In Notice 2017-51, the IRS announced the inflation adjustment and the reference price used to calculate the marginal well production credit (MWC) for qualified natural gas production during tax years beginning in 2016. The inflation adjustment and reference price announced by the IRS result in a credit for qualifying production of $0.14 per 1,000 cubic feet (mcf).

Background

Section 45I allows a credit for producing oil and natural gas from qualified marginal wells. Qualified marginal wells include any well producing oil or natural gas that qualifies as marginal production for purposes of the percentage depletion allowance. These generally are stripper wells producing on average no more than 15 barrel-of-oil equivalents of oil and natural gas per day and wells for which heavy oil accounts for substantially all production. Marginal wells also include wells having an average production of no more than 25 barrel-of-oil equivalents per day, and water production at a rate of no less than 95% of total well effluent. The credit is limited to the first 1,095 barrels or barrel-of-oil equivalents produced from a well during the tax year (with adjustments for short tax years and less-than-full-year production). Unlike the percentage depletion allowance, there is no overall per-taxpayer limitation.

The basic credit amount for qualified natural gas production is $0.50 (adjusted for inflation) per mcf. The basic credit amount, however, is reduced (but not below zero) if the applicable reference price for natural gas for the year exceeds $1.67 (adjusted for inflation). The reduction is computed in four steps:

(1) Subtract $1.67 (adjusted for inflation) from the applicable reference price for natural gas
(2) Divide the result in (1) by $0.33 (adjusted for inflation)
(3) Multiply the basic credit amount ($0.50 adjusted for inflation) by the result in (2)
(4) Reduce the basic credit amount by the amount determined under (3)

The inflation adjustment for a calendar year (applicable to tax years beginning in the calendar year) reflects price increases between 2004 and the preceding calendar year. The reference price for a calendar year (also applicable to tax years beginning in the calendar year) is the Secretary of the Treasury's estimate of the annual average wellhead price per mcf for all domestic natural gas in the calendar year preceding the calendar year. Thus, the reference price for tax years beginning in 2016 is based on wellhead prices of natural gas in 2015.

Similar rules apply for purposes of determining the marginal well production credit for qualified crude oil production, with $15.00 per barrel substituted for $1.67 per mcf and $3.00 substituted for $0.33. For all years since the enactment of the marginal well production credit, the reference price for crude oil (e.g., $38.29 in 2016) has been substantially greater than $15.00 per barrel adjusted for inflation ($18.50 in 2016) and the marginal well production credit for crude oil has been phased out.

Until December 2012, the Energy Information Administration (EIA), an independent agency within the Department of Energy, published estimates of annual average wellhead prices for natural gas. Because of the one-year lookback, these estimates provided reference prices through calendar year 2013. Based on the EIA estimates, the marginal well production credit for natural gas was not available for 2013 and prior years. In 2013 and 2014, other indices for natural gas prices (such as Henry Hub spot prices) reflected substantial increases in natural gas prices, and it is unlikely that the credit would have been available for natural gas in 2014 or 2015. In 2015, however, natural gas prices fell significantly, leading many in the industry to believe the credit for natural gas would be available for tax years beginning in 2016.

Notice 2017-51

The Notice announces that the inflation adjustment factor for tax years beginning in 2016 is 1.2332. Accordingly, the $1.67, $0.33, and $0.50 amounts described previously are increased to $2.06, $0.41 and $0.62, respectively. The Notice also announces that the reference price for tax years beginning in 2016 is $2.38 per mcf. Accordingly, the credit amount for tax years beginning in 2016 is $0.14 per mcf, computed as follows:

(1) $2.38 (reference price) — $2.06 ($1.67 adjusted for inflation) = $0.32
(2) $0.32/$0.41 ($0.33 adjusted for inflation) = .78
(3) $0.62 ($0.50 adjusted for inflation) x .78 = $0.48
(4) $0.62 - $0.48 = $0.14

The Notice explains that the reference price for tax years beginning in 2016 was calculated by reducing the EIA estimate of annual average wellhead prices for 2012 ($2.66 per mcf) proportionally to the reduction between 2012 and 2015 in the Producer Price Index for natural gas from the wellhead. The Notice announced that a similar procedure would be followed in the future. For example, for tax years beginning in 2017, the annual average wellhead price would be the annual average wellhead price for tax years beginning in 2016 ($2.38) adjusted up or down proportionally to the change in the Producer Price Index between 2015 and 2016. The Producer Price Index used in these calculations is published by the Bureau of Labor Statistics as part of its Producer Price Index program.

In the Notice, the IRS states it will provide guidance on how to claim the credit on IRS.gov, tax forms, or instructions or through other published guidance. It also allows 2016 return filers that either did not claim the credit or claimed a different credit amount from the Notice's $0.14 per mcf credit to file an amended return claiming the $0.14 per mcf credit.

Implications

The Notice provides much needed certainty to taxpayers producing natural gas from qualified marginal wells.

The Notice advises 2016 return filers to consider consulting with a tax advisor to determine if they want to file an amended return to claim the credit (or the proper amount of the credit). Although it is unfortunate that such advice is necessary, it is likely to be a concern only for 2016 returns. The Notice announces the procedure that the IRS plans to follow in calculating the reference price for 2017 and subsequent years. Thus, the IRS should be able to publish future reference prices on a timely basis.

The IRS requests written comments, including comments on the methodology for determining the reference price. It is our understanding that EIA was not fully confident in its methodology for determining the 2012 annual average wellhead price for natural gas. Since this has become the baseline for determining the reference price for 2016 and subsequent years, there may be opportunities to improve the Notice's methodology. Any comments should be submitted to the IRS before November 16, 2017.

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