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Tax reform drives oil and gas growth

Frontiers, Issue 8

Corporate response to US tax reform has largely been positive, with companies across multiple sectors announcing new or enhanced projects and investments in response to tax savings. How does oil and gas fare under the new law?

The oil and gas industry has been slower than some to respond publicly, but tax reform is likely to spur growth, investment and transactions across all segments of the industry.

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Stabilizing tax costs boost US investments

In a capital-intensive sector such as oil and gas, the long-term stability of tax costs helps companies better evaluate the return on investment for large, lengthy horizon projects. It also eases decision-making for capital providers, who recently faced price curves and uncertain returns.

While the ultimate impact of tax reform will vary slightly across subsectors, overall the legislation is expected to have a positive outcome on the oil and gas industry.

Downstream

Downstream investments may become more competitive as margins increase due to lower US federal income taxes and an uptick in oil prices. This may accelerate projects and the development of refineries and chemical plants that otherwise might not have been viable to be built in the United States. This, coupled with the long-term expectation of low-cost feedstock for both refineries and chemical plants, may change the location preferences of many projects currently on the drawing board.

Upstream

Upstream companies can still expense intangible drilling and development costs, subject to certain limitations, as that provision was retained and unmodified by the sweeping tax reform legislation. Similarly, for small and mid-sized domestic independent oil and gas companies, the percentage depletion allowance remained intact, which may continue to benefit growth and capital investment plans. The limitations on interest deductibility, however, may increase the cost of capital in some cases coupled with the natural rise in interest rates under current monetary policies. However, most of the current operators de-levered through the downturn and may not be immediately impacted. In the longer term, the interest limitation may be a negative factor on the ability of smaller companies to grow, as the limitation becomes more impactful beginning in 2022.

Midstream

Midstream companies should benefit similar to the downstream group. The larger impact comes not necessarily from tax reform but red tape on permitting and approval processes. The rapid rise in the Permian Basin and the dramatic rise in exports of both crude and refined products has been a major boon for this sector. For midstream companies, the Master limited partnership (MLP) is the most common capital market vehicle for public offerings. The MLP structure is a pass-through entity, and, under the new tax law, individual unitholders may now get the benefit of a temporary, pass-through deduction. This is widely seen as helpful. However, for private companies, with the much lower corporate tax rate, many pass-through entities are examining whether they should incorporate.

Oilfield services

Oilfield services are a bit more complicated. Many of these companies operate globally, and the international provisions have varying effects depending on their operating footprint. However, the lower corporate tax rate will certainly be welcomed as it allows US-based companies to be on competitive footing with non-US based companies.

The elimination of the corporate alternative minimum tax and the inclusion of a temporary 100% expensing regime for certain assets may help spur industry investment as well throughout all of the subsectors.

Since it may take many years to recoup investments in the sector, expanding the expensing provisions to be both full and immediate may significantly impact the deployment of capital and development of new projects, providing oil and gas companies with an immediate cash tax benefit. Additionally, the fact that this 100% expensing (for many assets) is available for a pre-determined five-year period followed by a five-year phase down provides companies with some certainty for short and long-term planning.

Tax reform spurs industry M&A

The new law is a game changer for oil and gas deal making and points to an increase in M&A appetite over the next several years.

  • Asset transactions are more attractive across all oil and gas industry segments due to tax changes that allow companies to immediately expense tangible assets, such as certain infrastructure assets and equipment, for the next five years. For example, the purchase cost of an existing pipeline system for US$1 billion would previously have been deducted and recovered over a 15-year period; however, under current law, such cost may be recovered as incurred (subject to certain limitations).
  • Oil and gas transactions offer benefits for both buyers and sellers thanks to the relative certainty of the legislation, the reduced rate and the immediate expensing of certain assets (albeit temporary). By eliminating some level of uncertainty around what tax reform could look like and improved economics for both sides, a more robust M&A environment is expected.

Buybacks versus investment

One concern is companies will use their new purchasing power on stock buybacks — or to pay down existing debt — instead of investing in new facilities or technology or pursuing M&A deals.

That said, the cost of capital has been low for some time, and many companies have leveraged up in recent years, funding significant buybacks. This reduces the attractiveness of buying more stock, and while it does point to the need to reduce debt, most companies will likely use at least a portion of their savings for new capital investments and M&A.

Finally, companies that stay on the sidelines may find their stock price punished by markets desiring an aggressive approach that takes advantage of the new tax regime.

Return to US competitiveness

The move to a corporate rate of 21% has important global competitiveness ramifications. While we may see some governments adjust their own corporate tax rates in an effort to re-establish themselves as attractive markets for investment, the United States is in a good position — for the time being — relative to markets elsewhere.

On pace for growth

It’s easy to sketch out a scenario in which global economic growth and increased demand for oil and gas leads the industry back into growth mode, with higher investment in production areas, such as the Permian Basin and deepwater offshore, along with midstream and downstream projects.

With tax changes and more stabilized commodity prices, the United States is on pace for oil and gas growth once again.