What Chesapeake's Tax Bill Tells Us About Its Profits

Workers prepare for adding pipe at a Chesapeake Energy natural gas drilling site.
Daniel Acker | Bloomberg | Getty Images
Workers prepare for adding pipe at a Chesapeake Energy natural gas drilling site.

How is it that Chesapeake Energy pays so little in taxes?

Last year a team of enterprising Bloomberg journalists reported that although Chesapeake had booked $5.5 billion in pretax profits since its founding, it had paid just $53 million in federal taxes. The Bloomberg story framed this as the result of an outdated tax subsidy.

The thrust of the Bloomberg story was that Chesapeake unfairly benefits from the tax subsidy. Predictably, Democratic lawmakers reacted by calling for an end to the practice.

But truth might be even more troubling than the lawmakers or Bloomberg reporters realize. The tiny amount of taxes Chesapeake pays may better reflect the economic reality of the company than its financial reporting. That is to say, the tax code may have it right—Chesapeake may not really be very profitable at all.

Ordinarily, companies are required to capitalize expenses on things that are expected to last more than a year. This means that they cannot deduct the full cost of a piece of equipment in the year it is purchased. Instead, they get to take smaller deductions over what the tax code considers the useful life of the thing purchased.

The big "tax break" that Chesapeake reportedly takes advantage of is a rule that allows oil and gas producers to immediately expense their "intangible drilling costs" (IDC).

KPMG has a helpful primer on how this works. Here's its example:

If the taxpayer purchased a fuel storage tank for $10 to power a drilling rig, the taxpayer would recover the $10 cost through depreciation. However, if the taxpayer purchased $5 in metals to make the fuel tank and incurred $5 of IDC in constructing the tank, the taxpayer would recover the $5 tangible cost through depreciation and deduct $5 as IDC.

That is to say, Chesapeake is able to reduce its taxable income by immediately deducting the costs of stuff related to the drilling and preparation of wells for oil and natural gas.

Chesapeake is not, however, required to apply the same immediate deduction to its income for the purposes of financial reporting. In fact, it's not permitted to do so. Generally accepted accounting principles require companies to recognize many of these expenses in stages—over the lifespan of the equipment.

This means that Chesapeake's GAAP expenses are much lower than its expenses for tax purposes, which is part of the reason why the company has been able to report $5.5 billion in pretax profits over the years. But, in this case at least, it appears to be the tax code that has it right when it comes to the economic reality of Chesapeake. The company burns through lots of cash by drilling.

This difference between tax accounting and GAAP accounting is not unique to Chesapeake, of course. Almost every major corporation reports income differently for GAAP purposes and tax purposes. But because of the favorable treatment of intangible drilling costs, the gap at Chesapeake is larger than it is for many other companies.

A Chesapeake representative says that despite the tax break, the company paid over $6 billion in combined federal, state and local taxes, including ad valorem taxes, severance, sales, employment and corporate income and franchise taxes. The company has accrued an additional $3 billion in future corporate income taxes, according to the representative.

This raises another issue. The tax code may be driving Chesapeake to drill more than it otherwise would. As long as Chesapeake is able to keep it's drilling costs high enough, it can continue to avoid paying those accrued taxes. But if it were ever to slow down drilling or stop altogether, it would get hit with a tax bill for the revenue from its wells.

So it's a safe bet that Chesapeake will stay on the treadmill of spend and drill for as long as it can.

Follow me on Twitter @Carney