While much has been said about the impact on the dollar from the proposed Border Tax Adjustment, which may or may not be implemented depending on what Trump says/tweets on any given day (and as a reminder, there has already been a loud outcry against it by powerful lobby groups, including the Kochs, as a result of the expected decimation of US retailers should BTA be implemented) little has been said about how it could impact US commodity production in general, and oil in particular.
This morning, in a note titled "Destination-based taxation and the oil market", Goldman's Damien Courvalin focused on this issue and found that the price gain from shift to destination-based border adjusted corporate tax would prompt US drillers to “sharply increase activity" as a result of lower US corporate tax rates, which would aggressively incentivize shale drilling, resulting in a global oil price shock, sending domestic prices spiking, as global prices slide.
The border tax would have an inflationary impact on U.S. service costs and reduce U.S. dollar costs of foreign producers. A lower U.S. corporate tax rate “could force a deflationary tax policy response” elsewhere further reducing the marginal cost of oil. In short, "US oil prices would appreciate immediately and sharply vs. global oil prices"
If domestic oil prices remained at the same level as imported crude oil prices upon implementation of the BTA, US refiners would have an incentive to consume only domestically produced crude instead of importing crude as only the cost of domestic crude would be deducted for tax purposes, and (2) US producers would have an incentive only to export crude rather than to sell to domestic refiners as there would be no taxes on exports. This would lead to a sharp appreciation of the US domestic oil price relative to the global price oil.
Because US oil demand of 19.6 mb/d currently vastly exceeds domestic crude production of 13.5 mb/d, the US market requires imports of crude. As a result, refiners would bid domestic crude up until domestic prices rise enough to leave them indifferent about importing crude for their incremental barrels. Put another way, pricing power would be in the hands of producers upon introduction of this policy and they could charge US refiners up until these prefer to import foreign crude instead. Financial markets would anticipate this new equilibrium, with domestic oil prices reacting immediately to offset the impact of the border adjustment and leave refiners with the same pre-policy incentives to consume domestic or imported crude oil.
The magnitude of this relative price move would be determined by the new US corporate tax rate and, at 20% (the rate currently being proposed by the Republican tax BluePrint), it would imply US prices trading at a 25% premium over global oil prices.
Goldman warns that rising U.S. production would create a “renewed large oil surplus into 2018” and that there would be an “immediate decline in global oil prices” as other producers offset ramp-up in U.S. output. OPEC would probably raise production, supplies would grow and forward curve would move into “steep contango."
As an example, assuming a 15% dollar gain and 30% pass through to global production costs, Brent would decline to $50/bbl in 2019 from ~$57/bbl now.
In pricing terms, the higher U.S. crude price would pass through to consumers with modest impact on U.S. fuel demand growth. With $5/bbl rise in U.S. crude, demand to rise 70k b/d in 2018, 55k b/d below present forecast. Meanwhile, refiners would be left with excess returns as a result of the border tax.
In the longer term, Goldman predicts that a “new market equilibrium would arise” with U.S. prices returning to pre-policy level. Border tax would reduce imports and boost exports “in theory” causing dollar to appreciate 25% to reverse initial distortion; the USD appreciation has been duly noted. However, the medium-term outcome would likely be “modestly higher U.S. oil prices and sustainably lower global oil prices, with a shift down by U.S. producers and refiners on the global cost curve.”
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Here is the big picture from Goldman:
A switch to Border-Adjusted Tax (BTA) would immediately lead to a 25% appreciation of US crude and product prices vs. global prices (at a 20% corporate tax rate). This appreciation would provide excess returns to domestic producers and incentivize them to sharply increase activity. This improvement in shale’s competitiveness would be exacerbated by the introduction of a lower US corporate tax rate funded by the BTA. While the BTA’s inflationary impact on US service costs and the deflationary impact of USD appreciation on foreign costs should theoretically offset these shifts and push global prices down by 20%, the contracted nature of oil services implies that the BTA will initially leave US producers moving down on the global cost curve and capturing higher returns.
This significant incentive to ramp up US production in a market that is only starting to rebalance would create a renewed large oil surplus in 2018, likely exacerbated by a reversal of the OPEC cuts. This prospect should lead to an immediate sharp decline in global oil prices to try to offset such a potential US ramp-up, either by creating an offsetting foreign production decline or by normalizing US excess returns. Over the longer term, the decline in the US corporate tax rate and shale’s significant growth potential at higher returns could force a deflationary tax policy response abroad, sustainably reducing oil’s marginal cost of production.
Importantly, there would initially be no changes in US crude differentials and crude or product trade flows, with all US refiners benefiting from higher margins because of the lower tax rate. Differentiation between US refiners would only materialize if the supply response of US producers creates logistical constraints and wider domestic crude differentials.
And the executive summary:
Among the meaningful potential changes to the US corporate tax code, the most controversial appears to be the House Republicans’ proposal for a shift to a destination-based border-adjusted corporate tax (BTA) alongside a reduction of the federal statutory corporate tax rate. The practical effect of switching to destination-based taxation would be that US firms would exclude export revenues but would no longer deduct import costs when calculating their tax base.
There remains high uncertainty on whether this proposal will go ahead given the disruption that such an abrupt change in corporate tax policy likely entails. As a result, our economists assign only a 20% subjective probability to this policy being implemented , with the potential exemption of certain industries lowering the chances that it would impact the oil market further. Current WTI and Brent oil futures imply a 9% probability for a shift to BTA with no oil exemption.
Despite this perceived low probability, we believe that a switch to BTA would have significant impacts on the oil market:
- Because the US oil market is short domestic crude production relative to domestic demand, the impact of such a tax shift would be an immediate appreciation by 25% of US oil prices relative to global oil prices (at a new 20% corporate tax rate). This appreciation would initially leave US crude and product trade flows unchanged but would provide excess returns to domestic crude producers and would incentivize them to sharply increase activity. This improvement in shale’s competitiveness would be exacerbated by the introduction of a lower US corporate tax rate funded by the BTA.
- This significant incentive to ramp up US production in a market that is only starting to rebalance with the help of OPEC producers would create a renewed large oil surplus into 2018. This reversal of oil fundamentals and the gain in competitiveness of US producers would further likely lead low-cost producers to reverse their decision to cut production and instead return to growing output to maintain market share and long-term revenues.
- Such a prospect should therefore lead to an immediate decline in global oil prices to try to offset this ramp-up in US production, either by creating an offsetting foreign production decline or by normalizing US excess returns. Because the velocity of shale’s supply growth exceeds the ability for the rest of the world’s supply to decline, and because OPEC would likely resume production growth, it is likely that inventory would nonetheless resume rising in 2018, driving the oil forward curve back into a steep contango.
- Beyond this bearish impact on 2018 spot prices, the extent of the decline in deferred global oil prices needed to rebalance the oil market over the medium term will be a function of the respective shifts in the US and global costs curves, driven by a combination of the BTA’s inflationary impact on US service costs and the deflationary impact of USD appreciation on foreign production costs. Because of the contracted nature of oil services, these shifts in costs would pass through gradually and would initially leave US producers moving down on the oil cost curve. A decline in the US corporate tax rate could further force a deflationary tax policy response abroad, sustainably reducing the oil’s market marginal cost of production and long- term oil prices.
- Assuming a 15% USD appreciation upon implementation of the BTA and a 30% immediate pass through to global production costs, we believe that 2019 Brent prices could decline to $50/bbl, from $57/bbl currently. In the short term, the prospect of rising inventories and the reversal of the OPEC cuts could drive prices meaningfully lower, while, longer term, a greater pass through of the USD appreciation onto global costs and our 2020 Brent base case forecast of $53/bbl would imply global prices falling to $40/bbl. Over both horizons, the decline in global oil prices would help offset the outright appreciation in US prices with a likely greater fall in global oil prices than rally in US oil prices.
- With refining a low-margin industry, the appreciation in US crude oil prices would be almost entirely passed through to the US consumer, with only modest offsets from compressing marketing margins. This appreciation in domestic prices would therefore negatively impact US domestic demand, although the effect’s magnitude would be offset by lower global oil prices. All else constant, a $5/bbl increase in US oil prices would, for example, lead US demand to grow 70 kb/d in 2018, only 55 kb/d less than our current base case forecast of 125 kb/d.
- The impact of BTA on US refiners would be similar to that on US producers: the appreciation in US crude and petroleum product prices would be immediate and exceed the inflationary impact of the BTA, leaving them with excess returns (outright and vs. foreign refiners), especially if the corporate tax rate is reduced as well. Higher returns would translate into higher US refinery utilization and would push global refining margins lower, negatively impacting marginal refiners in Europe and Asia. There would initially be no change in US domestic crude differentials and crude or product trade flows, with all US refiners benefiting from higher margins . Differentiation in returns between US regional refiners would only materialize if the supply response of US producers once again creates logistical constraints and wider domestic crude differentials.
- Over the long run, a new oil market equilibrium would arise and, conceptually, it should be one in which US oil prices return to their pre-policy level. Border adjustment would reduce demand for imports and increase demand for exports, in theory causing the USD to appreciate by 25% to reverse the initial distortion of competitiveness and trade flows. Over the long run, the deflationary passthrough effect of this stronger USD on foreign service costs should lead to a decline in global prices of 20%. At such a new equilibrium, US prices would therefore revert to their pre-policy levels, although still up 25% vs. global oil prices.
- This new equilibrium is unlikely to be reached as the USD is unlikely to appreciate by 25% given currency intervention in many trading partners. Further, potential barriers to entry and termed service contracts would lead the US and global cost adjustments to be only gradual, leaving the evolving macro-economic landscape to create a new equilibrium beforehand. The medium-term outcome of the introduction of the BTA would therefore be one of modestly higher US oil prices and sustainably lower global oil prices, with a shift down by US producers and refiners on the global cost curves.
These shifts in local vs. global prices and returns would hold for other commodity markets, such as metals, as well as markets where the US is a larger producer than consumer, like agriculture. It will also hold for the global gas market, depressing global LNG prices, although the less-fungible nature of natural gas and the current US logistical bottlenecks may initially lead to mostly regional shifts in US gas prices.