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Governor Kasich has proposed an oil and gas severance tax increase for Ohio, and not surprisingly, the oil and gas producers are not keen to see it placed into law. But the burden is on the producers to demonstrate why the proposed tax increase is unfair.

This is because Ohio's current severance taxes are well below that of other oil and gas producing states.

So what is the argument to be made against the proposed severance tax increase?

From the producing company's perspective, the severance tax is just one of a number of taxes they pay, which needs to be looked at together to assess the “fairness” of the tax. Texas, for instance, has a higher severance tax than the proposed Ohio severance tax. But Texas also has no state income tax. So it is not immediately clear if the Ohio commercial activity tax (CAT), ad valorem and severance taxes together are more or less than all of the Texas taxes together.

The severance tax is taken off the top of production; it is a gross proceeds tax, and one that is easy to understand and compute. Unfortunately, the ad valorem tax and the CAT are not so easy to understand. The ad valorem tax, which is a local property tax producers pay on the reserves, is based upon a complex formula using producing records. But it is at least reasonably easy to compute and predict.

The problem for producers is in determining the likely CAT they must bear. The CAT was enacted into law in Ohio to replace the corporate income tax. It is not a sales tax, but it operates similar to one: it is assessed on commercial activity that takes place within the state, in this case, the sale of hydrocarbons.

Historically, all natural gas produced in the state has been consumed in the state, and as a result, it has triggered a commercial activity subject to the tax. Presumably it is for this reason that the Ohio Oil and Gas Association, in its economic development study conducted a year ago, assumed that the CAT would apply to all natural gas production from the Utica.

But with the advent of processing for natural gas liquids in Ohio, together with the larger volumes produced, it is by no means clear that the CAT will in fact apply to most natural gas produced from the Utica Shale. Producers may choose to pipe and sell the gas out of state, and if so, no commercial activity takes place in Ohio, and no tax would be owed. The same may well be true for natural gas liquids and oil. Indeed, oil produced in Ohio has historically not been sold in Ohio, and this will probably not change unless we develop some new refining capability here.

So this is the producer's dilemma: without knowing the future disposition of this gas, how can they establish to Ohio lawmakers that the new severance tax will make Ohio's overall taxation of oil and gas higher than that of other oil and gas producing states?

To be sure, Ohio wants the oil and gas to be sold in Ohio, and not just to get the tax money. We also want the commercial activity stemming from manufacturing and other industries consuming hydrocarbons intrastate means employment intrastate. This is the gift that keeps giving.

It is also worth noting the public right to a share of the value derived from oil and gas production is customary worldwide. Only in the United States, Canada and the United Kingdom are mineral rights privately owned. In the United States the public enjoys direct participation in oil and gas revenue principally through the severance tax.

Moreover, producers want the state to have this direct interest in production proceeds. The government that shares in hydrocarbon revenue is usually a willing enabler in its development. This does much to address the public angst over the balancing of economic development against environmental impact. Indeed, this can go too far, such as was the case with the Mineral Management Service, which became captured by the industry it was regulating, leading to sloppy oversight of British Petroleum in the Gulf of Mexico.

In the end, I think that the producers expect that a severance tax increase in Ohio is inevitable, and they prefer it be implemented by the current administration, which has demonstrated considerable oil and gas industry acumen. But they are understandably anxious about how this large tax increase will affect their return on investment, especially when they don't yet know how the CAT will play out in Ohio.

There is a public right to share in the value derived from production of minerals. The oil and gas producers understand this, and will support a reasonable severance tax. The tax proposed by Gov. Kasich is in keeping with industry custom. Now the burden is on the producers to explain to Ohio lawmakers why the tax increase will place Ohio's overall taxation of the industry outside the realm of what is usual and customary for other oil and gas producing states.
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