Is MENA oil at risk from the BAT?

An ambitious proposal to overhaul US corporate tax rules is creating anxiety across the global oil industry. A House Republican plan to introduce a border adjustment tax (BAT) would see imported goods, including oil at this stage, no longer deducted to form taxable income while exports of US produced goods would be allowed to be shipped abroad free from tax. The objective of the change is to impose a flat corporate tax of 20% at the point of consumption rather than origin and hence encourage exporters and eliminate penalties on repatriating foreign profits back into the US.

The plan has the potential to substantially disrupt oil pricing: oil producers in the US would be incentivized to ship output abroad tax free while US refiners would need to bid up the price of US crude to ensure domestic producers were indifferent to export or domestic markets. With a flat tax rate of 20%, US oil prices would rise 25% for a producer to receive the same net profit as exporting tax free crude.

The response from the US oil industry to 25% higher domestic prices would near certainly be positive and exacerbate the recovery already underway in US production. From a trough in July US crude production has already added more than 533k b/d of output when long-dated futures struggled to move above USD 55/b for much of last year. The scale of shale's response to prices at USD 65/b (a 25% gain on our 2017 WTI forecast) would be enormous and reverse the oil market's tentative march to balancing.

Longer-date futures are already pricing in some expectation that the BAT will come into effect with WTI's discount to Brent narrowing from around USD 2/b, where it spent most of 2016, to less than USD 0.50/b during the last week of January. Futures positioning has also followed suit as speculative length in WTI futures and options has begun to move higher just as Brent longs have been quietly unwinding positions.

The impact of the tax changes would hit the US refining industry unevenly, negatively affecting areas which rely nearly exclusively on imported crude, like the North East (PADD I) where around 80% of refinery inputs come from imports. Along the Gulf coast (PADD III), refiners make use of a higher proportion of domestic output and would in any case be better positioned to export products (tax free under the BAT) to markets in Latin America.

What impact for MENA oil producers?

In volume terms the introduction of a BAT would have a varied impact on MENA oil exporters. Producers whose output can be easily replaced on a quality basis by domestic US output would be the hardest hit in our view. As a share of its total crude exports, Algeria is the regional producer most exposed to the US and its lighter grades of oil have already been increasingly displaced by light tight oil produced in the US. A resurgence of US production would exacerbate this situation and push Algeria's light grade Saharan Blend back into the Atlantic basin market.

For the GCC producers, Saudi Arabia has the most consistent exposure to the US, sending the bulk of its US-bound exports to the Gulf coast where the refining infrastructure can accommodate heavier, sour grades of oil. But a like-for-like replacement of the Saudi (or Iraqi and Kuwaiti) barrels with US domestic output would be trickier given tighter availability of these crudes in the US. Were the BAT to be enacted as it stands we would expect volumes from the GCC to the US to remain reasonably steady, barring a major drop in US oil demand.

The UAE would largely be insulated in volume terms from the changes to tax law as it is an irregular exporter to the US. In 2016 there were just 12 arrivals of crude or fuel oil from the UAE that discharged into the US compared with over 250 arrivals from Saudi Arabia. 

The heavier crudes from the GCC will eventually face competition in the medium term from higher imports into the US of Canadian crude. President Trump has signed an executive order in support of the Keystone XL pipeline which will link Alberta's oil fields with US pipeline infrastructure and help bring the crude south to Gulf coast refiners.

The far bigger risk to MENA producers, however, stems from what will happen with oil prices following the introduction of the BAT. Oil producers outside the US would have to respond to the likely higher volumes of US exported oil by either:

• Accommodating the US volumes by limiting output. OPEC and major non-OPEC producers have already cut output once to try and support prices but we doubt they would be prepared to cede more market share to US producers that are in an advantageous position to send crude seaborne.
• Raising production to restart the market share battle. We think this is the eventual outcome of the market as it stands already, even without a BAT, and the argument to raise output and prevent additional US cargoes entering OPEC's key Asian markets would be even stronger under the new tax law.

Neither outcome helps to maintain the precarious balance emerging in oil markets and could tip the Brent curve back into a deep contango from the mild backwardation that is present from September 2017 onward. From an oil balances point of view then, the BAT could end up being negative for prices as inventories resume building and producers seek to secure their markets through discounts. Flooding the international market with crude would help to prevent US producers getting excessive returns and help to narrow any WTI-Brent gap.

The changes to taxation could also end up boosting the dollar as imports into the US become less attractive for consumers and exports enter the global market freely. A stronger trade balance, if it emerged, would help support the dollar and act as a further drag on oil, and broader commodity, prices. The BAT would also come on top of the Fed raising rates several more times in 2017 and presumably normalizing rates further in 2018.

The border adjustment tax remains a proposal at this stage but considering the political alignment of the Congress and White House there is a risk that it will become law. The changes could put the US under pressure from the WTO for unfairly discouraging imports but the protectionist stance of the White House means warnings from international agencies may fall on deaf ears. For MENA oil producers, the introduction of a border tax adjustment that allows tax-free oil to leave the US could end up being the first shot in a new market share battle. 

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