The Trump administration has signaled its intent to make potentially major changes to US tax and trade policy, which the administration believes would bolster US industries. A range of proposals are being discussed, including a direct imposition of higher tariffs on imports and changes to the tax code that would penalize imports and support exports.
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One of the more talked-about proposals is a border adjustment tax. A BAT would make changes to the way corporate income taxes are calculated, increasing the cost of imports and boosting the value of exports. Specifically, the cost of imported goods (such as crude oil for refining) would no longer be tax deductible as an expense, effectively raising the cost of these goods by the marginal tax rate. At the same time, revenues from exported goods would be tax exempt, effectively raising the value of exports by the marginal tax rate. With a corporate tax rate of 20 percent, this would raise the costs of imports by 20 percent and increase the value of exports by 20 percent.
For the US refining industry, which both imports large amounts of crude oil and exports large amounts of oil products, this has the potential to significantly change pricing dynamics.
Potential impact on crude markets
The entire US refining industry is affected by any increase in the cost of imported crude oil. US refiners process about 16 million barrels per day of crude oil through roughly 150 refineries spread across the country. About half of this crude oil comes from US domestic production and half from imports, and this broadly holds true for all regions of the US. As a result, an increase in the cost of imported crude would directly raise the price of much of the primary feedstock for the industry.
More importantly, the cost of imported crude effectively sets the price for all crude oil—both imports and domestically produced volumes—sold to US refiners. Prices for different crude oils are essentially set by the producers competing for refiners’ business. This forces prices to equilibrate so that all grades from all sources are equally attractive to refiners. This means that any increase or decrease in the price of one major source of crude (such as imports) will quickly translate to a similar shift in all crude prices.
In the example of a 20 percent increase in imported crude prices (about a $10 per barrel increase in the current ~$50 per barrel world), we would expect US crude benchmarks such as WTI to rise about $10 relative to international benchmarks such as Brent.
For US crude producers, this would provide a significant boost to profitability and would stimulate increased supply. At current prices, producers are just able to maintain production levels and break even on the marginal barrels they produce. A 20 percent increase in prices should stimulate a substantial uptick in development, adding to US crude supply. This would provide a strong boost to the profitability of the domestic upstream industry from both higher margins and higher production volumes. This would also benefit associated industries such as oilfield services and crude transportation, whose profitability is closely tied to the level of activity in the upstream sector.
The increase in crude supply would likely translate to higher crude exports from the US. Refiners in the US are already saturated with US crude, which is lighter and sweeter than the imported grades the US refineries were largely designed to process. Crude producers will find a more receptive audience for additional barrels in the international market, where the relative demand for lighter crude is higher. Also, with an effective 20 percent subsidy on exports, the price that US producers will realize for exports will be at least as attractive as what US refiners would be willing to pay. With crude exports already exceeding 500,000 barrels per day, the infrastructure is in place to handle additional exports.
The resulting higher prices for US crude could be, at least partially, offset by lower global crude prices. This could happen in two ways. Additional supplies of US crude stimulated by higher domestic prices would add to global supply and on the margin put some downward pressure on global prices. However, the size of this effect would depend on OPEC’s response. Secondly, there is a widely held belief that a broadly applied BAT could result in appreciation of the US dollar. This too could put downward pressure on global oil prices, which is for the most part traded in US dollars.
Impact on product prices
Prices for oil products in the US will also be higher with a BAT, as a result of both higher costs for refiners and higher values for product exports. Prices for oil products across the US are essentially set based on prices in the big refining center along the US Gulf Coast, which acts as the marginal source of supply for all other regions. Prices in the Gulf Coast region are linked to the cost of crude to refiners and the value of oil products in the international market, both of which would rise with a BAT.
Traditionally, prices for oil products in the Gulf Coast have been set based on the marginal cost of producing them from crude oil in a Gulf Coast refinery. As crude prices have risen and fallen, product prices have followed, passing on much of the volatility in global crude prices to consumers. If a BAT resulted in higher crude prices for refiners, we would expect this increase to result in higher prices for US gasoline, diesel, and other fuels, largely keeping refiners whole and transferring wealth from consumers to domestic oil producers (and the US government).
In the current market, this trend is reinforced by the connection of US product prices to the international market. The US currently imports around 1 million barrels per day of oil products such as gasoline, diesel, and jet fuel. These imports would be exposed to the same 20 percent higher cost as imported crude, raising the marginal cost of product in any region relying on imports for supply.
More importantly, the US also exports over 2 million barrels per day of finished petroleum products, mostly gasoline and diesel, to Latin America and Europe. These exports account for more than 10 percent of US refiners’ utilization. Under a BAT, the value of these flows to exporters would rise by 20 percent, incentivizing refiners to keep producing and exporting, even with a 20 percent higher cost of production from higher crude prices. Importantly though, the higher value would come from the tax benefit exporters receive, not from higher international market prices.
For US refiners, the net effect of a BAT in terms of profitability and operations is expected to be small but positive. The rise in product prices would more than offset the rise in crude prices, which would keep refiner margins at or above levels with a BAT and maintain their competitiveness in the international export market. Given that product prices on average are higher than crude prices, a 20 percent increase on both sides of the margin equation should actually translate to a 20 percent higher margin for refiners—a small but positive impact.
While higher prices could dampen US domestic product demand, the effect is likely to be small. A $10 per barrel increase in prices translates to a little over 20 cents per gallon at the pump. This level of increase has typically not generated a strong demand response, especially in an environment where prices are starting out at relatively low levels. Also, any small drop in US demand would easily be absorbed by increased exports of products at no change in international price levels.
The primary area of concern for refiners would likely be in how effectively the BAT is applied. If for any reason the impact on product prices did not match the impact on crude prices, there would be a direct hit to refiner profitability.
Implications for players across the value chain
While details on the proposed BAT are still limited, there are a number of directional implications that can be drawn about the BAT proposal as it is currently being discussed:
- The US upstream oil sector is likely to be the biggest winner, seeing both higher margins and higher activity.
- US consumers would bear most of the cost of a BAT applied to the oil sector in the form of higher costs for all oil-based products.
- US refiners would potentially see a small but positive impact from a BAT, as long as it was effectively and equally applied to both imports and exports.