As expectations grow that oil exporters actually might cut production to support the price of crude, a new complication emerges. It attaches to a proposal gaining political momentum in the US: tax reform.
Last June, congressional Republicans embraced a border tax adjustment (BTA) as a way to encourage exports and discourage imports. The mechanism increasingly is seen an alternative to President-elect Donald Trump's campaign suggestions for stout tariffs on imported goods. Many analysts fear new tariffs would invite retaliation and trigger a trade war.
How BTA works
A BTA is less provocative than a toughening of tariffs. European countries use border adjustment in conjunction with value-added taxes.
As now discussed, the US would install a BTA while cutting the corporate income tax rate to probably 20% and ending worldwide taxation. The BTA would exempt exports from the corporate income tax but not imports.
Refiners dependent on imported crude oil and domestic product markets dislike the idea. Their concerns are shared by other businesses that focus on US markets and import much of their raw materials or goods for resale.
In a Jan. 6 article in the Wall Street Journal, economist Martin Feldstein argued that dollar-value changes would compensate for the feared price disparities. The BTA wouldn't change national saving or investment, he pointed out, and therefore couldn't affect the balance of trade. What it would affect, in an economy with a floating currency, is the value of the dollar. By favoring US exports and punishing imports, a BTA would strengthen the US currency.
"To preserve that original trade balance, the exchange rate of the dollar must adjust to bring the prices of US imports and exports back to the values that would prevail without the border tax adjustment," he wrote. "With a 20% corporate tax rate, that means that the value of the dollar must rise by 25%."
Feldstein, a Harvard professor who served as chairman of the Council of Economic Advisers in the administration of Ronald Reagan, supports the BTA. He believes it would raise "substantial tax revenue."
For much of the oil and gas industry, however, adoption of a BTA could be troublesome. A strengthening of the currency typically suppresses nominal, dollar-denominated prices of crude oil and petroleum products. For a market sensitive to any sign of weakened OPEC discipline, the effect could be unsettling. And a suddenly stronger dollar would disrupt economies.
According to veteran economist Philip K. Verleger Jr., a jump in the dollar's value on a scale contemplated by Feldstein would cause financial stresses. At present, he writes in his Jan. 9 Notes at the Margin newsletter, cash prices of crude are being bid up by OPEC members and others trying to limit supply, traders buying for inventory in competition with consumers, and speculators betting production restraint will work. Recent changes in the market positions of major traders support that view, he writes.
The oil market Verleger describes is vulnerable to financial pressures aggravated by interest-rate hikes likely to accompany a strengthening dollar. "News of major bond defaults or difficulties at banks writing hedges to investors in foreign countries that have purchased dollar-denominated equities that sends foreign markets down will likely lead to sales of oil futures by money managers," Verleger writes. "News of debt problems in China and an indication of an economic spillover could have the same effect. In short, adoption of the border tax could pop the oil-market bubble."
Fragile enterprise
Because oil in the US might sell at a 25% premium to foreign oil, Verleger notes, "the biggest beneficiaries of the tax change will be the smaller independent oil producers." For non-US producers US trying to enforce supply restraint, however, currency-related price movements sometime this year might be easy to misinterpret.
Under the best circumstances, coordination of production is fragile. The oil industry now must wonder whether and how sudden oil-dollar adjustment might affect an enterprise in which it has invested much hope.