Taxes and Non-Renewable Resources: The Impact on Exploration and Development

Abstract

Oil & gas projects consist of a series of options. The mineral owner must first decide whether to spend money on "exploration" in order to learn the extent of potential reserves, the cost and timing of recovering the reserves, and the probability that the reserves are actually recoverable. The mineral owner holds an "exploration option" since the owner need not explore immediately but may wait until an increase in mineral prices makes the potential rewards from exploration more promising. After exploration of a property, the owner holds a "development option." The owner may pay to drill a test well to see if the reserves are recoverable, or the owner may put off any such test until prices are higher. If the test well proves there are recoverable reserves, the owner has a "production option." This option consists of the ability to complete the test well as a producer, and to drill and complete any other wells required to completely drain the recoverable reserves. The incentives for exploration, development, and production depend on the "threshold prices" at which an investor will execute each option. This article examines the impact of various tax policies on exploration and development threshold prices, using a simplified production model that collapses the production option into the development option. Capitalizing rather than expensing development costs (such as intangible drilling costs) creates incentives to do projects that have a lower probability of success, that have shorter well lives, and that have lower development costs. This shift in incentives creates a nonneutrality, causing investors to develop some properties prematurely while unduly delaying the development of other projects. Capitalizing development costs also causes a slight increase in the exploration threshold price and therefore reduces exploration. Capitalizing rather than expensing exploration costs (such as the costs of seismic analysis to detect potential underground deposits) results in a more complicated pattern of effects. This policy causes a large increase in the exploration threshold price, thereby reducing exploration. Since the taxpayer will not recover capitalized exploration costs until development, this policy also reduces the cost of development and lowers development threshold prices. As a consequence, capitalizing exploration costs results in more intensive development and production of known reserves as well as reduced exploration. This pattern is undesirable if the goal is to enhance national security by encouraging the creation of a pool of reserves that are available for immediate exploitation in case foreign supplies become unavailable. It also is possible that taxpayers may be able to circumvent most of the impact of rules requiring capitalization of exploration costs by strategically realizing losses. This possibility may blunt the undesirable national security impact of such rules, but the costs of the associated trading are social costs that would not arise under expensing.