House Republicans have a plan – and President Donald Trump has made a promise – to reform corporate tax in the United States. Economists say it could be a game-changer for oil and gas.
Touted as tax reform worthy of the late President Ronald Reagan, the package of talking points, “A Better Way: Our Vision For A Confident America,” is making its way through the halls of Congress now that the new administration is installed.
Among the key elements of the proposal is a controversial border adjustment tax (BAT), which would cut the tariff on exports and levy a 20 percent fee on imports, and chop corporate taxes from 35 percent to 20 percent.
The U.S. corporate tax is currently the highest in the developed world, a function of decades’ worth of global trade policy.
“This tax burden is driving businesses out of our country,” said Speaker Paul Ryan, R-Wisconsin, when he unveiled the plan. “In 1960, 17 of the 20 largest global companies were headquartered in the United States. As of 2016, that number has dropped to just 6. Our plan lowers the corporate tax rate to a more globally competitive level.”
Ryan and others say any pass-through costs to the consumer would be balanced by an increase in the value of the U.S. dollar. Not only would the currency align, so would the price of WTI as it surges $10 per barrel past Brent, they argue.
The philosophy of taxing what comes into the country, but not what goes out, fits into the “America First” rhetoric that factored into Trump’s ascendancy. And for his part, the Trump Administration has floated the idea of selectively taxing imports – and in the case of Mexico, to force the country to pay for Trump’s border wall.
But that approach poses challenges, said Ed Hirs, managing director at Hillhouse Resources and an energy economics professor at the University of Houston.
“Take a look around you, your cell phone, the telephone you’re speaking on, the computer monitor, essentially the cost of those items for the importers is going to go up, which means of course it’ll be passed along to you, the consumer,” Hirs said. “They’ve got a naïve, simpleton assumption that the value of the dollar will increase enough to offset the losses to consumers. But that assumes that our trading partners and the Federal Reserve go along with this scheme.”
Indeed, Hirs and other economists suggest the move could easily lead to a trade war – and inflation.
“The simpleton plan that’s been proposed really has not thought through the downstream impacts,” Hirs said. “They’ve got their order of conditions of what will happen, but they really haven’t stopped to think that this is going to cause a very significant dislocation that just with the ordinary frictions in the economy will not be a trivial realignment.”
Still, the idea of reducing the corporate tax rate is one it seems everyone in the United States – on both sides – could get behind.
But critics say the plan is so short on details that it’s hard to say what it represents. Indeed, no bill has been filed. And there is concern the proposal is all-too-likely to raise the price of gasoline, and ultimately, set the stage for a recession.
The president has pledged to reform corporate taxes reform, but he’s not quite on board with the GOP’s reform package. In January, Trump told the Wall Street Journal the tax was too complicated.
“Anytime I hear border adjustment, I don't love it,” he told the newspaper.
Analysts at Credit Suisse (CS) said this month their outlook for 2017 shows political risk on the rise.
“U.S. President Trump, for his part, has wasted no time introducing a bit more uncertainty since his inauguration January 20,” they said. “Most pertinent for oil markets, so far, is the uncertain prospect of a border adjustment tax regime being imposed on trade with the U.S.”
A realignment between WTI and Brent would immediately benefit domestic oil and gas producers, who would finally get a higher price for their product when selling it locally.
“You could easily see a boom in domestic production,” said John Gimigliano, head of federal legislative and regulatory services at KPMG LLP. “But on the flipside, if you don’t buy the currency issue, what does this do to the refining sector? Either way, there is a demand in the U.S. for finished products that is not going to go away. In fact, Congress is arguing that the plan would increase [gross domestic product] and that in turn would increase that demand.”
Analysts at Goldman Sachs (GS) said U.S. exploration and production (E&P) companies could see as much as $20 billion each year in extra cash flow. But even that could cause problems, GS said.
“We assume that U.S. producers would re-invest cash in incremental activity, driving higher U.S. production, cost inflation and ultimately lower global oil prices,” they wrote in researching the proposal.
But refiners, especially those that are miles away from the coast and depend on foreign-sourced crude, could see more downside than other sectors, Gimigliano said.
“Under current law, if I buy [crude] for $50 and then I sell the finished products for $100 – today, I’d have $50 in income subject to tax at a 35 percent rate. Under the border adjustable tax, if I buy it for $50 and sell it for $100, I don’t get any deduction for the imported crude. I would have $100 of taxable income taxed at a 20 percent rate,” he said. “So I double the amount of taxable income I have under that scenario but tax it at a lower rate. That’s the big implication for the import side.”
It creates an incentive for refiners to buy “Made in America” crude, said Regina Mayor, KPMG’s global sector head and U.S. national sector leader of energy and natural resources.
“That means that U.S. supply potentially becomes more valuable inherent to Saudi or high sulfur grades that come from Mayan crude in Mexico, and there is a strong belief that WTI will start trading at a higher differential and it will exceed Brent because there will be this constrained, non-free market requirement that incentivizes refiners to buy these ‘Made in America’ molecules,” she said. “That’s a net positive for the U.S. producer, but that cost can get passed on to the American consumer, and it will result in much higher gasoline prices. It can’t be absorbed into anything else.”
In addition to the benefit to domestic producers from higher WTI prices, a producer exporting crude would see significant upside.
“There’s no tax on that at all. That creates a really strong incentive for exporting,” Gimigliano said. “That’s a big change. It wasn’t that long ago that you weren’t even permitted to export crude.”
As such, refiners might look to export their products to find upside to balance the tax on imported crude. Or, Mayor said, from a margin perspective, a refiner could buy domestic crude and export the refined product – but that would reduce domestic supply, which could also drive up domestic gas prices.
“I live in Texas, and we still have our Ford F-250 trucks and our Cadillac SUVs. We like our vehicles. Refining margins are a little bit higher right now with depressed crack spreads, but we’re roughly where supply equals demand,” she said. “I don’t see how you can meet that demand without having these companies stay in business. They (the refiners) will likely figure out how to play the economic game.”
But ultimately, it could be consumer pain at the pump that thwarts the border adjustment tax. Indeed, it’s that fear of increasing the price of gasoline that has derailed attempts to limit imported oil into the United States.
“We haven’t increased the gas tax in this country since 1993 because it is viewed by many as a political third rail,” Gimigliano said. “How will that argument play out in Congress? I don’t have a good answer for that.”