Shale I stay or shale I go? Pennsylvania's 'Marcellus Shale-size' of a debacle over fracking severance taxation.

• Author: Mondock, Amber R.

INTRODUCTION

Severance taxation--a subject as dull as a rock. Bringing this topic of conversation to the table over a decade ago would have been relatively equivalent to singing a sweet rock-a-bye baby lullaby to the majority of Americans who would have replied "What is the big fracking deal?"--Yes, all puns intended. The extraction of natural gas has emerged to be known as "the environmental issue of our time." (1) Thanks to the beauty of technology, the once nearly impossible to reach natural gas goldmine in the United States is being brought to the surface, and the pockets of those lucky enough to drill and frack for it. (2)

Natural gas extraction is a dilemma over half the states in the United States face. Thirty-two states have implemented hydraulic fracturing and horizontal drilling (3) efforts to utilize America's emerging valuable energy resource. (4) Hydraulic fracking is a relatively new process used to extract natural gas resources from underneath the earth's surface. Various positives and negatives emerge with the extracting of natural gas--many of which impact the local communities and citizens. The dangers of fracking are still not fully understood, and little if any regulation exists on how the process is conducted. "So while safety, land and mineral rights litigation often grabs the spotlight when discussing Marcellus Shale activities, taxes could be the final frontier in Marcellus Shale litigation." (5) Thus, the topic of severance taxation on the precious mineral, and the resulting potential policy impact in any given state is forthcoming.

The imposition of a severance tax to help ensure that costs associated with resource extraction are paid by the producers, essentially those companies extracting and selling the gas, rather than placing the burden on the people of the given state, is a route most states have adopted. However, one major natural gas producer has declined to enforce the severance tax on those extracting natural gas from its territory: Pennsylvania.

DRILLING TO WHAT'S INSIDE: THE CONTENTS

Part I of this Note proceeds through history, concisely examining Pennsylvania's development with natural gas extraction from the Marcellus Shale. Moreover, Pennsylvania's position as one of the major producers of natural gas in the United States coupled with its unique policy stance provide the background of why Pennsylvania stands out and is the subject of scrupulous debate on severance taxation.

Part II explains what severance tax is and how it works. Furthermore, this part takes a deeper look into the various severance taxation schemes that have been created by natural gas producing states, identifying three main methods: volume-based, value-based, and a hybrid combining both volume-and value-based. This will help to delineate the different manners by which natural gas can be taxed, in addition to the associated positives and negatives with each. Lastly, the second part will also explore two types of severance tax specific exemptions that are used with the various tax methods to afford cost reductions in certain situations.

Part III discusses the current policy in Pennsylvania legislation specific to natural gas extraction known as the impact fee. The purpose behind the levy will shed light on determining whether this is the solution Pennsylvanians are looking for when apportioning costs on the natural gas industry. Additionally, the tension between political parties as proponents and opponents to severance tax will be shown to largely shape the severance tax debate.

Lastly, Part IV offers a recommendation of what the best method is for Pennsylvania and its citizens to take towards natural gas producers within the state. This part discusses the current circumstances and events in the Commonwealth. Additionally, a reflection on similar events of the past and the pitfalls of industry on the community will be utilized to provide an additional perspective on the matter. Taken together these four parts will conclude upon Pennsylvania's enactment of a severance tax in order to ensure the state and citizens directly benefit from this hometown geological windfall and to promote the state's sustainability for years to come.

1. PENNSYLVANIA: STANDING OUT IN THE NATURAL GAS CROWD

   A colossal underground sedimentary rock formation spanning 54,000 square miles between 300 and 6,000 feet below the Earth's surface has not only created a highly attractive energy industry, but has also made this Note possible. (6) While various rock formations, otherwise known as "shale plays," have been the source of natural gas extraction in the United States, one in particular spans thousands of feet below the surface of Pennsylvania, New York, West Virginia, and parts of Ohio: The Marcellus Shale. (7) The natural gas found within the cracks and pores of the rocks has taken millions of years of decomposition to develop this one-time immovable resource. (8) The Marcellus Shale, one of the first shale plays to be tapped, has been producing gas for over fifty years. (9) The untapped natural gas within the shale is enough to supply United States consumption for almost two decades. (10) Not until recently have the technological advances and developments of the horizontal drilling process allowed natural gas to be extracted in greater quantities and more efficiently. This innovation has made the industry more profitable and natural gas a more desirable, obtainable resource.

   Buried up to 9,000 feet under the surface, approximately sixty percent of Pennsylvania's total land mass is above the Marcellus Shale. (11)

   Historically, natural gas exploration and development activity in Pennsylvania was relatively steady, with operators drilling a few thousand conventional (vertical) wells annually. Prior to 2009, these wells produced about 400 to 500 million cubic feet per day of natural gas. With the shift to and increase in horizontal wells, however, Pennsylvania's natural gas production more than quadrupled since 2009, averaging nearly 3.5 billion cubic feet per day in 2011. (12) Despite years of policy debate amidst increased production levels, Pennsylvania has yet to impose a severance tax on natural gas.

   In fact, this birthplace of the oil industry has never taxed oil production, coal mining, or any of its natural resources. (13) "Pennsylvania is the only one of the top 15 gas-producing states that doesn't have a gas tax ... [I]t's one of 17 states that don't [sic] have a natural resource extraction tax of any sort." (14) While this resource remains untaxed, natural gas production has continued to boom within the boundaries of the state. "As of August 2012, about 6,400 Marcellus wells were drilled in Pennsylvania and nearly 2,500 additional permits were provided. On average there are two wells per pad, or roughly 3,200 pads in the state currently." (15)

   Undoubtedly, the fracking process has enabled Pennsylvania's success as a prominent natural gas supplier. This method of extraction involves a combination of vertical drilling which bends into horizontal drilling upon striking the shale formation, followed by injecting millions of gallons of water mixed with chemicals (16) and sand at a high pressure to break up the rock, releasing gas allowing it to flow up the vertical section to the surface. (17) Natural gas has the ability to change the energy sector in the United States, and Pennsylvania's prime real estate atop the Marcellus Shale will be a large contributor to this transformation.

2. SEVERANCE TAX: WHAT IS IT? (18)

   Talks of taxation are often intimidating to individuals who are not familiar with the intricacies of the business. This wariness often leaves the topic as the "elephant in the room." Despite taxation's seemingly intimidating nature, when broken down, the term "severance tax" appears to be self-explanatory and largely unoriginal. Put simply, severance tax is a form of taxation placed on the individuals or, most likely, companies who sever or extract natural resources from the state. The tax is usually paid by the gas well operator who physically extracts the gas from below the surface, and also by anyone else with a royalty interest in that gas. (19) Severance tax has two defining characteristics that separate it from other tax forms such as property taxes. First, "severance tax is on the volume or value of the commodity removed, as assessed at the time of removal." (20) Second, after severance tax is applied to a unit of gas, such gas is never subject to severance tax again. (21) Severance taxes have been placed upon a variety of natural resources such as coal, timber, and natural gas. (22) The money generated from this tax is then often used towards maintaining the state's environment and infrastructure.

   1. Severance Taxation Schemes: The Methods to Solve the Madness

      Because severance taxation is a creature of the state, the manner of assessing the tax has taken various forms. Large natural gas-producing states such as North Dakota, Texas, and West Virginia are all case studies for the different methods. (23) Overall, three main methods of severance taxation exist, those being: (1) volume-based, (2) value-based, and (3) a hybrid combining both volume- and value-based. (24)

      1. Volume-Based Extraction Tax

         The volume-based extraction method involves monitoring natural gas wells. The tax is measured by a flat rate charged per thousand cubic feet of gas that is piped from an individual well. (25) A major disadvantage to this system is that fluctuating gas prices do not change the rate of tax. (26) "When the price of gas is relatively high, gas producers gain a windfall, while the Commonwealth is left without benefit from the higher prices." (27) Conversely, when prices are low, this tax appears to be a hefty cost for the producers.

      2. Value-Based Extraction Tax

         On the opposite end of the spectrum, there is value-based extraction tax. This tax on the value of gas extracted is applied to the value of the gas...