Statement of the Hon. Wes Watkins, a Representative in Congress from the State of Oklahoma

Mr. Chairman, I thank you for the opportunity to submit testimony today. I also applaud your efforts on holding this series of hearings on the effects of federal tax laws on the production, supply and conservation of energy.

As you know, I have always stressed the need for a national energy policy. The world is operating with a small supply of petroleum and the U.S. is facing tight natural gas supplies. We now depend on foreign nations for nearly 60 percent of the oil we use -- and that figure is growing rapidly. From 1986 to 1997 (before the latest price crisis) domestic oil production dropped by 2 million barrels per day–roughly 25 percent of 1986 capacity.

The fact is that the United States is now dependent on foreign countries--some who have unfriendly dictators--for the very life-blood (oil) of our Nation.

Now is the time to clearly address a national energy policy and build a program that is needed to meet future demand. I believe a clear national energy policy will stabilize the roller coaster energy prices and make the U.S. more energy self-sufficient.

It is very important to recognize that the domestic oil and natural gas industry has changed significantly over the last fifteen years. Independent producers of both oil and natural gas have grown in their importance. They account for 85percent of the wells drilled in the U.S., produce 40 percent of the oil–60 percent in the lower 48 states onshore–and produce 65 percent of the natural gas.

Tax incentives are critical to help the energy economy survive the peaks and valleys of energy prices. Because oil and natural gas exploration and production are capital intensive and high-risk operations that must compete for capital against more lucrative investment choices, much of its capital comes from cash flow. The federal tax code is a key factor in defining how much capital will be retained.

Therefore, I believe we must enact provisions designed to encourage new production, maintain existing production, and put a safety net under the most vulnerable domestic production–marginal wells.

I have authored and cosponsored legislation in the past that is designed to preserve production of independent oil and gas producers’ marginal wells, and to protect this high-risk sector of the economy from volatile world price fluctuations.

Two fundamental tax incentives are the suspension or elimination of the net income limitation on percentage depletion and the marginal well tax credit.

The net income limitation severely restricts the ability of independent producers to use percentage depletion, particularly with respect to marginal wells. Percentage depletion is already subject to many limitations. First, its allowance may only be taken by independent producers and royalty owners and not by integrated oil companies. Second, depletion may only be claimed up to specific daily production levels of 1,000 barrels of oil or 6, 000 Mcf of natural gas. Third, depletion is limited to the net income from the property. Fourth, the deduction is limited to 65% of net taxable income. The net income limitation requires percentage depletion to be calculated on a property-by-property basis. It prohibits percentage depletion to the extent it exceeds the net income from a particular property.

This provision is extremely important for marginal oil wells. These wells account for approximately 20 percent of domestic oil production. The U.S. is the only country with significant production from marginal wells. Once wells are plugged, it becomes nearly impossible to reclaim the remaining oil or gas. Eliminating the net income limitation on percentage depletion would encourage producers to keep marginal wells in production and enhance optimum oil and natural gas resource recovery.

As you know, I worked to include a two-year suspension of the net income limitation on percentage depletion in the Taxpayer Relief Act of 1997. The suspension has been extended through 2001. We must act to extend or eliminate the suspension before it expires at the end of this year.

To help preserve our domestic production and energy security, we must create a counter-cyclical marginal well tax credit. Essentially establish a sliding scale tax credit that kicks in for marginal well producers when prices are low, as they were in 1998 and 1999. A marginal well is defined as an oil well producing less than 15 barrels a day or a gas well producing less than 90 cubic feet per day. The tax credit would be phased in and out in equal increments as prices for oil and natural gas fall and rise. The tax credit will protect during down turns and helps marginal wells to keep producing during low price cycles.

In addition, two other tax incentives allow taxpayers to expense (a) delay rentals and (b) geological and geophysical expenses. Delay rental payments are contractual payments made by an oil and gas producer to the mineral owner in the event mineral production is delayed. Geological and geophysical ("G&G") expenses are costs incurred by an oil and gas producer for the purpose of obtaining and accumulating data that will serve as a basis for the acquisition and retention of oil or gas properties. In both cases, these are out-of-pocket expenses incurred by taxpayers in the oil and gas drilling business.

Again, I thank you for this opportunity to testify before your subcommittee. I look forward to working with you and the Committee to structure the Federal tax code so it encourages increased domestic energy production; therefore, as a Nation, we can declare our independence from foreign oil and gas.