Federal taxation of g^s wells R OS we 11 H, Johnson THE LIBRARY OF THE UNIVERSITY OF CALIFORNIA LOS ANGELES GIFT OF R. E. Collom The RALPH D. REED LIBRARY DKl'AKTMKNT OF GEOLOtiY UNIVKRSITY OF CAI.IFOUNIA. IA>W ANOKl.KS, CAI.IK. Federal Taxation of Gas Wells By ROSWELL H. JOHNSON FIFTEENTH ANNUAL MEETING OF The Natural Gas Association of America Broadway Auditorium BUFFALO May )7lh. 18th, 19th and 20th, 1920 WM. B. WAY. Secretary Ceo/ogy Q^^^ FEDERAL TAXATION OF GAS WELLS By Roswell H. Johnson, Rttsburgh, Pa. To prepare the tax return oi a natural gas company, one should provide himself with the following literature : 1. A copy of the Act, which is Public Document No. 254, 65th Congress. It may be had on application to a congressman. 2. Bureau of Mines Bulletin, No. 177. 3. Regulations 33 and 45 (edition with addenda) of the Treasury Department. 4. Form O, of the Treasury Department. 5. The Manual of the Oil and Gas Industry, published by the Department. This Manual is now out of print, but a private reprint has been published by John Wiley and Sons, 432 Fourth Avenue, New York. 6. Application should be made to the Bureau of Mines to receive the new bulletin on decline curves by Willard W. Cutler, Jr., when it appears. 7. Subscribe to the Income Tax Bulletin Service, Superin- tendent of Documents, Washington, D. C, $2.00. INCOME TAX FOR IQIQ In preparing the tax for 1919, one starts with Form O. The first schedules to be filled out are I, IV, VI & VII. The remain- ing schedules are dependent upon these. Schedule I calls for cost of property as of date of acquisition. The blanks must be filled out separately for each producing lease and it offers little difficulty except that some of the data may not be obtainable. In some of such cases the bonus may have been only nominal so that little barm is suffered under those circumstances. Where the bonus was nominal and other expenses were charged as such and one knows that the capital to be ascertained while obtainable would 543396 not justify the search, one is justified in writing across a number of these entries "cost only nominal and not claimed." Nearly every gas company has a number of abandoned leases, the whole cost of which is so low and always so difificult to ascertain that it is advisable to merely state that there have been such and the costs were not large enough to warrant preparation of the data to claim the invested capital. Schedules IV. VI and VII offer little difficulty and lead u^) to the very' difficult Schedule II. This is the valuation schedule and is made out for properties as of March i, 191 3, the beginning of the income tax law. The most obvious way to ascertain "fair exchange value" would be to cite sales of similar properties. Where such sales are of truly similar properties and between a willing buyer and willing seller at the same date it is the exact index of "fair exchange value." Such sales are almost always non-existent so it becomes a question of how dissimilar the prop- erty may be and yet permit still the analogy to be drawn. The sale must have taken place at very nearly the same time because the prospect of future price changes is constantly changing and hence, the tone of the market. Lastly, there must be the condi- tion of a willing buyer and a willing seller, a condition which by no means always pertains in -the gas business, since there is gen- erally a restriction on the freedom of exchange between a com- pany or individual without pipe line and one with a pij>e line and selling to consumers. Only two gas pools furnish sales of usuable sort, so far as known to us, so that probably very many of the gas properties must be appraised analytically. These pools, Mc- Keesport and Elk City are each unique and not comparable to other pools. The appraisal of a gas property is vastly more difficult than that of an oil property, and furthermore, there has been very much less written and very much less data collected that woul.I be of use in such appraisal. Yet. such appraisals can l>e and are made. The method recommended is to establish first a predicted price curve for what may reasonably have been expected to be the probable future prices at the timo of appraisal. This is best obtained by taking a curve of past prices and then continuing it into the future on the same average percentage o£ advance. This gives a curve that is too conservative but safe, since it never reaches even the present price of artificial gas in the Hfe of a well. This extrapolation is most conveniently done by drawing a straight line on semi-logarithmic paper which automatically gives a regular percentage advance in successive years. One may also calculate in the same way the advance in mainte- nance costs. From these one may get an average expected profit per unit for each successive year in the future, until the abandon ment of the well. The price at the we-i. not that to the consumer must be used. The next task is to get the yield which the well will produce in the successive years. Where the wells are metered, as at McKeesport, this is a less difficult task, but in other instances yield cannot be had directly and the capacity must be obtained at the successive inter\'als by calculating from the open flow read- ings or the minvite pressures which have been read. Minute pressures taken by merely closing the gate into the line at that line pressure give a figure quite different from the open fiovv capacity obtained by the minute pressure formula if taken after blowing. The open flow capacity obtained is best reduced to yield values for the several years by the use of the ratios given given by \\'eymouth. However, if the history of a line pressure is so erratic that no regular change of ratio can be used, one is forced in these cases to fall back on the general ratio of yield to capacity. Wyer gives 25% as an average value but this should be ascertained for the company or pool in question. However, if minute pressure from line is used to compute a "capacity", for which the name "going capacity" is proposed, the yield will constitute a higher percentage thereof. The greatest difficulty in working out a gas capacity or yield decline curve, lies in the fact that a number of the wells are pulled on so much less, either becau.se their well pressure is op- ]josed to a relativel}' high line pressure or else because they are lield as reserve so that they cannot be used in working out the decline curve of a typical ^^■ell. After the expected profits are determined each year by this method each one is multiplied by a compound discount factor for its \'car. None of the published "present worth" or compound discount tables are available as they all start with a full ^•ear and assume that the money is not realized till the end of the year. It should be observed that if the appraisal is of IMarch i, 1913. that the compound discount factors should be calculated en the basis that the average dollar is re- ceived one-half of the period from the beginning, i. e. at the end of five months in the first ten months period and at the end of six months in the subsequent periods. The rate of compound discount to be used is influenced by ihe reluctance of the in- vestor to invest under the circumstances. To the sum of the discounted future expected profits add the discounted value of the eventual salvage. The composite curve can be constructed following the method of Deal's family curve. This can )ye done by his graphic method for which the term "shingling" is proposed or by calcu- lation from the corresponding parts of many well declines as described in the Manual of the Oil and Gas Industry for which the term "segmental" curve is proposed. If the famil)^ curve constructed by either method does not extend to the economic limit it should be extrapolated by finding the nearest suitable hyperbola by the method of shifting the origin or by using the exponential curv^e if it gives a better fit. Either method is easy because they constitute straight lines on logarithmic and semi- logarithmic paper respectfully. Except under conditions of inflation gas property buyers are unwilling to pay up to the full productive value expected. The compound discount factor used may recognize any needed dis- count for risk or a further discount of risk may be necessary in the appraisal of some wells. However in the valuation of un- drilled acreage, a further deduction as a risk factor and' for de- ferment resulting in loss of pressure will nearly always be nec- essary. Form O calls for the valuation and classification of every single producing lease. Having appraised the well and its sup- porting acreage, the remainuig acreage in the lease should be given a percentage of probability of becoming productive. The value of the productive acreage as acreage multiplied by this probability and less deduction for reduction of pressure because of deferment of drilling and risk, as conditions may warrant, give us a value for this remainmg portion of the lease. Non-producing leases may be reported under one head, un- developed acreage, as a more detailed classification would be of no consequence to the Department as it cannot enter capital sum until producing. Our next step is to calculate the value of the physical prop- erties as of the date of appraisal. If installed prior to 1913 its original cost must be depreciated to a 1913 basis. The rate of depreciation of the well equipment should be calculated on a straight line for the estimated life of the well. The fair exchange value of the whole property must now have deducted from it the value of the physical property as of tlie date of appraisal. This value of physical property constitutes the depreciable capital sum after subtracting a percentage equivalent to the eventual salvage. The fair exchange value less the cost of the physical property is the depletable capital sum and represents value attributed solely to the gas in the ground. It in turn, however, should be divided into three parts, one rep- resenting the cost of the gas reserve, one that of drilling and exploration, earnings on both of which are merely a return of capital and the remaining portion of the value the earnings from which are on an appreciation shown by the appraisal over cost so that such earnings can be transferred to surplus -and increase the invested capital, provided they are not distributed as divi- dends. We now have the amount which is to> be taken as depletion and depreciation allowance through the years in proportion to which depreciation and depletion is sustained. It remains to as- certain the rate at which the depletion allowances are to be taken for use in Schedule V on De]:)letion, and that not from 191 3, but because also used in depletion of invested capital prior to 1913, from the drilling of the first well. To do this, one must first get the estimated future recoverable reserve of gas as of the date of completion This is a technical procedure for which the reader is referred to Bulletin 177, Bureau of Mines and the foregoing paragraphs on appraisal. The salvage value received in the terminal year is a further deduction from income of that year since it is a return of capital. The rate of depletion is based in the regulations upon the rate of decline in rock pressure. This method was chosen as against yield or capacity because it was known that in the case of many small operators yield or even capacity figures could not be had by pool units and the regulations demand separate com- putation by pool units or, if not feasible, geographical districts. It is expressly stated, howicver, that depletion need not necessarily be worked on a rock pressure basis if there can be shown good reasons why any other method would give a better result. There are two circumstances where rock pressure decline is not ade- quate. The first is where water has been encroaching. Obvious- ly, if the volume occupied by the gas had been contracting as the result of the encroachment of water, the pressure will not go down as rapidly although the depletion may have been as great. It is for this reason that it is very important to keep a history of the water in every gas pool, so that if water is encroaching, a more rapid depletion can be obtained than would be shown in the rock pressure curves. The correction varies with the pro- portionate volume of the sand flooded. A second circumstance, where rock pressure decline is alone ir^adequate is where a pool has been pulled upon rapidly one year, and the next year for some reason, such as a new gas pool coming in elsewhere or because of a partially mild season, or desire to use it in part as reserve, it is pulled upon less rapidly. It not infrequently happens under such circumstances, that there is an actual gain in rock pressure and there may even be an actual gain in capacity. It is clear that depletion is to be claimed in these years if gas was actually taken fronr the well even though there has been a gain in the apparent condition of the well. This may be calculated by using an actual yield curve instead of rock pressure if that can be obtained, or if that is not possible then we must recompute the depletions so that some is shown in each year and the whole amount is determined from initial to last pressure is allocated to the years mainly on the basis of the extent to which the wells were known to be drawn upon. The construction of the curve for ascertaining the rate of depletion is essentially like that of curves for appraisal, except that in appraisal the curves must be one of yield and the valua- tion is set up once for all, and no information subsequent to the date of appraisal can be utilized. Whereas in making out the depletion rate rock pressure, yield or other index may be used. All the data is utilizable and revision from year to year is per- missible and indeed desired in the Regulations. The question of what the economic limit, i. e., how small a well must be before it must be abandoned is a matter to be determined for each field recognizing that it will become regularl}^ lower in the future. While the depreciable capital sum in so far as represented by well equipment should be depreciated on a straight line repre- senting the life of the well, this does not apply to other features such as pipe lines, marketing facilities, etc., which receives a straight line depreciation set upon that experience has shown to be their p'robable life which frequently exceeds the life of the wells. We may add each year the money invested in new physical property and also the money spent in new development work, one going into the depreciable capital sum and the other into the depletable capital sum. Cost should always be entered unless the well is such as to permit the use of ascertained value under the Regulations. The conditions which give the discovery appraisal right are as follows : first, the well must have a value which is dispropor- tionate to the cost. Further, the acres of the reservoir appraised must have been purchased or leased prior to its having become a proven area, and it must not have previously received a discov- ery appraisal. The definition of what constitutes a proven area is given by the Regulations as being the i6o acres of that reservoir sur- rounding the hole in question. From this it follows that a well which strikes gas in a dififerent reservoir altho in the same area from that in which the 160 acres was proven may constitute a discovery. The area to be appraised in case of discovery, is all within "the exterior limit of a continuous tract held under leases or in fee by the taxpayer" vv^hich belongs to the lessee and which 10 is included within this 160 acre square surrounding the dis- covery well. In the case that the lease has had a former ap- praisal as of 1913, only the value newly created is to be used. In appraising a discovery well, one is of course, limited to the knowledge of that date. This involves the use of a differ- ent predicted price curve, as of that date rather than that one would have used March i, 191 3. The law permits the appraisal to be of the date of discovery or 30 days thereafter. One should appraise, of course, at the earlier date, unless the value increased during the 30 days, because depletion is most rapid in the first 30 days and is not allowed until a valuation is established on the property. Observe that the unit to be appraised is not only the well and its supporting acreage, but the deposit underlying the acreage of the reservc^r extending beyond this, which may in some cases be as much as r6o acres. The Treasury Department will not allow all of this to be appraised as if it were truly proven or 100% probable, although it is legally so called, but rather it will be appraised on the basis of "fair exchange value." To as- certain its fair exchange value one can, of course, fall back on analogous sales as before or else one may assume a percentage value of the inner acreage, which supported the first well, as ex- pressing its probability of being productive. If we allow forty acres to the discovery gas well we would then have 120 additional acres or less for appraisal. The value of the central supporting acres is derived from what it was when newly drilled by sub- tracting the cost of the material and drilling. The total usually requires a further deduction because of the risk of investment and loss of pressure from deferment of drilling. If an area is proven for oil, the discovery of the first com- mercial gas well if commercial as to its gas alone, in this area will give a discovery appraisal for gas if the other conditions are fulfilled. Where gas has a gasoline value commercial in amount, either by compression or absorption method, a separate value should be placed on this product and it is to be included in both the 191 3 and discovery appraisal where it would have been considered by a buyer or seller in arriving at a price at the time of appraisal, but the gasoline is treated as a part of the gas where the well is II a commercial gas well, not as a third product. Where an oil well produces casinghead gas in an amount not sufficient to justify drilling for the casinghead gas alone, it is an oil well with a gas by-product not a "gas well." INCOME TAX LAW FOR I917 RETURN While the income tax law applying to 191 8 is worked out on the same basis with differing rates than 1919, the income tax law applying to 1916 and 1917 has one important difference, namely, that the depletion allowance to the lessee is allowed only on cost, not on appraisal value, and that there is no discovery appraisal right. But in the case of the lessor, he may have de- pletion allowances based as in the law of 1918 with reference to appraisal of March i, 1913, but not discoveries. Note, how- ever, that discoveries in 191 7 and back to March i, 1913 are permitted for purposes of calculating the tax for 1918 and thereafter. The laws applying to 1913, 1914, and 1915 grant an allow- ance for depletion only to an extent of 5%. The law does not permit us to go back and redress this deficiency which is now admitted to be inadequate, and it is necessary to take off a sus- tained depletion in calculating tax for later years even though it was not allowed at the time. This 5% limit does not apply, moreover, to the depletion of invested capital. EXCESS PROFITS TAX FOR I9I9 In w^orking out the excess profits tax the principal peculiarity of interest in this connection is in the matter of adding surplus. Invested capital is capital actually invested, but where a propor- tion of the earnings is attributable to capital w-hich is apprecia- tion shown in the appraisal as over cost, then we may add this as surplus to invested capital for the next year, provided it was not distributed as dividends. In making out net incomes for computing excess profits tax, depletion and depreciation should be deducted. The invested capital itself is also cut down each year by depletion and depre- ciation although it may also be added to by newly invested cap- ital and additions to surplus. 12 In summary, gas companies must realize the great amount of labor in merely hunting up the data to fill in Form O and its supporting blanks for each producing lease, entirely aside from the technical matters of establishing proper valuation, recogniz- ing which wells have the discovery right, properly valuating these discoveries and working out the rate of depletion. The task commands vastly more attention than has hereto- fore been given to taxation. It should be prepared for through- out the year and should alter methods of management and ac- counting to make possible the preparation of a report acceptable to the Department. » THE LIBRARY UNIVERSITY OF CALIFORNU LOS ANGELES ''"his hook is DU^ ""ti thf* ' Manu/aelured by I AYLORD BROS. Inc. 1 Syracuse, N. Y. UCLA-Geology/Geophysics Library * HD 9566 J63f L 006 566 143 1 'S^^«