By Alex Kimani
President’s Biden’s administration is reportedly planning the first major tax increase in nearly three decades in the next economic stimulus package. The president is reportedly planning to include the first major tax hike since 1993 in the next spending bill following the $1.9 trillion coronavirus relief package that Congress has already approved.
That initiative is expected to be even more ambitious, clocking in at ~$4 trillion. However, unlike previous stimulus bills, it won’t rely solely on government debt as a funding source; rather, it will also likely include a hike in corporate tax rate as well as income tax rate for high-income individuals earning more than $400,000, as per Bloomberg News.
Biden is considering a walk-back on Trump’s tax bonanza that raised the corporate income tax rate from 21% to 28% resulting in a substantially lower after-tax profit for the majority of U.S. companies.
However, the impact on the U.S. oil and gas sector is likely to be a bit more nuanced and not as straightforward–all thanks, ironically, to the majority remaining trapped in a profit hole for years.
Loss carrybacks and deductions
Whereas the consensus is that the U.S. oil and gas sector may face a tougher environment under Biden, unfavorable policies and not higher corporate taxes might be its biggest worry at the moment.
For years now, oil and gas exploration and production (E&P) companies have been printing red ink due to persistently low commodity prices, leaving them with little tax liability. In fact, a check into their respective SEC filings reveals that Big Oil companies including Exxon Mobil Corp. (NYSE:XOM), Chevron Corp. (NYSE:CVX) and ConocoPhillips (NYSE:COP) paid the lion’s share of their corporate taxes in 2019 to other countries with only COP being slapped with a federal tax bill for $18 million.
Only 23 of the 94 upstream and integrated companies in the United States incurred a federal tax bill in FY 2019 at the 21% rate. Most of these were Permian, Bakken and Appalachian shale oil and gas drillers such as EOG Resources Inc. (NYSE:EOG), Continental Resources Inc. (NYSE:CLR) and Cabot Oil & Gas Corp.(NYSE:COG) thanks to their lower drilling costs.
But with oil prices now flirting with $70/barrel, U.S. shale companies could soon return to the green.
Luckily, many will still be in a position to extend their ‘tax holiday’ thanks to several tax provisions that could help them increase liquidity by reducing tax liability, producing tax refunds or deferring certain tax payments.
These include several established tax provisions as well as new tax changes in the Coronavirus Aid, Relief, and Economic Security (CARES) Act.
A key provision of the CARES Act is the reinstatement of the net operating loss (NOL) carryback under IRC Section 172(a). Companies in all 11 sectors of the U.S. economy including energy can now carry back NOLs incurred in 2018, 2019, and 2020 for up to five years and offset up to 100% of taxable income for the years to which the carryback is applied. In other words, oil and gas companies can carry back losses from recent periods of low prices to offset prior periods of higher oil prices and higher profitability.
That’s significant for the shale industry because many have likely turned cash flow positive, with J.P. Morgan estimating that Permian’s Delaware Basin oil drillers now require oil prices of just ~$33/bbl to break even down from $40/bbl in 2019. JPM says most U.S. onshore operators are economic at current oil prices, and many operators are even likely to ramp up activity in H2 and build solid momentum for higher volumes in 2022. Thankfully, Bloomberg has reported that shale drillers are mostly sticking to their pledge to hold the line on production in order to cut costs, pay down debt and return money to shareholders.
Oil and gas producers though will eventually have to contend with Biden’s higher tax if the sector goes on to recover fully in the coming years.
Intangible drilling costs
Oil and gas executives might be even more interested in yet another significant tax provision–deduction for intangible drilling costs.
U.S. oil and gas companies have the option to either deduct or capitalize their intangible drilling costs (IDCs), which include ground preparation costs, labor, and similar costs in the preparation of a well. Deducting IDCs can significantly lower a company’s earnings exposed to taxes, particularly when oil and gas prices are higher and the industry appears to be in good shape.
A win for MLPs
The biggest winner yet in a Biden tax hike though would be Master Limited Partnerships (MLPs).
MLPs are business ventures that operate as publicly traded companies with the company that manages day-to-day operations being the general partner while the investor acts as a limited partner. The first MLP was formed by shale company Apache Corp. (NYSE:APA) in 1981. Six years later, the MLP structure was recognized by law after Congress passed laws for publicly traded partnerships in Internal Revenue Code Section 7704.
An MLP is required by law to derive at least 90% of its cash flow from commodities, natural resources or real estate. They, in turn, distribute cash to shareholders instead of paying dividends like a standard company would. MLPs combine the liquidity of publicly traded companies and the tax benefits of private partnerships because profits are taxed only when investors receive distributions.
The biggest draw of MLPs is that they are considered pass-through entities under the U.S. federal tax code. Whereas most corporate earnings are taxed twice (first through earnings and again through dividends), pass-through status of MLPs allows them to avoid this double taxation because earnings are not taxed at the corporate level. Another key benefit: Midstream MLPs act as toll collectors for the energy companies that use their pipelines. As such, their cash flows are protected by long-term, take-or-pay agreements, meaning they are less susceptible to commodity price fluctuations.
In recent years, MLPs have fallen out of favor after changes were made to the way partnerships are taxed and, perhaps more importantly, due to Trump’s bonanza.
In 2018, the Federal Energy Regulatory Commission (FERC) reversed a key policy in MLP tax costs for interstate pipelines that led to increased cost of business for some companies.
A tax hike could reverse some of the damage and significantly improve the value proposition of MLPs.
According to CreditSights analyst Charles Johnston, Biden’s tax plan would increase the tax advantage for MLPs over C-corps from around seven percentage points to 17.
The Alerian MLP ETF (AMLP) has managed to reverse its earlier losses and now boasts 26.1% gain YTD and 53.7% over 12 months.