A Magic Way to Make Billions

By Donald L. Barlett, James B. Steele

The wording is so bland and buried so deep within a 324-page budget document that almost no one would notice that a multibillion-dollar scam is going on. Not the members of Congress voting for it and certainly not the taxpayers who will get fleeced by it. And that is exactly the idea.

With Washington reeling from the Abramoff lobbying scandal and Republicans and Democrats alike pledging to crack down on influence peddling, with one lawmaker already gone from Capitol Hill because he traded favors for cash, you're probably guessing this isn't the best time for members of Congress to dispense a fortune in favors to their friends.

Guess again.

Buried in the huge budget-reconciliation bill, on which House and Senate conferees are putting the final touches right now, are a few paragraphs that accomplish an extraordinary feat. They roll back the price of a barrel of crude oil to what it sold for two years ago. They create this pretend price for the benefit of a small group of the politically well connected. You still won't be able to buy gasoline for $1.73 per gal. as you did then, instead of today's $2.28. You still won't be able to buy home heating oil for $1.60 per gal., in place of today's $2.39. But a select group of investors and companies will walk away with billions of dollars in tax subsidies, not from oil but from the marketing of a dubious concoction of synthetic fuel produced from coal and dependent on government tax credits tied to the price of oil.

From 2003 through 2005, TIME estimates, the synfuel industry raked in $9 billion in tax credits. That means the lucky few collectively cut their tax bills by that amount, which would be enough to cover a year's worth of federal taxes for 20 million Americans who make less than $20,000 a year and pay income taxes. How important is the tax credit to synfuel producers? In its latest annual report, Headwaters Inc., a Utah-based purveyor of synfuel processes and substances, says flatly, "Headwaters does not believe that production of synthetic fuel will be profitable absent the tax credits."

To understand why Washington wants to backdate the price of oil for its friends, it's necessary to return to the oil shocks of the 1970s, when long lines formed at gas stations and people dialed down the thermostats in homes and apartments so they could afford to pay their utility bills. In 1980, Congress enacted tax incentives that were designed to spur the development of a synthetic-fuel industry. The goal was to build huge plants using new technologies that would transform raw coal, which the U.S. has in abundance, into synthetic natural gas and oil to heat homes and factories, power cars and--here comes the ever popular bromide--reduce U.S. dependence on foreign oil. As then House majority leader Jim Wright, a Texas Democrat, put it at the time, "[This] will show Americans the nation is moving ahead. We are going to declare our energy independence."

When oil prices fell, Washington lost interest in creating a real synfuel industry, and the grand projects to promote energy independence came to nothing. But the synfuel credit remained on the books, dormant, until a group of enterprising entrepreneurs came across it in the 1990s and saw a way to transform coal into gold.

The coal can look and burn like regular coal. The IRS rule for transforming coal into synfuel--and getting the tax credit--requires only that the substance be chemically altered in some way. The alchemy that satisfies the IRS is a simple process: some plants spray newly mined coal with diesel fuel, pine-tar resin, limestone, acid or other substances--a practice that industry critics call "spray and pray." Other operators mix coal-mining waste with chemicals, coat it with latex and blend it with untreated coal to form briquettes. (For an earlier story on the scheme, see "The Great Energy Scam," TIME, Oct. 13, 2003.)

Once a few pioneers started reaping the tax credits, it wasn't long before plants using various techniques sprouted next to coal-burning power plants, which buy the so-called synfuel and use it as they would any other coal. Those synfuel operations were a far cry from the state-of-the-art plants that Congress had envisioned as performing a more radical transformation. Instead, they were flimsy facilities that could be easily dismantled and moved to other locations.

Today about 55 such plants around the U.S. process 125 million tons of coal or, in many cases, coal waste from an earlier mining era. For owners and operators, the whole point isn't creating a profitable new energy resource for the U.S.; it's about collecting the tax subsidy. Progress Energy Inc. of Raleigh, N.C., which owns electric utilities that serve portions of the Carolinas and Florida, reported in a filing with the Securities and Exchange Commission that in 2002-04 its synfuel-production losses added up to $400 million. No problem: the company claimed $852 million in tax credits, magically transforming a money-losing operation into a money-making business with $452 million in profits--courtesy of the American taxpayer. And that's not all. Like other synfuel producers, Progress Energy can't immediately use all the tax credits it mines because of tax-law limitations. As of Dec. 31, 2004, it was sitting on $745 million in deferred credits that it can write off against future earnings for years to come. And Progress Energy is not alone. Plants run by DTE Energy Co. of Detroit generated $1.2 billion in tax credits during the same years.

This was not what Congress had in mind in 1980 when it enacted the subsidy. The idea was to stimulate the birth of a new industry that would make synthetic fuel competitive with the price of conventional oil and gas. To achieve that end, lawmakers pegged the value of the credit to the price of crude oil. If oil prices were to rise above a certain level, the synfuel industry would no longer need the credit to make a profit and the subsidy would be phased out. As long as oil prices were below $50 per bbl., synfuel producers could claim the full value of the credit. But in the past year, as prices have risen to as much as $66 per bbl., anxiety has spread through the synfuel ranks that their boondoggle is imperiled.

Tax experts differ on how high oil prices would have to go to wipe out the full value of the credit, but most agree that if oil were to remain at recent peak levels, or climb even higher, few synfuel operators could claim the full credit. Citing that uncertainty, the Marriott Corp., which has invested in four synfuel plants, temporarily suspended production in January. Before the shutdown, Marriott had racked up $370 million in synfuel profits.

With so much at stake, the synfuelers have pumped money into a campaign to preserve their tax break. At the center of the synfuel lobby in Washington is a consortium called the Council for Energy Independence. It's a name worthy of the most successful Washington lobbies, in which private interests camouflage their mission under the banner of a worthy-sounding cause. The council is directed by one of Washington's premier tax lobbyists, Kenneth J. Kies, managing director of the Clark Consulting Federal Policy Group. A former chief of staff of the Joint Committee on Taxation, the congressional panel that oversees the drafting of tax laws, Kies is well situated to guide legislation that could be worth hundreds of millions of dollars a word.

Since 2002, the Council for Energy Independence has spent $2 million lobbying Congress to preserve the tax credit, according to reports filed with the Senate Office of Public Records. Overall, TIME estimates, the synfuel lobby has spent more than $5 million during that same period. The effort has got results. In recent years, the lobby has successfully turned aside efforts to revoke the IRS rulings on which the tax credits are calculated. It beat back an effort in the House Ways and Means Committee last year to send a bill to the House floor that would have virtually eliminated the tax credit. The bill's sponsor, Lloyd Doggett, a Texas Democrat, called the tax credit "one of the worst tax loopholes on the books" and described the synfuel industry as "basically a sham." Nevertheless, because of industry lobbying, Doggett's bill has never made it out of committee.

Last November the lobby scored a remarkable coup. 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."

Section 559 begins on page 317 of the bill and is written in the obscure jargon of all special-interest tax breaks--almost impossible to decipher, so bewildering is its language. At first glance, it looks like nothing more than a technical amendment to clarify some arcane section of tax law. But one clause offers a clue. It says the synfuel credit will be based not on current oil prices--the yardstick used in the past--but on "the amount which was in effect for sales in calendar year 2004."

In 2004 oil prices were safely below the line to allow synfuel producers to claim the maximum credit. The stealth amendment would roll back the calendar. (Sort of like your missing the deadline for your mortgage payment, then backdating your check to avoid a late charge. But much more lucrative.) The backdating clause was in a larger bill introduced in the Senate by Charles Grassley, the Iowa Republican who heads the Senate Finance Committee. It was inserted in the Tax Relief Act, which provides aid for Hurricane Katrina victims and sets new policies for tax-exempt groups. With so many higher profile issues at stake, the clause on synfuels sailed right through with no discussion. Many lawmakers, if not most, don't even know it's there.

When asked about the provision's origins, Senate Finance Committee aides at first said they did not know, only that it did not "originate" with Grassley. One aide noted that the Senator "ultimately is responsible for everything in [the bill], but routinely with such bills, other committee members propose certain ideas, and he accepts them or rejects them as he sees fit."

Asked again by TIME to identify the author, the Senate Finance aide later wrote in an e-mail, "the provision originated as an amendment from Sen. [Rick] Santorum [a Pennsylvania Republican]. Sen. [Gordon] Smith [an Oregon Republican] had a similar amendment co-sponsored by several other Senators, Republicans and Democrats. Chairman Grassley accepted the Santorum amendment ... It's routine for him to accept non-controversial provisions that way rather than have the committee vote on each amendment ... So now the Santorum amendment is in the bill." A Santorum aide said the senator pushed the provision to "provide parity for the non-conventional fuel tax credit with other energy tax credits and to provide certainty for taxpayers." He added that it would also "allow coke plants" to take advantage of tax incentives, claiming "this is important to the steel industry, which employs thousands of Pennsylvanians -- making it more competitive in the global market." Coke, produced from coal or crude oil, is used in steelmaking.

The bill is now part of Congress's budget-reconciliation process. But there is no synfuel amendment in the House bill, meaning that it cannot become law unless the House conferees agree to the Senate provision. Bill Thomas, the California Republican who heads the House Ways and Means Committee, by some accounts is not in favor of the synfuel provision, but whether he will actively oppose it remains to be seen. There are already major differences between the House and Senate reconciliation bills on much larger issues like Medicare, so the odds are that synfuel may slip through again.

Another Senate supporter of the credit is Orrin Hatch of Utah, the ranking Republican on the Finance Committee. An aide said Hatch believes the new provision in the Senate bill "helps make the current credit work better." Utah-based Headwaters Inc., one of the synfuel industry's most active companies, licenses its technology as well as sells materials to synfuel producers. "If the tax credits under Section 29 of the Internal Revenue Code are repealed or adversely modified," the company said in its latest annual report, "Headwaters Energy Services' profitability will be severely affected."

The synfuel lobby contends that the exemption from the run-up in oil prices is necessary to create stability in the industry. "We think it is very fair legislation," Gordon Gillette, chief financial officer of Teco Energy Inc., a utility based in Tampa, Fla., told investment analysts last month. "It eliminates the uncertainty that we have right now and are dealing with right now on oil prices."

And the synfuel lobby expects to carry the day too, largely because Congress has bigger issues to deal with. Kirk Benson, the chairman and CEO of Headwaters, told analysts that "in the world of Washington, D.C., what we want to do isn't material ... It's an afterthought."

Whatever the outcome, the battle over the provision is little more than a warm-up for the legislative fight that will take place in 2007. That's when the tax credit is set to expire and the industry will seek to make it permanent. As Headwaters' Benson has told analysts, with a touch of understatement: "It will become an intense topic in '07."

With reporting by Jeremy Caplan, Research by Joan Levinstein