From The Fuse
President Trump is promising a major overhaul of the U.S. tax code, with an eye on cutting corporate and income tax rates. But one provision of the Trump tax proposal is a border-adjustment tax, which would exempt taxes on U.S. exports but eliminate the deductions that corporations are allowed to take for the cost of imports. The intended effect will be to raise the cost of imports while incentivizing exports.
While the cross-border tax tweak may seem benign, it would have a substantial impact on the oil industry, potentially fueling another drilling boom while leaving consumers to foot the bill of higher prices at the pump.
While the tax tweak may seem benign, it would have a substantial impact on the oil industry, potentially fueling another drilling boom while leaving consumers to foot the bill of higher prices at the pump. Ultimately, however, the economic disruption that might occur from the proposed tax might be too politically difficult to overcome, making its passage in the U.S. Congress highly uncertain.
Potential windfall for U.S. oil industry…until prices fall
Under the border-adjustment tax, U.S. oil would be exempted from taxes if it is exported abroad, making it much more competitive. That would allow producers to charge more to domestic refiners, leading to higher gasoline prices. The border tax would “immediately lead to a 25 percent appreciation of U.S. crude and product prices vs. global prices,” Goldman Sachs wrote in a recent note to clients. The windfall to U.S. drillers would lead to a flood of new capital and drilling in the shale patch. The promised cut in corporate tax rates would just be an added bonus for the U.S oil industry.
The result could be a dramatic ramp up in output, creating “a renewed large oil surplus in 2018,” Goldman Sachs wrote. U.S. oil production could increase by 1.6 million barrels per day, double Goldman’s current prediction for 2018 without the tax. But such a sharp increase in output would lead to another downturn in prices. In addition, Goldman argues that OPEC will likely back off production cuts if it sees U.S. output surging, further exacerbating the global surplus. In other words, the border-adjustment tax could lead to another bust for oil prices as inventories “resume rising in 2018, driving the oil forward curve back into a steep contango.”
The border-adjustment tax could lead to another bust for oil prices as inventories “resume rising in 2018, driving the oil forward curve back into a steep contango.”
Another consequence of the border tax would be a sharp appreciation of the dollar. Goldman Sachs says that in theory there would be a strengthening of 25 percent for the dollar, although it would never get that far as central banks around the world respond to currency movements. Nevertheless, the upward pressure on the greenback might be helpful to oil producers selling their product in dollars, but consumers around the world would have to pay more for petroleum products, cutting into global oil demand. Ultimately, that is bearish for oil prices as well.
A more intriguing, if speculative, conclusion that Goldman lays out in its report is the longer-term effect on prices. In order to keep up with a U.S. tax code that shifts in favor of domestic drillers, governments around the world could slash their own tax rates, which would lead to “sustainably reducing the oil’s market marginal cost of production and long-term oil prices.” President Trump could lower the breakeven cost of producing a barrel of oil not just in the U.S. but around the world, keeping prices permanently lower than they otherwise would be.
Canada and Mexico left out in the cold
Implied in an “America First” worldview is a zero-sum approach to policy. Indeed, foreign oil producers would be hit hard by the move. “Bluntly speaking, for oil the law’s passage is pure mercantilism. Exporters from Mexico, Canada, and the rest of the world could be shut out,” Philip Verleger, an energy economist and principal of consultancy PKVerleger LLC, wrote in a report to clients. He is also the author of a Koch Industries-funded report that opposes the tax.
Foreign oil producers would be hit hard by the move.
If oil and gas companies lose the ability to deduct the expenses of imports, the cost of importing would be much higher. Verleger estimated in his report, published by The Brattle Group, that the cost of imported goods would rise by 25 percent. That would include not just drilling equipment but also oil and gas products.
The effect would be a higher domestic price for U.S. crude, somewhere on the order of $10 per barrel. Meanwhile, however, it would eventually lead to a decrease in international benchmark prices, as demand would sharply wane.
Canada and Mexico would be emblematic of the predicament facing foreign oil producers. As a result of the shift in U.S. oil prices versus international benchmarks, the flow of global capital would be rerouted into higher-priced crude coming from places like Texas and North Dakota, for example, while investment would take a hit in Calgary and the Campeche Basin. Through a recent executive order, President Trump is hoping to revive the Keystone XL Pipeline, but the border tax would put a severe dent in the prospects of oil flowing through pipeline. The end result could be lower production abroad as U.S. shale captures more market share. “It’s blindsided everybody,” Verleger said in an interview with Canada’s Financial Post in mid-January. “Canadian producers should be worried.”
Politically difficult
It is not at all clear that the border-adjustment tax will survive in legislation, for several reasons. First, it would raise the price of oil in the U.S., which would trickle down to higher prices at the pump, as refiners would simply pass on higher costs to consumers. The report from the Brattle Group estimates that it will add $0.30 per gallon to the price of gasoline. President Trump and his Republican allies in Congress might abandon the border tax proposal if they believe it will lead to blowback from angry motorists. The visceral reaction from the public from higher gasoline prices is a timeless problem for any energy reform proposal.
The energy industry is also not monolithic. Refiners would have to pay more for imported crude to process into products. They could pass that on to end-users, but there would likely be resistance from an industry forced to pay more. Even integrated oil companies, such as ExxonMobil, might be cool on the idea. Perhaps just as important is the effect that the border tax would have on non-energy sectors. Automakers, for instance, would have to pay more for imported parts. Unease among U.S. corporate titans could dissuade the Trump administration from pursuing the tax.
It is also unclear if the border-adjustment tax is even legal under World Trade Organization (WTO) rules. It is likely that the tax would spark retaliatory protectionist measures abroad, creating economic uncertainty should the U.S. Congress choose to go down that road. Even then President-elect Trump said in mid-January that the tax is “too complicated” in an interview with the Wall Street Journal.
In the end, Republicans in Congress could quietly put the proposal to the side when they take up tax reform. Goldman Sachs only puts the odds of a border-adjustment tax actually being signed into law at 20 percent, while oil futures spreads place an implied probability of just 9 percent.
