By Parth Vaishnav (left) & Nathaniel Horner (right) of Carnegie Mellon University
A common argument against enacting a severance tax on shale gas in Pennsylvania is that the additional cost will cause the industry to leave the state. As graduate students in the Department of Engineering and Public Policy at Carnegie Mellon University, we decided to test that idea.
We found that replacing the state's current drilling impact fee with a 5% severance tax would be very unlikely to inhibit new drilling. Our study looks at what such a tax would mean on a driller's internal rate of return (IRR) and how that would influence drilling decisions. What we find is that while a severance tax would decrease a well's IRR, as does the impact fee, the decrease is rather small — making wells still quite profitable for drillers.
If people are worried that a severance tax would kill the goose that lays the golden egg, our study shows they shouldn't. Even with the tax, drillers would be able to generate a greater return from drilling and operating a well than it would cost them to borrow the funds needed for the development costs.
Under our base scenario, which assumes the current low gas prices and that gas will remain plentiful in the future, we estimate that a well would have an IRR of 13% with the impact fee versus 12% with a 5% severance tax in place. With a severance tax, the driller would net $1.6 million from its investment — after paying leasing costs, taxes, royalties, and industry typical development costs.
For the state, the difference between the impact fee and the severance tax revenue is much more pronounced. A 5% severance tax would generate $830,000 from a well in our standard case — more than double the $380,000 that could be expected from the impact fee. Both figures represent the net present value of the payments.
We analyzed other scenarios (in which the well driller paid maximum U.S. tax rates or lease acquisition costs were much lower than current prices), and the results were similar: the imposition of a severance tax had little difference on a well's IRR over the current impact fee, although the overall IRR could vary markedly depending on the assumptions. Even using the most conservative scenario, well development still generated returns comfortably above the typical cost of corporate borrowing.
From a driller's financial perspective, a severance tax would have little more impact on drilling and operating decisions than the state's current impact fee.