Tuesday, October 25, 2011

Advantages of Drilling Your Own Well

Oil and gas law in the State of Texas operates under the rule of capture as the fundamental law governing the rights of landowners owning petroleum in a common reservoir. It is settled law that landowners absolutely own all of the oil and gas in place under their land.

Farmout, Joint Venture, Working Interest Provides
Tax Benefits For Landowners 

Direct participation in oil and gas development by either JV, joint operation, farmout, or having a working interest can generate several tax benefits for landowners. By deferring a large up-front bonus payment, common to a Paid Up oil and gas lease, in favor of direct participation, generous tax benefits can flow to landowners from directly participating in the drilling of a well. Some landowners find the large up front deductions for intangible drilling costs (IDC) and tax credits for the development of certain types of tight sands and shale formations to be more attractive. The IRS allows deductions for the cost of equipment and/or services used during the drilling, testing, fracking, and/or completion of the well.

Direct participation through Farmout, Joint Venture or other Working Interest in a well offers the following tax benefits.

Intangible Drilling Costs (IDC): The cost of drilling a well can usually be deducted immediately. The cost of labor, drilling rig time, drilling fluids, fracking services, etc. are intangible expenses deducted against the tax bill. Intangible drilling cost represent 60 to 80% of the total cost of the well. intangible Drilling costs is generally taken as a deduction in the tax year in which the intangible costs occurred.

Intangible Completion Costs: As with IDCs these costs are generally related to non salvageable completion costs, such as labor, completion materials, completion rig time, fluids etc. The deduction for intangible completion costs are usually about 15% of the cost and generally taken in the year they occur.

Depreciation: That part of the cost of the well associated with equipment, such as the well casing, Christmas tree, storage tanks, pumps, etc. are usually depreciated over a seven year period.

Depletion Allowance: Some say depletion allowance is the mother of all tax breaks. Once a well begins production, the IRS allows owners of the well to shelter some of the gross income derived from the sale of the oil and/or gas. Two types of depletion are available, cost and statutory (also referred to as percentage depletion). Cost depletion is calculated based upon the relationship between current production as a percentage of total recoverable reserves. Statutory or percentage depletion is subject to several qualifications and limitations. This deduction generally shelter's 15 per cent of the well’s annual production from income tax.

Tax Credits: The US Congress passed laws granting several tax credits to crude oil or natural gas production. Enhanced Oil Recovery legislation grants tax credits when applied to certain project costs incurred to enhance production from a oil or gas well. The credit can be 15% of the costs directly incurred to enhance production. Another generous credit is the Non Conventional Source Fuel Credit which provides for a $3 per barrel of oil equivalent credit for production from the so called qualified fuels. Qualified fuels include oil shale like the Eagle Ford, other tight formation gas, and fuels made from coal.
Lease Operating Expense: Day to day operational costs involved with the operation of a crude oil or natural gas well also offer tax deductions. The expense deduction also covers the costs of re-entry or re-work of an existing producing well. Lease operating expenses are generally deductible in the year incurred, without any AMT consequences.


It should be entirely obvious by now that the tax benefits of participating in a oil or gas well on your property generates substantial tax benefits. In a nutshell, oil and gas risk capital has the effect of being subsidized by the government resulting in greatly reduced federal income tax. Some people say that oil and gas exploration and production uniquely offers a bonanza of tax benefits not seen in any other business enterprise. Intangible drilling cost is very significant and by taking this deduction it mitigates greatly against the loss of any lease bonus money from a oil and gas lease agreement. I am not an accountant and I encourage everyone to consult with their own tax adviser in regards to the information provided herein.