U.S. Energy Policy, Intangible Drilling Costs (IDCs) and Income Tax Deductions

Since 1913, the intangible drilling costs (IDC) tax deduction has allowed oil and gas companies to obtain capital for the huge risk of exploring and developing new locations of oil and gas. This tax deduction is critical when it comes to providing an incentive for oil and natural gas companies to continue to explore and develop new sites for oil and gas. For tax purposes, IDCs get special treatment. Usually, costs that benefit periods in the future must be capitalized and recovered over those periods as opposed to being expensed in the period they are realized.

Under the special rules, an operator or working owner can either expense or capitalize these costs if they pay for or incur IDCs in association with the exploration and development of gas or oil on property located in the U.S. IDCs include all payments made by an operator or working owner for wages, fuel, repairs, hauling, supplies, drilling or development work done by contractors under any contract which is necessary for the drilling of a well including drilling, shooting, cleaning, clearing, roads, surveying, geological work, and in the construction of tanks, pipelines, and any other physical structure necessary for the drilling and preparation of the well which are incidental and necessary to the drilling and preparation of a well for oil and gas.

If elected to expense these items, the owner or working operator deducts the amounts of the IDCs as an expense in the taxable year the cost is paid or incurred. If IDCs are not expensed but capitalized, they can be recovered via depreciation. If the well is dry, the IDCs can be deducted.

The ability to expense IDCs is critical for the exploration and development of new sources of oil and gas. Natural gas and oil is a key component with respect to U.S. demand for sources of energy. Currently the Obama Administration wants to repeal the expensing of IDCs.

This could crush the domestic U.S. oil and gas industry.

There would no longer be any incentive for small to medium sized oil and gas companies in the U.S. to explore and develop new wells. Moreover, the repeal would essentially wipe out millions U.S. jobs associated with this industry at a time when many state governments are bankrupt, unemployment levels are high and revenues for state governments and the federal government are declining.

In addition, some estimates have indicated that a repeal of IDCs could wipe out $3 billion of U.S. business investments in oil and gas development and exploration at a time when the U.S. needs these types of investments. Moreover, a repeal of IDCs would destroy corporate financial value which would directly impact securities such as mutual funds as well as 401(k) plans or other retirement plans.

There is no doubt that America must develop alternative sources of energy including renewable sources but oil and gas remains a key ingredient for the U.S. energy policy including national security. Repealing the tax benefit for IDCs would put a significant dent in America’s security and ability to compete in a global economy during a severe economic downturn which does not appear to be showing any signs of quick recovery.