Ken Silverstein EnergyBiz Insider Editor-in-Chief

A recent expose in Time magazine points out that buried deep inside the pending 324-page budget is one provision that might otherwise go unnoticed. Specifically, it points to an obscure passage that would allow "synfuel" makers the right to base their tax credits as if the price of a barrel of oil were at 2004 levels. While that sounds sort of bland -- it's meant to be just that -- the reality is that it will put billions into the pockets of a very few.

"Last November the (synfuel) lobby scored a remarkable coup," says Time, in a piece dated March 6. "Buried deep in a bill called the Tax Relief Act of 2005, passed by the Senate on Nov. 18, was Section 559, titled Modification of Credit for Producing Fuel from a Nonconventional Source."

It's all worth $9 billion, says Time -- federal taxes saved between 2003 and 2005. The controversial tax credit is worth $1 billion to $3 billion annually and is allowed under "Section 29" of the tax code. That break is set to expire for all facilities in 2007.

In 1980, U.S. lawmakers envisioned the synthetic fuel tax credit as helping the country ease its dependence on foreign energy sources. Certainly, many companies have tried to create new fuel sources from coal. But, others have merely sprayed already marketable coal with pine tars and diesel fuels just so that they could argue it has been chemically altered. While there was no discernable difference in the coal, the tax credits had at certain points actually exceeded the cost of a ton of coal. In 2002, the Charleston (WV) Gazette reports that coal synfuel tax credits were worth $26 a ton, which was higher than the price of a ton of coal in the state.

The pending tax provision is now awaiting reconciliation by a House and Senate conference committee. Here's how it would affect the synfuel industry: Under the law as written, if oil prices stay below $50 a barrel, synfuel companies can take the full tax credit for every ton of synthetic coal they produce. Oil prices, of course, have risen to at least $60 a barrel and that means some of those credits can't be taken.

When the law was written, the rationale was that if oil prices rose, the market would then have the incentive to develop alternatives to crude. If the new provision sails through Congress, the synfuel makers could assume oil is well below today's price and at a level that they could qualify for the full tax deduction.

"The program remains controversial, in part because of the significant investment in plants and associated tax benefits by the owners," says Standard & Poor's credit analyst Jodi Hecht, in a previous report.

IRS Attention

In essence, the synfuel tax credits could reduce a corporation's effective tax bracket. Since 1995, the IRS has suspended the issuance of private letter rulings for synfuel plants at least four times. Companies that own, operate and benefit from tax credits are still at risk for audits of past tax years, Hecht adds. Furthermore, the potential liability grows over time as the production and current tax credits are used. Most of the nation's 56 synfuel plants are located east of the Mississippi River, with many of those in West Virginia and Kentucky.

The Time story reports that the synthetic fuel industry has formed a group called the Council for Energy Independence, which has spent $2 million lobbying Congress to preserve the tax credit. The price tag is apparently a good deal: It was able to revoke efforts by the IRS to recalculate just how the credits are calculated and helped kill bills in Congress that would wipe out the benefit.

The IRS, for its part, "continues to recognize that many taxpayers and their investors have relied on its long-standing ruling practice to make investments. Therefore, the [IRS] will continue to issue rulings on significant chemical change but only under" closer scrutiny. The agency acknowledged certain processes do not produce the "level of chemical change" and that those methods would get reviewed.

Lots of utilities are in the synfuel business: Cinergy Corp., Constellation Energy, Duquesne Light, DTE Energy, Dominion Resources, PacifiCorp, PPL Corp., SCANA Corp., Southern Co., Sempra Energy, TECO, Vectren Corp. and WPS Resources.

Progress Energy is also a synfuel maker. In filings with the U.S. Securities and Exchange Commission, it said that its losses tied to the fuel source between 2002 and 2004 were $400 million. But, it was able to take about $850 in tax credits. Basically, taxpayers subsidized a company profit in this endeavor of $450 million.

In its latest annual report, Utah-based Headwaters that makes synfuel-related products says, "Headwaters does not believe that production of synthetic fuel will be profitable absent the tax credits." TECO adds that the pending legislation to allow companies to peg their tax breaks to the price of oil in cheaper days is "very fair legislation."

To be sure, there are worthy projects. "Syngas" -- the gasifying of coal -- to generate electricity is getting increasing attention. Coal waste, meantime, can be transformed from an ecological nightmare to a low-cost way to produce electricity. Along those lines, Progress Energy vehemently defends its synfuel services, noting that it takes an otherwise environmental hazard -- coal waste -- and makes it usable.

Synfuel was a well-intentioned federal undertaking. And, in some cases, it remains a viable program. In others, however, it has been abused. The goal now before lawmakers is to narrow the scope of the law so as to weed out the legitimate projects from those that are merely shams.

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