Conglin Xu
Senior Editor-Economics
Using its Global Economic Model, Wood Mackenzie recently modeled the impacts of a lowered corporate tax rate on US exploration and production companies. WoodMac found that the cut in the corporate tax rate to 21% from 35% could provide value to US E&Ps with profitable assets seeing large increases. Including all minor interests, modeled assets show a post-tax value increase of 19% or $190.4 billion.
"While the headline change is the drop in corporate tax rate, improvements to the terms of the pass-through rate will also help the industry. Pass-through rate changes will affect privately owned companies as well as publicly traded master limited partnerships-a popular structure for midstream companies," WoodMac said.
Other benefits include accelerated expensing of capital costs and changing from a worldwide system to a territorial one. While it may not see much increase in more marginal assets, the increased profitability of valuable proved onshore and deepwater plays will likely drive more international capital towards the US.
"The change to a territorial system will reduce the burden on companies with foreign assets, though they may face short-term cash issues from repatriation. Long term, it will help solve the 'trapped cash' problem where under the old system US companies would face steep tax payments for repatriating funds from abroad," WoodMac said.
State governments may look to expand their share of profit. States may see this as an opportunity to raise their share of hydrocarbon income without the fear of discouraging investment. There will likely be international fiscal changes resulting from the bill as well as the increased attractiveness of US investment may lead other countries to decrease their own rates to keep investment capital.
The analysis also notes some of the adverse impacts of the tax law that includes many provisions that reduce the deductions that companies have available to them. Prior to the tax bill, companies could fully apply operating losses from previous years against their taxable income. The bill placed a limit on this application under which companies can only apply losses up to 80% of the taxable income in any given year. Additionally, while operating losses could be carried back 2 years before the tax bill, they can now only be carried forward. This could present issues for companies in a volatile market, as they cannot fully apply losses incurred in down markets against gains made in subsequent years.
The tax changes combine to create a capital shift from debt and towards equity. Before the tax bill, companies could deduct 35% from the cost of debt financing, as the interest payments due are fully deductible. After the bill, this deduction is reduced to the new 21% and potentially further reduced by the cap placed on interest deductions. The combination of these factors increases the effective cost of debt financing.
"While the bill will give companies value, we are seeing balance sheet losses. The heavy losses taken by the industry in the price crash have left many companies with carry forward losses and other deferred tax assets to apply. In the wake of the tax bill, these assets will apply the same deduction, but will only reduce tax payments by 21% of that applied value, rather than the previous 35%. Effectively, these carry-forward losses will save the company less on taxes than before. Additionally, the limit on applying carry forward losses can further reduce the value of these assets, as they are calculated by discounting at the cost of equity. This leaves companies like BP and Shell reporting balance sheet losses," WoodMac said.
