Things can change very quickly in the oil market.
Just a few months ago, or until September, the commodity had a very difficult year when the broader market was hitting all-time highs. In June, U.S. West Texas Intermediate (WTI) fell to nearly $42 a barrel -- the lowest in ten months. Since then, the contract has risen about 37%. In fact, WTI hit a more than two-year high of around $59 recently.
Unlike other short-lived rallies over the past three years, we believe the current higher oil prices are a result of improving fundamentals. Solid demand growth, declining inventories and the extension of OPEC-led supply cuts until the end of 2018 is helping to balance the market and support the strong uptrend.
Add to this support from the pro-energy tax reform bill and the industry has not been this bullish in more than two years.
Senate Passes Tax Bill: Energy Sector to Benefit
In the early hours of Dec 2, the Senate approved the biggest U.S. tax overhaul in three decades by a 51-49 vote.
With the Senate clearing its version of the tax reform bill, President Donald Trump has secured his first major legislative win after more than 10 months in office. We note that the House had passed its version of the tax bill in mid-November. The $1.5 trillion tax overhaul package is expected to be enacted into law by year-end, following resolution of the differences in the two versions.
The plan’s proposal to reduce the corporate income tax rate – from 35% to 20% – have been generally welcomed by corporate America, and justifiably so. The top U.S. corporate rate is 35% but it balloons to an average of almost 39% when local taxes are included - higher than most large developed countries.
The domestic oil and gas industry is one of the many beneficiaries of the sweeping tax reform.
In particular, cutting the corporate tax rate and changes to cost-recovery allowances are expected to aid the energy industry to keep on ploughing back billions of dollars in the domestic economy, apart from creating new jobs to go with the 10 million the sector already employs.
Digging into the Details
Energy companies invest significantly for capital expenditure as the industry is capital-intensive in nature. For example, the world’s largest publicly traded oil company ExxonMobil Corp. XOM has announced a $22 billion capital plan this year, while Chevron Corp. CVX has set its capital spending budget for 2017 at around $20 billion.
In the current scenario, capital expenditures cannot be tax-deducted in the year they are incurred. Consequently, U.S. companies need to plan judiciously regarding their capital expenditure. However, companies will be able to deduct their capital expenditures from taxable income immediately, as per the provisions of the tax reform bill. Naturally, this aspect of the bill hugely favors the oil industry and if it materializes companies in the space would be huge gainers.
In the event of companies being able to deduct capital expenses in the year of their occurrence, their tax bills for the year would be lowered significantly due to higher deductions. This will leave more cash in the hands of these companies to fund their capital expenditures, acquisitions, share repurchases among others.
Refiners Likely to Benefit the Most
While there might be a number of winners within the energy sector itself, refiners seem to be the standout gainers from the overhaul of the nation’s tax code. Should the plan go through and corporate income tax lowered from 35% to 20%, refiners are likely to experience a jump in their potential earnings.
This is because unlike crude producers and equipment makers who have been victims of the sustained period of stubborn low oil price environment and struggled to generate positive cash flows, refiners have been among the handful of energy subindustries that showed strength during the shaky period.
The business of the downstream players is negatively correlated with crude prices. This is because the companies use oil as an input from which they derive refined petroleum products like gasoline, the prime transportation fuel in the U.S. Hence, lower the oil price, higher will be their profits. Therefore, the income from converting crude into gasoline and diesel – also known as refining margin or crack spread – has been going up over the past few quarters.
Consequently, these companies – having generated positive income before taxes – are in a much better shape to take advantage of the lower corporate tax burden. Consequently, shares of the major downstream operators surged on Dec 4.
With the S&P 500 refining stock index climbing to its highest since at least 1996, it was no surprise that most participants had a field day. In fact, stocks like Andeavor ANDV and Zacks Rank #1 (Strong Buy) PBF Energy Inc. PBF gained 2.4% and 2.3%, respectively, on the day. The bill, in its current form, would also benefit the likes of Phillips 66 PSX, the largest oil refiner by market capitalization and one boasting of a healthy realized margin. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
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