Yesterday Goldman Sachs’ Damien Courvalin looked at the effects a Border Adjustment Tax might have on the domestic oil and gas industry. We expand on that analysis and look at impacts to not only the upstream industry but also to how it might play out for refiners who are challenged by shrinking supplies of low gravity crude that is their primary feedstock.

A border adjustment tax (BAT) in general means a tax applied to imports. It’s important to note that nothing is set in stone, but early discussions of the potential BAT being proposed by the GOP in their “A Better Way” plan would tax goods made abroad but sold in the US while exports would not be taxed. A 20% tax is the general rate proposed at this stage. For our discussion here about the impact on the US oil and gas industry, we will focus on how the proposed BAT would impact US oil and gas producers, refiners, and consumers.

For frame of reference, the charts below illustrate US crude imports broken out by origin (Canada, OPEC, Other) and by PADD.

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Figure 1 – Imports by Origin (Source: EIA)

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Figure 2 – Imports by PADD (Source: EIA)

Key Facts To Keep In Mind (these will come up again in the discussion below)

  • Global refined products trade with Brent today.
  • The US exports 3 MMBbl/d of finished petroleum products today (Figure 5 shows finished petroleum products in addition to crude oil and NGL exports) and commodities move/flow in the direction of higher prices. The mix of these exports is skewed towards heavy-end products like distillates and fuel oil. To maintain the current level of exports going forward, the refined products we export will need to be priced at a level that covers transport and incentivizes that movement.
  • US refineries are better suited to handle heavy and mid-range barrels. The growth of US unconventional production, which tends to be light, has pushed out nearly all light barrel imports. The remaining imported crude barrels are heavy and mid-range. There are no other major refining centers globally that are well suited to take these barrels.
  • US crude is growing again, but it is all light barrels. The US is better suited to take heavy and mid-range barrels than the light domestic barrel production that is growing today.
  • There are certain areas of the country (PADD 1 and PADD 5) that are not well connected to the US crude pipeline transportation network, and are instead heavily reliant on imported crude. PADD 1 and PADD 5 are also large demand areas and this demand pull is a large driver of refinery utilization rates.
  • The BAT would not happen in a vacuum. There are other global market trends unfolding that will impact the impact of the BAT in the medium-term. Specifically, there is a disconnect between the type of crude that is growing globally (light barrels), and the expected demand growth products (distillates that are primarily produced from mid or heavy barrels).
    • Drilling activity around the world has fallen dramatically in the past 1.5 years.
    • Global CAPEX tied to heavy and mid-range barrels is down dramatically
    • Demand growth expectations are expected to be skewed towards distillate products.

Near-Term Impact to WTI/Brent Spread

The BAT effectively makes imported crude barrels less competitive than those produced in the US. It would effectively cost 20% more to import a barrel than it does today so refiners would be incentivized to use a US barrel or the price of imported barrels would need to drop to cover the new tax. For example, if Brent were $50, the imported cost of the barrel would be $60 ($50+20% tax). Today, Brent (the international benchmark for crude prices) trades at a $2.46/Bbl premium to WTI (West Texas Intermediate, the US benchmark crude price). The BAT would result in a fundamental change in the Brent to WTI spread, with WTI trading at a premium. The logical question is whether Brent falls, WTI rises, or both. Assuming overall demand growth trends continue, the equilibrium supply/demand doesn’t change, so the answer is both (Brent falls and WTI rises). The chart below illustrates the Brent-WTI Spread today (white) versus the spread three weeks ago (red). The market has responded to the possibility of the BAT implementation; however, the full impact has not been priced in yet since likelihood of the BAT is unknown at this time.

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Figure 3 – WTI – Brent Differential Today vs. 3 Weeks Ago (Source: MarketView by DI)

Near-Term Impact to US Producers

The impact to US oil and gas producers that produce a WTI quality barrel or heavier barrel would be positive overall. They would receive a higher price for their production because their production would be advantaged at US refineries. This dynamic is very similar to that observed by ethanol producers (or corn growers) in the US when the renewable energy standards were implemented.

The impact to producers of light or condensate production is less clear. In the near-term, the producers of light crude would likely enjoy a similar uplift to that observed by producers of mid or heavy barrels. Light barrels in general produce more gasoline and light products while heavy barrels generally produce more distillate and heavy products. As mentioned in the key facts section above, there is shaping up to be a disconnect globally between the quality of growing crude production and the demand growth of specific refined products on the demand side. Demand for distillates is expected to lead demand growth going forward, but crude production growth of mid and heavy range barrels necessary to make those products is at risk given severely depressed CAPEX and drilling levels abroad.

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Figure 4 – Production Forecast by Crude Quality @ $50/Bbl WTI & $3.50/MMBtu HH (Source: DI ProdCast)

The impact to US oil and gas producers that produce a WTI quality barrel or heavier barrel would be positive overall. They would receive a higher price for their production because their production would be advantaged at US refineries. This dynamic is very similar to that observed by ethanol producers (or corn growers) in the US when the renewable energy standards were implemented.

Near-Term Impact to US Refiners

To understand the impact to refiners, we analyzed demand for refined products, crude exports, and imports by PADD. While we’ve seen opinions in the market on both sides (positive and negative for US refiners), we are of the opinion that margins will largely stay unchanged and refiners will neither win nor lose. The key thing here is that US refinery utilization rates in general hover over 90% (at a level higher than other regions globally) not just because WTI trades at a discount to Brent. The key drivers of US refining competiveness are high US demand for refined products, and US refiners’ ability to take heavy barrels and turn them into refined products the world demands because of the way they are tooled and the complexity of their operations. The US exports approximately 5 MMBbld/d petroleum products today of which is 3 MMBbl/d of refined products (crude oil and NGLs make up the balance). The specific mix of those exports is illustrated below:

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Figure 5 – Exports by Product (Source: EIA)

The majority of our product exports come from heavy barrels. We take heavy barrels because our refineries are well-suited to do so, and we export the refined products. This 3 MMBbl/d of exported refined product volume is demanded abroad and there are no other global refining centers well-suited to take this crude and refine it if we don’t. You also have to consider that 3 MMBbl/d of US heavy imports come from Canada, and those barrels are effectively captive to the US today because existing infrastructure is not set up to export those barrels.

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Figure 6 – Imports by Origin (Source: EIA)

It is our opinion that product prices will rise sufficiently to maintain existing margins and incentivize US refiners to continue operating at 90%+ utilization. US refiner margins will neither increase nor decrease.

It also must be noted that different market dynamics are at play depending on the US PADD in question. The map below illustrates refining capacity by PADD. One comment we’ve seen several times in the past couple weeks is PADD 1 refiners will lose because they are heavily reliant on foreign crude imports and their margins will be crushed if the BAT is implemented. We do not agree.

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As illustrated below PADD 1 is a high demand area that relies on a combination of products from other PADDs (PADD 3 mainly), product imports from abroad, and crude imports to PADD 1 refineries to meet demand in the region.

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Figure 8 – PADD 1 Demand & PADD 3 Supply to PADD 1 (Source: EIA)

This effectively makes PADD 1 a demand-pull region and product prices will do whatever they need to do to incentivize refineries to run or product imports to increase sufficiently to meet demand. Either way you look at it, refined product prices will likely need to increase to meet demand (and cover the new BAT). A similar dynamic is at play in PADD 5.

One logical question is why PADD 1 and PADD 5 could not simply take more US crude instead of imports? The answer lies in examination of the crude pipeline transport grid. Both PADD 1 and PADD 5 are effectively ‘islands’ within the US in terms of infrastructure connectivity. Neither is well connected to the main production supply areas as illustrated in the map below (there are also no planned infrastructure expansions underway to increase connectivity).

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The next logical question is whether other PADDs could supply additional products to PADD 1? The answer to that is illustrated below. The existing product pipelines that move volume from PADD 3 to PADD 1 are nearly fully utilized. Similar to the crude infrastructure piece, the refined product pipeline system is not able to increase significantly to move more product to PADD 1.
Another logical question is what the impact will be to product prices in other PADDs (3,2,4)? It is our opinion that those product prices will also rise because they will need to compete with higher prices abroad and in PADD 1 and PADD 5. Given the option, a refiner will opt to sell their product at the highest price available and if the price locally does not compete, the products will move out in the direction of the highest price.

Everything we’ve discussed points to higher product prices in general and the loser will be the consumer.

Near-Term Implications For US Production Growth

A border adjustment tax will push prices higher for WTI. Two production scenarios were considered using DI ProdCast. One that is meant to forecast production without the border adjustment tax ($50/Bbl WTI & $3.50/MMBtu HH). The other is meant to forecast production with the border adjustment tax ($60/Bbl WTI & $3.50/MMBtu HH). For simplicity sake, this analysis assumes that WTI will rise and Brent will stay flat (despite the reality that WTI will likely rise at the same time Brent falls) so that we can quantify the impact of higher WTI prices on US production. The difference between $50 WTI and $60 WTI prices is approximately 1.0 MMBbl/d more production by the end of 2020 as illustrated below in the chart. Higher WTI prices would support more drilling, primarily in US unconventional plays.

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Figure 10 – Production Forecast with BAT ($60/Bbl WTI) and w/out BAT ($50/Bbl WTI) (Source: DI ProdCast)

When you look at the quality of US production under these two different price scenarios in the two figures below, you can see that the 1 MMBbl/d of incremental supply is primarily in the ultra-light crude and condensate API gravity range (42-50 and 50+ API).

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Figure 11 – Production Forecast by Crude Quality @ $50/Bbl WTI & $3.50/MMBtu HH (Source: DI ProdCast)

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Figure 12 – Production Forecast by Crude Quality @ $60/Bbl WTI & $3.50/MMBtu HH (Source: DI ProdCast)

The logical question here is which of the follow scenarios play out:

  • Brent prices stay flat, WTI prices rise – global demand absorbs incremental supply of light barrels from the US (above what demand would be if the BAT wasn’t imposed).
  • Brent prices fall, WTI prices stay flat – mid range non-US production loses market share due to lower prices, overall global crude production is lower than it would be without the BAT, demand drops accordingly (otherwise crude prices would need to come up to meet more demand).
  • Brent prices fall AND WTI prices rise – US gains market share and produces more than it would otherwise, non-US production loses market share due to lower prices (which would lead to lower capital spending). The change in global crude quality in favor of light US barrels puts pressure on light crude prices, heavy and mid-range barrels gain relative strength.

It is our opinion that the third scenario is likely to play out if the BAT were implemented.

Near-Term Overall Winners and Losers

US Oil and Gas Producers – Winner

US Light-Heavy Quality Spread – Loser (Spread blows out more than it would otherwise.)

US Refiners – Indifferent

US Consumers – Loser

Canadian Producers – Loser

Post-2018 Implications

Up to this point, our analysis has primarily covered the immediate impacts if the BAT were implemented. There are other global market trends unfolding that will affect the impact of the BAT in the medium-term. Specifically, there is a disconnect between the type of crude that is growing globally (light barrels), and the expected demand growth products (distillates that are primarily produced from mid or heavy barrels). This dynamic promises to impact the value of specific qualities of crude dramatically. A relative ‘glut’ of light barrels will push prices of these barrels down. There are many US unconventional producers that will see lower prices for their crude based on the light quality (think back to 2014 when Gulf Coast condensate was trading $10-15 back from WTI).

At the same time light barrels are facing pressure, there will be a shortage of heavy barrels and the relative price of these barrels will improve as a result. In all likelihood, the BAT would result in a short-term boost for US producers but will do little to combat long-term market dynamics. On the refining side, the value of refined products will continue to drive refining demand for specific qualities of crude and margins will largely stay intact.

Things To Watch Out For

  • Most recent commentary from the administration has presented the possibility that the 20% tax might apply only to goods sourced from countries we have a trade deficit with. The majority of crude imports into the US today come from countries we have a trade deficit with.
  • Press Secretary Spice mentioned that the 20% tax was one of several options on the table. And the 20% tax itself “could be a multitude of things. Instead of 20 percent, it could be 18, it could be 5.”
  • The strength of the dollar will dictate the net impact of any Border Adjustment Tax. If the value of the dollar goes up, some (or all) of the impact of the BAT are mitigated.
  • Would the tax plan also include an exemption for American companies from paying taxes on exported crude and/or refined products? This would incentivize exports and/or result in higher US refined product prices.
  • Would Canadian barrels that flow through the US and are then exported through the Gulf Coast be subject to the BAT (Keystone XL implications)? Would proposed Canadian export pipelines like Energy East gain support?
  • What import taxes would be implemented by the countries that could be takers of US exported crude barrels as a response to the US BAT?
  • What import taxes would be implemented by the countries that take US exported refined products as a response to the US BAT?
  • The US imported 5.94 Bcf/d of natural gas on average in 2016 from Canada. The BAT would impact natural gas, not just crude, and make that production less competitive (basis would widen). In the medium term, pressure on Canadian natural gas prices would pressure supply competitiveness and this important source of marginal US supply would decline. The result would likely be higher overall US natural gas prices to mitigate these declines in Canada or incentivize additional US production.
  • What import taxes would be implemented by the countries that will take US exported petchem products (the US is expanding our petrochemical cracking capacity dramatically in the coming years; the utilization of this infrastructure may be at risk if barriers to global trade increase)?
  • The sulfur spec changes that will impact bunker fuel in the coming years will create an ‘edge’ for refineries all around the world that are sophisticated enough the achieve the lower spec (generally speaking a coking unit will be necessary). Adding infrastructure to refineries so that they are better able to handle sulfur and heavy-ends will create more competition for US refineries that are already well suited to do this.

Thoughts? Comment below.

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Sarp Ozkan & Bernadette Johnson

Sarp Ozkan is a Manager, Energy Analytics for Drillinginfo providing to the modeling, research, and fundamental analysis efforts of the Market Intelligence group. He manages the production forecasting models and leads upstream and crude oil related consulting projects. While having a focus on data-driven modeling, his ability to incorporate the effects of technological and market advances into analysis provides clients a thorough picture of the present and the future in their area of interest within the oil & gas industry. His analysis has been presented at industry and academic conferences alike. Prior to joining Drillinginfo, Sarp was a Senior Energy Analyst with Ponderosa Energy. Sarp holds a MS Degree in Mineral & Energy Economics from the Colorado School of Mines, MS Degree in Petroleum Economics & Management from the Institut Francais du Petrole (IFP School), and a BA Degree in Economics from the University of Chicago. Bernadette Johnson joined Drilling Info through the acquisition of products and services from Ponderosa Energy. She serves as Vice President, Market Intelligence for Drilling Info and is responsible for helping to grow and expand DI’s analytics offerings, building on the work she did at Ponderosa Energy leading consulting engagements and research efforts. With nearly 10 years experience in the energy industry, Bernadette has earned the reputation of industry expert with extensive experience providing crude, natural gas, and NGL fundamentals analysis and advisory services to various players in the North American and Global energy markets. A regular commentator for and speaker to the energy industry, her specific market involvement spans: financial trading, production forecasts, infrastructure analysis, midstream analysis, storage value analysis, and price forecasts. Prior to joining Ponderosa, and now DI, Bernadette was Senior Research Analyst for Sasco Energy Partners in Westport, CT where she provided analytics and research support for a team of financial traders active in natural gas, power and oil futures markets. Bernadette began her career with BENTEK Energy, LLC as a Senior Energy Analyst, Natural Gas Market Fundamentals and consulting project team lead. Bernadette holds a MS Degree in International Political Economy of Resources and a BS Degree in Economics, from the Colorado School of Mines.

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