The Debate

Yesterday I participated in a Skype call with a bunch of my homies from college days … many of whom read this blog. In this conversation I was jibed for a blog entry in which I criticized New Hampshire Senator Jeanne Shaheen for attacking Scott Brown over his support for the oil depletion allowance ... calling it a government subsidy for the rich oil companies. In it I equated this non-cash write-off allowed oil exploration companies to depreciation allowed other corporate taxpayers … see: Energy Independence.

To defend myself I thereafter participated in an e-mail debate with two of my homies in which they both took the position that this accounting entry was unfair. I think that this debate was a lively and edifying back and forth and so I want to reproduce it here. In order to protect the identities of these two opponents, I have given them aliases … Dr. Kildare and Godot. I tag my arguments with “Me.” Here is the verbatim trialogue:

Me: (replying to a comment made during the Skype call that mining companies don’t get an equivalent write-off as oil exploration companies.)  See: http://www.taxpayer.net/library/article/the-percentage-depletion-allowance-pda-a-double-giveaway. Even for land for which there is no payment.  This would be wrong in my book ... [George]

Me: By the way [Godot] ... you asked if steel companies should be allowed to depreciate the ore that they use to make steel ... if they buy this iron ore, they have a full tax right-off immediately ... as it is considered an operating expense [I should have said "cost of goods sold"] in the income statement. If they own the iron ore pits, then see my previous e-mail. George

Godot: George...thanks for this clarification. So the Feds do allow certain companies mining "critical" materials such as uranium, silver, etc. to get a depletion credit. We could certainly classify oil as a critical material. But in both cases, these credits or write-offs are little more than gifts from the taxpayers given to industries that are doing just fine on their own....which you seem to agree with. It is pure political pork. So will there be an update/revision of your earlier blog?

Me: [Godot], You, I think, once had a rental property ... which, I suspect you depreciated on your tax forms. This is the same as depreciating a piece of oil producing land. There is one major difference however ... oil-producing land does get less valuable after the oil is extracted.  However, rental real estate generally gets more valuable over time. Perhaps then we should eliminate this notion of allowing depreciation deductions on the tax returns for rental properties ... but keep it on oil lands? George

Godot: George...the basic difference between a rental property and oil in the ground is that the rental property is an asset one has to use other assets (usually cash) to acquire. Real estate wears out over time and use and that is the basis for its depreciation. Whether its sale price increases in value over time is immaterial to the depreciation value which is based strictly on what one originally paid for it...and that the value increases is far from certain. I have invested in real estate that has sold for much less than I paid for it (unfortunately). Oil companies should be allowed and are allowed to depreciate the assets they need to use to find and extract the oil from the earth....equipment, land purchases, leases, etc. Allowing oil companies to depreciate the actual oil they find, if any, continues to be a rip-off that we all pay for. Under this concept, all minerals mined from the earth should therefore be depreciable. We could even let DeBeers Diamonds have a tax write-off for every one of the diamonds they extract from their mines. [Godot]

Me: [Godot], Differentiating between the oil in the ground and the ground itself is sophistry. The oil depletion allowance IS depreciating the value of the land from which the oil is being extracted. So, can I assume you agree with me? George

Dr. Kildare: OK.  I went to the web to look up "oil depletion allowance".  There are several articles there defining the concept. It is a depletion allowance, not a depreciation, to allow recovering the cost of buying a mineral. I still think it is a kaka concept: You make money selling the oil, after taking off expenses of recovering the oil, and then receive a payment for having less oil, that you just made a bunch of money buy selling it.

Me: [Dr. Kildare], So when you have a rental property you should not be allowed to depreciate it because you are also receiving rents from the people renting said property? Don't forget this depreciation is on top of the money you spend (and deduct from declared income) to rent the property ... taxes, mortgages, upkeep, advertising, etc. These two concepts, to me, are analogous. George

Dr. Kildare: the depletion allowance is specifically for the mineral. Oil companies do not buy land.  It is done through leases, thus enriching some guy who owns useless desert land in Oklahoma.

Godot: "Land" that an oil company has to buy or lease for its drilling exploration might be legitimately depreciable. Land, in general according to GAAP, however, is not depreciable because land does not wear out or get used up.. George is talking about oil in the ground, or more specifically, an asset the oil company has not paid for. Therefore should not be allowed to write-off.

Me: [Godot], You say, "oil in the ground, or more specifically, an asset the oil company has not paid for. Therefore should not be allowed to write-off." Are you telling me that the purchase or leasing of land under which oil may be found is the same as that for land for grazing cattle? Come on!! George

Godot: George ... from a tax point of view, land is land. However, as your article points out certain industries get favored nation tax treatment. If the oil industry were an endangered species, I might agree. But we both know the oil industry is doing quite well. So the depletion allowance is pure political poppycock.

Me: [Godot], I thought we were arguing accounting ... and you have slipped over into politics.  I think you are confusing oil refining companies with oil exploration companies which are far riskier. If you agree with me about the accounting treatment, then we can discuss the actual amounts involved. I do believe that newer technologies might require the revisiting the formulas used for oil depletion allowances ... but I myself will not reject this accounting concept. The counter argument, in my mind, is a purely political calculus. George

Dr. Kildare: The law, for oil in the ground, is a special case, as passed by Congress.  that is why the law exists. and is also the cause of the yowls of those opposed to it.  This is not a standard and usual accounting rule. The depletion allowance is an exception to usual and customary to allow the oil companies to recoup some $.  It is specifically for loss of the volume of oil in the ground each year and has nothing to do with how the rights to extract the oil were obtained.  It is prorated yearly until the company has recouped all of its investment and then goes away. Any expenses to the oil men for obtaining rights to drill, remove the oil from the ground or sell it to me and thee are handled by usual and customary accounting. The screeching I have always heard relates to the fact that the oil company never paid for the oil in the first place.  They paid for a lease and spent money looking for and extracting oil which they then sold at a profit.  They paid someone the gamblers ante at the outset on the come that there was oil under the land. They did not have a guarantee that there was oil there so I believe it is specious to say that they paid the land holder for his oil.

Me: [Dr. Kildare], And, if there is no oil there, do they get any oil depletion allowances?  NO ... they ate these upfront costs. Your description, to me, sounds an awful lot like the equivalent of depreciation ... and I am reasonably sure that this was the argument that was made to Congress to get them to agree to these non-cash charges to their income statement. You say that the oil exploration company never paid for the oil to begin with ... and I say that they paid a lot more to buy or lease this land than they would have to use it to graze cattle. They also had considerable expense to drill, extract, and distribute this oil ... if any turned out to be there. These expenses could easily offset much of their eventual [dirty] profit.  Ergo they deserve to recoup all or part of this extra purchase or lease expense (and even that money which they sunk into dry holes) through this depletion allowance. Without this non-cash tax allowance, we probably would still be quite beholding to the Mid-East potentates. If it walks like a duck ... Do you really want to discourage such strategic energy exploration by removing this (to me, meaningful, rational and time-tested) accounting incentive? George

Me: [Dr. Kildare], One more thing. And to call it a "subsidy" is demagogic pandering to the uninformed voter. This suggests that the government gives these oil exploration companies taxpayer money. No, the oil-depletion allowance is just a non-cash charge ... a reduction in the amount of taxes owed against any revenues generated (exactly like depreciation is). George

Readers ... if you are still here ... I thank you for your indulgence. I do think that this is a very important topic ... if somewhat in the weeds.