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Further support for US expansion of oil and gas production

15th February 2018

The drama surrounding the proposed changes to the US tax system has finally run its course. The House and Senate reconciled their versions of the bills, and President Trump signed it into law.

New US tax system positive foe unconventionals
New US tax system positive foe unconventionals

The net impact of the bill is obviously still up for academic debate, but most believe that this will certainly be a net positive – at least to the corporate bottom line, if not overall economic growth.

From an oil and gas upstream perspective, one has to wonder about the impact this new world order will have on supply and commodity prices. Given the increasing importance of US unconventional shale, understanding the after-tax economics of US operators has not been as important to understand since successes in the deepwater Gulf of Mexico started to really pick up steam in the early 1990s (interestingly, just after the last major US tax overhaul).

As much of the world has come to appreciate, the US has practically altered the entire pricing structure for crude oil. No longer is the price of oil almost completely dependent on OPEC’s swing decisions around supply quotas. The introduction of thousands of investors into short-cycle, fast ramp-up drilling means pressure on prices is increasingly a function of what a true commodity market is arguably supposed to be: lowest cost and most efficient providers win.

Few things in life are absolute, and OPEC clearly still heavily impacts the supply/demand pricing calculus. Price volatility would certainly feel the effects of member countries suddenly deciding to reverse their efforts at maintaining lower quotas. Regardless, the results of any decisions are far less certain than they were only a decade ago. Suddenly the concept of a “cue-to-drill” becomes much more important to market participants. At what price do new groups of US drillers decide to step into the market, even if their efforts only serve to defeat the impact of reduced production from other parts of the world?

Under the now ‘previous’ US tax structure, Rystad Energy believes that shale and tight oil exploitation will be growing at a notably faster pace than will that of the rest of the world. Brazil will also be successfully competing for incremental investment. There is already considerable evidence for this assertion in the successes about which the country can boast through its recent bid rounds. However, the vast majority of those developments will be in longer lead time projects in the ultra-deep pre-salt “polygon”. From a purely academic perspective, facilitating US shale growth by allowing operators to keep more of their cash should strengthen the probabilities around the shale market continuing its impressive growth pattern.

Why do we care?

Relatively unique to US Shale analytics is the concept that most industry analysts benchmark wells and drilling campaigns using pre-tax economics. Understanding how every operator realistically compares on an after-tax basis is practically impossible, rendering an after-tax analysis academic at best and misleading at worst. The byzantine US tax code is hard enough to decipher on a marginal basis (e.g. MACRS asset classes, AMT, Section 179 for small businesses, etc.). Throw in the impacts related to unique tax structuring that companies frequently employ, and most would forgive an analyst for foregoing the mind-numbing exercise of calculating “incremental economics” for each operator’s consolidated operations.

Furthermore, when thinking about a cue-to-drill, most do so within the context of a breakeven price (“BEP”). All else equal, changing the tax rate for a currently tax-paying company should not materially alter that company’s BEP. All associated cost are tax deductible, even though some are deducted over time. For those who are not in a loss position and are not, therefore, paying taxes, there would be some further adjustments for net operating loss (“NOL”) carryforwards. But, again, while there would likely be some tweaks, there certainly wouldn’t be enough to move markets.

Regardless, the inconvenient truth of cash flow analysis is that investors, in general, do have to pay taxes, at least eventually. The reasons that many US operators do not currently do so are manifold and beyond the scope of this article, but most analysts would still second the idea that after-tax returns are the ultimate final arbiter of overall performance for any individual investor. It is for this reason that Rystad Energy analyzed the final version of the “Tax Cuts and Jobs Act” (“TCJA”).