less over 365 days

Does Texas provide tax relief for stripper wells?

The severance tax on the market value of oil produced in Texas is generally 4.6 percent. In 2014-2016, Texas faced a crisis in which many stripper and marginal wells found it unprofitable to extract oil and gas, and so the State of Texas finally stepped in to mitigate the situation by adding a tax break for every barrel of oil produced by stripper wells, of 25-50 percent. Unfortunately, this tax break no longer applies, as the law was set to only take effect if the oil prices of early 2016 continued for 3+ months, which did not happen.

The current Texas state tax laws do allow for severance tax relief, but only when the taxable oil price falls below $30 per barrel, or when the taxable gas price falls below $3.50 per mcf. Although these tax breaks may not take effect in the foreseeable future, they serve as a risk alleviation.

Federal vs. state tax credits for marginal wells

Federal marginal well tax credit: In 2004, Congress created a marginal well production tax credit amendment to the Internal Revenue Code that established a credit for existing wells. The purpose for the new credit tax policy was an intended safety net for marginal wells during periods of low pricing.

The tax credit looks out for the small guys. These are the well producers that typically produce a limited number of barrels a day. However, the credit is only available if commodity prices are below a certain threshold.

• The marginal well tax credit provides a $3-per-barrel credit for the production of crude oil and $0.50-per-1,000-cubic-feet (MCF) credit for the production of qualified natural gas.
• The credit is available for domestic production from a "qualified marginal well.”

For federal tax purposes, a qualified marginal well refers to a domestic oil well that produces an average of 25 or less barrels of oil per day. (Notice that this is a higher threshold than the state limit of 15 or less barrels per day.)

There is no limitation on the number of wells on which a taxpayer can claim the credit. To claim a marginal well credit, a taxpayer must own an operating interest in the well.

State incentives: In addition to the federal tax benefits, different states offer incentives as well. The Texas franchise tax, commonly referred to as the margin tax, is a state tax imposed on the gross margin of each taxable entity doing business in Texas. To qualify, there are two requirements that must be met by a Texas taxpayer a) the commodity price must meet the statutory threshold any given month and b) the well must be a qualifying well in the same month. If these two requirements are met, then taxpayers are able to exclude all revenue earned from the marginal well during the time in which it qualified.

Relief in real time

The reality is that oil and gas prices are going to continue to fluctuate. The good news is, there is tax relief, exemptions, and other incentives at the federal and state level for oil and gas producers.

If you are operating a stripper well or a marginal well, it’s extremely important to know the local tax breaks available to you.

For more information on this topic, or to learn how Baker Tilly oil and gas specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.