Written by John McFarland of the Oil and Gas Lawyer Blog.
An article by Jim Malewitz in The Texas Tribune, “As Oil Prices Plunge, Questions about Big Tax Credit,” sheds light on an arcane and technical issue not well understood even by most oil and gas lawyers – classification of wells as “oil wells” or “gas wells” by the Texas Railroad Commission. While most wells produce both oil and gas, under RRC rules a well must be either one or the other. Different rules apply depending on well classification. Why does it matter?
For one thing, oil and gas leases traditionally have allowed larger pooled units for gas wells than oil wells – allowing operators to hold more acreage with a single well. This distinction is based on the theory that gas wells drain a larger area than oil wells – probably true in most conventional reservoirs, where oil and gas migrate through the formation as wells withdraw production. Not so true for new unconventional shale formations, which have very low permeability and porosity, and where oil and gas don’t “flow” through the formation but are produced through artificially induced fractures.
But operators recently are rushing to “reclassify” wells as gas wells that were originally classified as oil wells. According to Malewitz, the RRC granted operator applications to reclassify 844 wells from oil to gas this year – nearly six times the number reclassified in 2013. And Devon Energy has asked the RRC to reclassify more than 200 of its wells from oil to gas. The reason? Tax credits.
The state severance tax on natural gas is 7.5%. In essence, the State collects a 7.5% royalty on all natural gas produced in the state – a large source of state revenue. But if a gas well qualifies as producing from a “tight sand” – one meeting certain technical specifications as having low porosity – the well gets a large tax break on its severance tax. This tax credit was passed years ago to give operators an incentive to drill tight-sands wells – long before the advent of shale plays and horizontal drilling technology. The catch? The tax credit applies only to wells classified as gas wells by the RRC.
To obtain the tax credit, the operator must apply for the credit with the RRC and the Comptroller after the well is drilled. The operator initially pays the 7.5% severance tax, and when the application for the tight-sands credit is granted the Comptroller refunds the excess severance tax paid, back to date of first production from the well.
Unconventional reservoirs like the Eagle Ford have wells classified as oil and gas. In the “condensate window” of the Eagle Ford, wells produce a lot of condensate and natural gas liquids along with natural gas. This is the “sweet spot” of the Eagle Ford because the gas in the reservoir provides the energy to lift the liquids to the surface.
So if an operator can get his well classified – or reclassified – as a gas well, it can apply for the tight sands credit and get a refund of the severance tax paid on the gas produced from its well – from date of first production. All shale reservoirs qualify as “tight sands” under the statute, as long as the well is a “gas” well. Thus the impetus behind all of the applications to reclassify oil wells as gas wells. Glen Hagar, the Texas Comptroller, estimates that the reclassification of wells to gas in the Eagle Ford alone could cost the state $250 million in the 2016-2017 budget cycle.
Well classification also became a contentious issue in the 1980’s, for a different reason. In the giant Panhandle field, oil and gas leases often leased “oil rights” and “gas rights” separately, and the right to produce oil was often owned by a different company from the right to produce gas. The Panhandle field is a gas field. Owners of “oil rights” sought to have their wells classified as oil wells in order to claim ownership of the production from those wells. Those operators went to great lengths to classify portions of their production as “oil.” The controversy raged at the RRC for years.
So what determines whether a well is classified as oil or gas? John Tintera, formerly executive director and now an agency consultant, says that “What the Railroad Commission does, is really a science and fact sort of finding.” It’s a mystery. In my view, the industry has deliberately kept the rule vague and obtuse.
There is really no factual basis to distinguish between an oil well and a gas well. The fact is that some wells produce mostly oil, some mostly gas, and most some of both. The well classification system is a vestige of outdated regulations.
Meanwhile, the Legislature is looking into the well classification issue. It should also reconsider the severance tax exemption as well.