Implications of Evolving U.S. Oil Pricing Policy for Domestic Reserve Values

Abstract

Summary U.S. oil reserve values have been affected significantly by recent changes in government pricing regulations and taxation. This paper presents a discounted cash flow model for the valuation of a hypothetical, though representative, producing property. The analysis addresses changes in present values for various major categories of oil (i.e. lower-tier, upper-tier, stripper, newly discovered, and qualified tertiary recovery oil). In addition, we examine the differences in a property's value attributable to varying windfall profit tax treatment of major oil companies vs. that of independent producers. Introduction Recent modifications of U.S. energy pricing policies have important implications for the value of both existing and undiscovered conventional oil reserves. The key changes examined in this paper include the following.In April 1979, the Carter administration decided to phase out gradually price controls on domestic crude oil classified as lower and upper tier. Under this program, oil in the lower-tier category is being released to upper-tier status at the rate of 3% per month. In addition, upper-tier oil is being released to the free market price at the rate of 4.6% per month. As a result of these measures, all domestic oil will be selling at free market prices as of Oct. 1, 1981. These changes are summarized in Figs. 1 and 2 and Tables 1 and 2. Under the Crude Oil Windfall Profit Tax of 1980, the price benefits of this decontrol program over a prescribed base price are subject to an excise tax (after partial adjustment for severance taxes). In the case of independent producers, the excise tax rate is 50% on the first 1,000 bbl of daily output and 70% thereafter. For major oil companies, the rate on lower- and upper-tier oil (Tier 1) is 70% on the increment over a base price of $12.81/bbl adjusted for inflation subsequent to June 1979. In reality, the economic effect of the windfall tax on lower- and upper-tier oil is not unlike the continuation of price controls at a significantly higher price and with improved escalation provisions.In its final version of the windfall profit tax, Congress also decided to apply the excise tax to stripper oil (Tier 2), with independent producers subject to a reduced 30% levy (again up to a total 1,000-B/D limit) and majors and other producers subject to a 60% tax on the realized price increment above a $15.20/bbl base adjusted for inflation after June 1979. In the case of stripper oil, which already was decontrolled, the imposition of the windfall tax has had the effect of a price rollback on the producer.Effective June 1, 1979, the Carter administration began to allow newly discovered oil to receive an uncontrolled market price instead of an upper-tier price. At the same time, newly discovered oil also was redefined to be oil from an onshore property from which there was no production in 1978 or from an offshore property leased after Dec. 31, 1978, from which there was no 1978 production. The excise tax rate on this oil is 30% for all producers, and the base price was set at $16.55/bbl with an adjustment provision for inflation plus an additional 2% incentive escalation subsequent to June 1979. Escalation adjustments to base prices reflect the GNP deflator as a measure of inflation and are posted with a two-quarter lag.