Understanding Pennsylvania’s Proposed Severance Tax

Last week, Pennsylvania’s Senate passed a budget that includes, for the first time, a severance tax on natural gas produced within the state. Whether it becomes law is still uncertain, but the debate over a severance tax, a perennial topic in recent years for Pennsylvania policymakers, has featured strong opposition from industry groups as well as vocal support from key lawmakers, including Governor Tom Wolf. So what can stakeholders expect going forward? How might the tax affect producers in the state, and what might it mean for Pennsylvania’s public finances?

Over the past decade, development of the Marcellus shale formation has catapulted Pennsylvania to become the second largest producer of natural gas in the United States, trailing only Texas (Figure 1).

Data source: US Energy Information Administration. Natural gas gross withdrawals. (Accessed July 31, 2017.)

Severance taxes, applied when a resource is “severed” from the Earth, are used in most US states to raise revenue from the extraction of non-renewable resources. These taxes are levied on the volume or value of production, and can be attractive to governments because mining activities such as oil and gas production often generate economic rents, defined as profits over and above the levels necessary to incentivize private-sector investment. In other words, severance taxes can—at least in theory—be designed to capture the rents generated by oil and gas development without deterring new development.

Since 2011, Pennsylvania has instead applied an Impact Fee to each new well drilled into the Marcellus formation, charging an annual fee to all “unconventional” (i.e., shale) wells. These revenues are mostly used to offset costs for state and local governments driven by increased drilling activity, such as road damage, housing costs, and strains on other public services. Despite having raised over $1.2 billion from 2011 to 2016—a figure highlighted by industry advocates—some argue that the state’s Impact Fee is leaving money on the table.

The proposed severance tax in Pennsylvania would apply to each unit of natural gas produced from unconventional wells and vary depending on a national benchmark price. As Table 1 shows, the tax varies from $0.015 per thousand cubic feet (mcf) to $0.035 per mcf depending on the price of natural gas, measured by the Henry Hub spot price. The tax would be levied in addition to the Impact Fee, which will ensure that local governments are still compensated for the negative effects associated with drilling.

Table 1. Pennsylvania Proposed Severance Tax Formula

Source: 2017–2018 Pennsylvania State Senate

In a recent paper, RFF President Richard Newell and I showed how state and local governments raise revenue from the oil and gas industry, highlighting the role of severance taxes, Pennsylvania’s Impact Fee, local property taxes, and other sources. Considering only taxes and fees, state and local governments in the United States collected an average of 6.9 percent of the value of oil and natural gas produced within their states in fiscal year (FY) 2013.

Pennsylvania collected roughly 2.3 percent of the value of oil and gas produced in FY 2013 through its Impact Fee (unlike most other states, local governments in Pennsylvania cannot tax oil and gas production property). If we add to the Impact Fee a severance tax of $0.025 per mcf applied to the gas produced from shale formations during FY 2013 (the average Henry Hub spot price in 2013 was $3.73 per mcf), this figure grows modestly to 3.0 percent (Figure 2).

Source: Adapted from Raimi and Newell (2016).

A key concern, not just for oil and gas operators but also for those interested in seeing local economies continuing to benefit from energy development, is whether this type of tax increase will drive away drillers. In recent years, a shortage of pipeline capacity has suppressed natural gas prices for producers in Pennsylvania relative to states such as Texas, Louisiana, and Oklahoma, where pipeline access is more robust. On top of this challenge, natural gas producers across the United States (and, to a lesser extent, globally) have struggled to turn a profit as gas prices have remained stubbornly low.

So would Pennsylvania’s proposed severance tax reduce investment in the Keystone state? In three words: Maybe. A little.

Like most other commodities, companies that produce oil and natural gas are price takers; that is, individual firms cannot pass along increased costs to customers. As a result, any new cost to producers (whether added by government or other forces, e.g., higher labor or capital costs) will affect investment decisions to some extent. The key question: How much?

Given the productivity of the Marcellus shale, it is hard to imagine drillers abandoning such a prolific resource en masse, particularly since many have sunk billions of dollars into acquiring leases, building office parks, and training workers. Indeed, gas production in Pennsylvania has consistently outperformed most other states despite other headwinds, such as lower regional gas prices and a limited local labor pool. Consider this: If the existing Impact Fee (equivalent to roughly 2.3 percent of production value in the state) did not stop Pennsylvania’s surging production, is it likely that an additional 0.7 percent will bring growth to a halt?

Some opponents of the severance tax have rightly pointed out that in Ohio, where gas production has also surged thanks to another prolific formation (the Utica shale), taxes on drillers are even lower than in Pennsylvania (see Figure 2). They worry that with the severance tax, companies operating in Pennsylvania will be more likely to walk their rigs across the border to Ohio.

As noted above, any new costs will have some effect at the margin and could reduce investment. But if tax rates were the only thing that mattered to oil and gas companies, they would all be moving to Ohio. Rather than taxes, investment decisions depend more on the quality of the resource, access to infrastructure (e.g., pipelines), and prevailing commodity prices, among other factors. Today, we see fairly robust drilling across all three Appalachian shale states: Ohio (24 rigs), Pennsylvania (32 rigs), and West Virginia (12 rigs).

Since 2013, Pennsylvania’s shale gas production has continued to climb, with levels in 2015 (the most recent available year) reaching roughly 4.5 trillion cubic feet. Given Henry Hub spot prices of $2.62 per mcf in 2015, the proposed severance tax would have raised a little more than $90 million. And although $90 million is nothing to sneeze at, it would have added just 0.26 percent to the state’s tax revenues in 2015—which totaled $35 billion.

To sum it up briefly: Pennsylvania’s current proposal for a severance tax on natural gas production appears unlikely to have a major effect on either government revenues or the investment climate for Marcellus shale developers. However, this debate has continued for years in the state, and it is doubtful that the outcome of the pending legislation will put it to rest.

The views expressed in RFF blog posts are those of the authors and should not be attributed to Resources for the Future.