The Downside of Energy’s Current Upside

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This article first appeared in the 2022 Minerals Business Report and Buyers Directory. 

Anyone involved with the oil and gas industry knows that the commodity price experiences its fair share of ups and downs. Over the last two years, that might be the single greatest understatement of all time. The industry has gone from low commodity pricing to negative commodity pricing to record high commodity pricing many times over in a 24-month period. Besides the obvious effects this instability causes in the industry, it creates issues that may not routinely be on leadership’s radar.

In today’s market, the pandemic has caused stress on supply chains across most industries. The oil and gas industry is no different. However, in oil and gas, the stress is even greater on the supply chain due to the surging commodity prices and demand for equipment and tubular steel. That stress has caused the prices of those items to go significantly higher.

While those facts are not going to be a surprise to anyone working in the industry, the impact on property tax bills that may arrive this tax year very well could be. Two of the most significant drivers of the valuations for property tax purposes are the cost of assets and the income produced by the assets. Both drivers are up significantly. While that trend has been going on in the world since early in 2021, it has yet to be fully seen in property tax valuations. However, you should expect that to change.

In the calculation of property taxes, there is a day that is referred to as the assessment date. That date is a snapshot in time used to decide the value of the assets for that tax year. For most oil- and gas-producing states, the assessment date is Jan. 1 of any given year.

Looking back to Jan. 1, 2021, the oil and gas industry outlook was still generally negative in nature. Oil prices had just begun to rise from the 2020 levels and were approximately $50. Natural gas prices were $2.70, not vastly different from the preceding few years. Demand for equipment and services was low, and the forecasted need was even lower. Capital expense budgets were being cut due to the loss of revenue. Fast forward to Jan. 1, 2022. Oil prices are approximately $90. Natural gas prices are $4.50, after reaching more than $6 during 2021. The demand for equipment and services is remarkably high. Capital expense budgets are increased. It is that delta and the timing of the assessment date that will directly affect the property tax liability for all sectors of the oil and gas industry. Each part of the value chain for oil and gas will be affected by the increased pricing and demand but not in an equitable manner.

The clearest example of the timing effect is found in the upstream sector. This is especially true in Texas. The property tax assessments for upstream assets in Texas are based on a discounted cash flow (DCF) formula. The formula is intended to estimate the fair market value as of the assessment date for the wells and related equipment. The calculation is tied to the present worth of the future income in the active producing zones. As a result, proved developed producing category reserves are the comparable measurement.

The average commodity price received in the prior year is the starting point in the calculation for revenue. That pricing is further adjusted based on Section 23.175 of the Texas Property Tax Code. That code section is intended to trend the prior year average price to a current market value through a series of calculations and comparisons.

Considering the price change alone in the DCF for the assets, the examples below are based on actual assessments to show the projected increase from tax year 2021 to tax year 2022. Notice that the relationship of the percentage increase in price to the increase in assessment is not direct. It may seem counterintuitive, but the largest percentage increases in assessment will be on the lower producing assets. This is due to the very marginal value calculated in tax year 2021 with lower pricing, compared to the same well and operating cost, at much higher pricing.

The 2021 property tax payments paid by companies in Texas were based on the 2020 average price trended, which was approximately $45 for oil and $2.25 for natural gas. During the year, the actual prices received averaged approximately $71 for oil and $3.79 for natural gas.

While there are natural swings in valuations using income information each year, 2022 is a tax year that companies need to prepare for in their cash management and accrual processes. The timing of the changes in commodity price in 2021 worsens the situation for one of the most common methods that companies project their annual property tax liability. That approach calculates taxes as a percentage of income in the prior year and applies that percentage to the current year to predict liability. That approach normally supplies a conservative, predictable result. When 2022 is calculated in the same manner, the result will be skewed by timing of the price change. It’s interesting that on the assessment date in 2021, the outlook and pricing was quite different from what ultimately occurred. The illustration below shows the impact of the timing of the price change to estimated taxes.

If the 2021 taxes as a percent of revenue is applied to the projected 2022 income, the accrued liability is understated by 53%. That type of variation between accrued liability to actual tax payment could be devastating to budgets and cash flow.

While there is downside to the upside of pricing, the impact can be mitigated. There is a difference between filing and processing tax payments in a timely and accurate way and actually paying on the asset’s accurate value. It is imperative that companies are initiative-taking and plan for the coming increased assessments. Qualified tax professionals, collaborating with the company accounting, engineering and operations groups, can affect positive results, effectively estimating and mitigating any increased liability. The illustration below shows the impact of the timing of the price change to estimated taxes.

The early identification of any valuation issues and prompt action are key to the process. Preventing overstated assessments from being incorporated into budgets helps the taxpayer and the taxing authority alike. If you let it, this could be a case of what goes up doesn’t automatically mean a down on your bottom line.

About the author: Daron Fredrickson is a partner with Merit Advisors LLC.