Chesapeake Is Making It Uncomfortable For Other Oil Companies To Pay Low Taxes Just Because They Take In Negative Money

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If you were at, say, Range Resources, wouldn't you be SO PISSED at Chesapeake? Uniquely in modern memory, every media report during Chesapeake's meltdown has had immediate and dire results. Aubrey's a bit of a scoundrel? Strip him of his chairmanship. His founder participation program creates conflicts of interest? Terminate it. There was maybe a bit of collusion in bidding on some mineral leases? Why hello DOJ antitrust probe.

Bloomberg dug up another mini outrage today with its discovery that Chesapeake doesn't pay taxes much, mostly because it spends much much more money than it takes in:

Chesapeake Energy Corp. (CHK) made $5.5 billion in pretax profits since its founding more than two decades ago. So far, the second-largest U.S. natural-gas producer has paid income taxes on almost none of it.

Chesapeake paid $53 million over its 23-year history, or about 1 percent of the cumulative pretax profits during that period, data compiled by Bloomberg show. ... The biggest tax break, for Chesapeake and other independent U.S. oil and gas companies, is a rule that’s been around since at least 1916 that allows some producers to expense “intangible drilling costs.” Companies can count most of the cost of boring a new well against their taxes at the time the money’s spent, rather than recognizing it over several years. That allows them to effectively put off tax payments, even during years when they turn a profit.

This is a story about the mismatch between tax and GAAP accounting, which is a story that is as old as time; one question you could ask is, which is right? If you spend $100 to drill a well and it will return $15 a year for 10 years, is your profit in the first year $5 (like, $15 revenue minus $10 straight-line amortization of costs), or is it an ($85) loss? GAAP thinks it's a $5 profit and there are good accounting and economic reasons behind that. Here for instance are some tax-policy folks who think that capitalizing the cost of drilling successful wells "is consistent with economic theory and accounting principles."* And if you believe that, as Bloomberg seems to, then Chesapeake is ripping off the treasury (legally obvs) by taking huge tax deductions even though it's profitable.

On the other hand you can't eat GAAP profits, or even pay off your massive liabilities with them, if you happen to have massive liabilities, as some independent oil and gas producers do, not naming any names. For that you need money, which is something that for all its $5.5 billion in pretax profits Chesapeake is strangely lacking.

As are its peers. Here is Bloomberg again:

While Oklahoma City-based Chesapeake is the biggest U.S. oil and gas producer with such low tax payments, it’s far from alone, according to the data that calculated several companies’ so-called long-run cash effective tax rates. Range Resources Corp. (RRC) paid income taxes of about 0.4 percent of pretax income over the past decade, the data show. Southwestern Energy Co. (SWN) paid 2.1 percent and EQT Corp. (EQT) paid 5.3 percent, the data show. ...

Other companies whose tax strategies have attracted scrutiny in recent years have much higher rates than the oil and gas producers. Google Inc., which has used tax strategies with names like the “Double Irish” and “Dutch Sandwich” to minimize its tax bill, had a cash effective rate of 18 percent over the past 10 years, according to data compiled by Bloomberg. General Electric Co., whose tax strategy the New York Times termed “aggressive” in a front-page article in 2010, paid 12 percent.

And here is a really wretched graph I made for you:

You'll notice the enormous but still not to scale bar for Chesapeake's negative forty-nine billion dollars in free cash flow over the last ten years. That's its choice, of course - basically that is "money comes in from selling gas and goes out to drill new wells" - and taxes aren't charged based on free cash flow. But nor are they charged based on GAAP income - and at least for me this chart makes it a little easier to understand why Chesapeake writes actual checks to the government for a lower percentage of its GAAP income than GE does.

As do Range, Southwestern, EQT, etc. But judging by the track record of Chesapeake stories turning swiftly into action, what do you think the odds are that this loophole gets closed?

Justice Dept. probes Chesapeake over possible collusion [Reuters]
Chesapeake’s 1% Tax Rate Shows Cost Of Drilling Subsidy [Bloomberg]

* Also, food for thought, about the fact that even if you capitalize drilling costs on successful wells you still get subsidized by being able to write off unsuccessful wells, which viewed in a certain light are part of your costs of finding the successful ones:

The revenue loss estimate excludes the benefit of expensing costs of dry tracts and dry holes, which includes expensing some things that would otherwise be capitalized. This is a normal feature of the tax code but confers special benefits on an industry where the cost of finding producing wells includes spending money on a lot that turn out dry. This is probably more important than [actual "loopholes" like intangible drilling costs, or] IDCs or percentage depletion.

Not relevant to CHK, though: what with being onshore and having good geologists, Bloomberg points out they basically never drill dry holes.

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