In Notice 2018-52, 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 2017. The inflation adjustment and reference price announced by the IRS result in a credit for qualifying production of $0.51 per 1,000 cubic feet (mcf). (See IRB 2018-22, page 629.)

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 2017 is based on wellhead prices of natural gas in 2016.

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., $48.05 in 2017) has been substantially greater than $15.00 per barrel adjusted for inflation ($18.78 in 2017) 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 and the IRS announced in Notice 2017-51 that a credit of $0.14 per mcf would be available for natural gas produced in tax years beginning in 2016. The credit was based on an inflation adjustment factor of 1.232 and a reference price of $2.38 per mcf for tax years beginning in 2016. The Notice explained that the reference price 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. The Notice announced that a similar procedure would be followed in the future, with two modifications. First, the Producer Price Index for natural gas from the wellhead would be used instead of the Producer Price Index for natural gas. Second, the reference price would be calculated by applying the change in the index since the previous year to the previous year's reference price. Thus, for tax years beginning in 2017, the IRS intended that the reference price would be the reference price for tax years beginning in 2016 ($2.38) adjusted up or down proportionally to the change in the Producer Price Index for natural gas from the wellhead between 2015 and 2016.

Notice 2018-52

The Notice announces that the inflation adjustment factor for tax years beginning in 2016 is 1.2518. Accordingly, the $1.67, $0.33, and $0.50 amounts described previously are increased to $2.09, $0.41 and $0.63, respectively. The Notice also announces that the reference price for tax years beginning in 2016 is $2.17 per mcf. Accordingly, the credit amount for tax years beginning in 2016 is $0.51 per mcf, computed as follows:

(1) $2.17 (reference price) – $2.09 ($1.67 adjusted for inflation) = $0.08

(2) $0.08/$0.41 ($0.33 adjusted for inflation) = .195

(3) $0.63 ($0.50 adjusted for inflation) x .195 = $0.12

(4) $0.63 – $0.12 = $0.51

The Notice explains that the IRS was unable to follow the plan described in Notice 2017-51 to use the Producer Price Index for natural gas from the wellhead in computing the reference price. That would have required full year indices for both 2015 and 2016, and only the full year index for 2016 was available. Accordingly, the computation continued the use of the Producer Price Index for natural gas. For years beginning after 2017, the Producer Price Index for natural gas from the wellhead will be available for the two preceding calendar years and will be used to calculate the reference price. The Producer Price Index used in these calculations is published by the Bureau of Labor Statistics as part of its Producer Price Index program.

Implications

The Notice provides much-needed certainty to taxpayers that produced natural gas from qualified marginal wells in 2017 and provides a transparent process for computing the credit going forward. Although the Notice does not address the credit amount for tax years beginning in 2018, BLS reported a substantial increase in the Producer Price Index for natural gas from the wellhead between 2016 and 2017 (from 67.5 to 83.4). As a result, it appears that, under the Service's current methodology, the credit will not be available for tax years beginning in 2018. For the months of March and April 2018, however, BLS has preliminary reported that the index has dropped below the annual average for 2016 (which was used to compute the 2017 credit). If this reduction in wellhead prices is sustained, the credit may once again be available for tax years beginning in 2019.

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