LIFO

When the drinks are flowing at the open bar, it's not a big surprise that patrons swarm for their free pints.  Tax bills are the same, with amendments aplenty as the hours ticked on towards the Senate passage of a massive tax reform package last week.  Hey, when you are spending somebody else's money and nobody has time to read what you are sticking in anyway, why not take a gander on a nice payout for your district friends?

Here's a rundown of a few energy-related items of interest in the tax bill.  The Senate version, with hand markups and all, and run through OCR so you can search it, can be accessed here.

1)  Wildlife reserves are for drilling 

Tax bills aren't just for taxes, and wildlife reserves aren't just for wildlife.  After decades of trying, the Senate moved to open the coastal areas of the Alaska National Wildlife Refuge (ANWR) for oil and gas exploration and leasing (see Title II, page 474) of the bill.  

Some background on the remaining hurdles and not so great economics of oil and gas in ANWR are found in this useful piece by Oil Change's Andy Rowell.  Analysis I did with the Stockholm Environmental Institute looking at field-level data across the US also indicated these areas well below breakeven at current market prices. 

No such ambiguity about the move can be seen from Alaska Senator Lisa Murkowski though.  She fought hard for this change and believes it'll bring great wealth even if scientists and economists don't.  But other short-term factors are also driving this decision.  First, Alaska's budget remains heavily dependent on oil and gas revenues -- something that aging fields and falling prices have hurt.  Second, the Trans-Alaska Pipeline System (TAPS) needs more product to keep the unit costs low and the infrastructure maintained.  Indeed, it turns out that getting flow from ANWR was a core assumption when it was designed.In his extensive article on the role of boosting flow in pushing for drilling in ANWR, Philip Wight notes that "In 1970, M.A. “Mike” Wright, the CEO of Humble Oil (soon to be renamed Exxon), delivered extemporaneous remarks to a government task force and offered a rare glimpse of the oil industry’s plans for Arctic development. Wright explained that the industry committed to a 48-inch-diameter pipeline in part because it anticipated drilling offshore in the Arctic Ocean and restricted onshore areas, including the Arctic National Wildlife Refuge. Production from these areas would be necessary to realize the pipeline’s optimum daily flow. Wright’s statements were not only the first public announcement that the oil industry wanted to drill in ANWR, but a revelation that the pipeline’s design was intimately tied to extracting oil from it."   And boosting the flows will reduce unit costs, reduce operating costs (low flows in a massive diameter line cost more to keep moving), and boost confidence in continued service to existing fields that would be stranded were the line to close.  One final benefit of keeping TAPS running:  pipeline operator Alyeska can continue to defer its responsibility (and associated cost) to dismantle the pipeline and clean up the right-of-way. 

Oil revenues are easier to measure than fish and wildlife values, and there is quite a bit of wildlife in the areas being opened for drilling.  Audubon magazine notes the region being opened has the highest biological diversity for any protected area above the Arctic Circle.

Look for low realized values on the lease sales due to a low price environment, remote and expensive fields, and a high risk of delays from court challenges.  Expect state or federal subsidies to infrastructure, perhaps combined with weak financial assurance requirements for the drillers to spur deals along.  And finally, expect some spills and other damage to natural resources.  All will erode the net gains to the state from this move.

But in the arcane rule of budgets, all that counts is the gross gain to Treasury from the sale of a natural resource, resulting in net offsetting receipts of $1.1 billion according to CBO.  Not much in the context of an increased deficit of $1.5 trillion, and even this low value treats as zero the damages to natural resources or other property values.  But that, unfortunately, is how this rather bizarre world operates.

2)  Strategic reserves are for selling (to help offset continued subsidies to hedge fund managers)

The very last section (Section 20003) of the Senate bill authorizes the sale of $600 million of oil from the Strategic Petroleum Reserve in 2026 and 2027.  This is a very small amount of money at the very end of the scoring period for this bill. Yet, it does help a bit to offset some of new tax subsidies in the bill.

How's it relate to hedge fund managers?  Because the Senate instituted a 3 year holding period (up from one) on private equity and hedge fund carried interests, boosting revenue by only $1.2 billion over 10 years.  Had they instead eliminated carried interest subsidies altogether, tax revenues would have been increased by $16 to $180 billion over the same period.  

Not making the hard decisions leaves the Republican Senators using a combination of gimmicks, like selling oil from SPR starting in 9 years -- and simply running up the debt -- instead. 

3)  Tax-favored status on pass-throughs confirmed to apply to MLPs 

Pass-through entities escape corporate level taxation, but historically were taxed at the individual level based on the economic situation of the individual partner.  Many of these partners are wealthy and taxed at the highest marginal rates.  They don't like this.

The House bill caps the individual rate on income from pass-throughs at 25%.  The Senate bill instead allows up to 23% of expenses to be deducted from taxable income, with a similar effect on the effective tax rate.  Earlier versions of the Senate bill capped deductions at 17.5%; boosting it to 23% increased the revenue loss by $114 billion (to a total of $476 billion) over the 2018-27 period.JCX-62-17, p. 1; and JCX-59-17.

A last-minute amendment sought to expand this benefit to both MLPs and to financial PTPs such as Blackstone.  Only the first got through -- though it's a big one.  It further extends the tax subsidies on offer to oil and gas MLPs by reducing the taxes even the partners have to pay.

I remain unclear as to whether even the financial MLPs are fully frozen out of this new subsidy.  To the extent their energy investments are organized as limited partnerships within the larger PTP, income would flow out of the investments both to the parent company (and those invested in the traded shares) and directly to the limited partners who have bought into the individual investments or investment funds.  For this latter group, my assumption would be that the lower tax rate would apply.  Please email if you know the definitive answer on this. 

4)  LIFO no more for Grandaddy; but still available for ExxonMobil  

Any tax rules that enable taxpayers to deduct a higher proportion of their expenses more quickly generates a financial benefit on a time-value-of-money basis.  Inventory turns out to be important in this way.  Firms usually have many identical products in their inventory -- whether barrels of oil or computers.  When they sell a product, they deduct the cost of that product (via cost of goods sold) from revenues in order to calculate the taxable income.  The costs of that product are not identical over time:  commodities may change sharply in value over the inventory turnover cycle; and during periods of inflation costs across all sectors can change quickly.  The freedom to deduct the highest COGs sooner can greatly reduce near-term taxable income.

Historically, firms could choose whether to deduct the costs of each sale based on the COGS for the oldest item (or barrel of oil) still in inventory (FIFO, or "first-in, first-out"); or select more recent costs if those were higher (LIFO, or "last-in, last-out").  This same logic applied to people's stock portfolios.  It Grandad bought 400 shares of Apple Computer for $10 share (split-adjusted) back in 2006, and another 400 shares at $115 each back in 2015, and he needed to raise cash to pay for home repairs, he could decide which "inventory" to sell from.  Selling the 2006 shares would generate a much larger capital gains tax cost than selling the 2015 shares; the tax cost would drive which shares he picked. 

Too bad for Grandaddy:  the bill the Senate passed (section 13533) removes this choice and requires that whatever shares were purchased first get applied to any sale (first-in-first-out).  Taxes for him, and millions of other individual investors will rise.  Investors in mutual funds could be particularly hurt. 

No such constraints are being put on the oil industry -- even though the International Financial Reporting Standards (IFRS) have not allowed LIFO for many years.  Though pressure has been building for the US firms to comply with international standards, for now LIFO is still allowed in corporate accounting.  US accounting rules do require firms to track the difference between the first-in-first-out method required internationally and the tax-favored LIFO approach via a line item called the "LIFO Reserve."  This data allows one to see which firms and industries are benefiting most from LIFO accounting:  the bigger the reserve, the more the firm is saving.  Privately-held firms can also benefit from this, but there is no public data to see the resultant amounts.

Available data illustrates that some of the biggest beneficiaries of LIFO are the oil industry.  Using data from Moody's Investor Services, CFO Magazine estimated that in 2010, that two thirds of the LIFO reserve for the energy sector was ExxonMobil alone; and that the energy sector comprised 37% of the total LIFO reserve for all public firms.

More recent data on the energy sector shows that the beneficiaries of LIFO are highly concentrated, still dominated by Exxon Mobil (see Table 1).

Table 1. LIFO Reserve (2008-2015) in Millions

With pressure building in Congress to strip out at least the most obvious subsidies to oil and gas, Taxyapers for Common Sense has released a new tally of some of the major ones.  The report is useful in providing updated cost estimates, and for going beyond the narrow set of provisions that the legislation has targeted.  For example, they pick up the billions in losses due to negligence by the Minerals Management Service in structuring lease contracts for 1998 and 1999 that resulted in taxpayers getting no royalties at all for massive quantities of oil and gas in the Gulf of Mexico. 

There are some areas where I disagree with how provisions are characterized, however.

VEETC.  The single largest subsidy tagged in the report is the volumetric ethanol excise tax credit.  The arguments I've seen presented to include this as a subsidy to oil rather than to ethanol have been that (a) the subsidy is paid at the point of blending, and the blenders are often oil companies; and (b) the subsidy is totally unnecessary since blenders would have been required to use the ethanol anyway under the Renewable Fuel Standards (RFS).  The RFS mandate use of pre-set levels of ethanol in the nation's motor fuel supply. 

Both arguments are inaccurate.

• Regardless of what point in the value chain the credit is earned, it is earned only for using ethanol and skews markets towards this input rather than other blending agents or fuel extenders.  The economic incidence of any subsidy (who ends up with the improved economic returns) often differs from the point of payment, and often shifts over time as the relative market power of different parts of the value chain shift.  But the policy clearly provides government payments for using ethanol, not oil.  
• It is true that the tax credit and the RFS are, indeed, duplicative.  But this duplication plays out through the price system.  The larger the tax credit, the lower the incremental cost (as measured by the trading price of a compliance unit under the mandate called a "Renewable Identification Number" or "RIN") will trade for.  Proper accounting for ethanol subsidies would be the sum of subsidies under the RFS and the credit (plus other policies as well).  All of these support the use of ethanol.  But the existence of dual systems merely means the full subsidy cost needed to reach the mandated level of consumption is split between taxpayer costs (through the credit) and consumer costs (through RIN prices pushed through into fuel prices).  It does not mean that the entire credit is a windfall to oil companies.

LIFO.  Last-in first-out accounting is one of a range of inventory accounting methods allowed to all industries under US law.  During times of rising prices (including those due to inflation), LIFO approaches result in higher near-term tax deductions.  During times of falling prices, first-in last-out (FIFO) results in higher near-term deductions.  With flat prices it doesn't matter much.  Over a longer period of time, the tax impacts of large past price surges begin to subside.

Thus, during a run-up in oil prices LIFO will provide large benefits, but if prices stay high for awhile the benefits to the Treasury from banning LIFO will diminish because more and more of the investory will have been procured at the new, higher prices.  Estimates of the tax savings from eliminating LIFO in oil and gas were done during a time of rising prices, and reflected the time window during which the changes in tax revenues were highest.  However, this is a short-term surge, not one that will result in continued higher revenues, year-in and year-out.  In constrast, overdue reforms such as eliminating the silly percentage depletion rules would generate recurring subsidy reductions.

LIFO may well fall in order for the US to comply with international accounting standards (which bar LIFO), but I don't consider it a subsidy to any one sector today.

The other two "general" tax subsidies TCS listed were the Manufacturing Tax Deduction for Oil and Gas Companies and Deductions for Foreign Tax Credits that are really related to resource payments.  I believe there are strong arguments for at least substantial portions of both of these programs to be counted as subsidies to oil and gas, and would actually favor including that portion within the primary list of subsidies to the industry (TCS has included these in a separate table).  More on the Manufacturing Tax Deduction here.

The TCS report did not cover all subsidies to oil and gas.  Among those left are large subsidies to bulk transport of oil via our inland waterway system, subsidized financing and operation of the Strategic Petroleum Reserve, oil defense, a variety of other accelerated depreciation provision for oil and gas infrastructure, and massive shortfalls in fuel tax collections to finance the nation's interstate highway system.  Thus, I expect that even with the adjustments noted above, the aggregate subsidy levels to oil and gas would be higher, not lower, than what they have reported.