U.S. tax reform has benefited the refining sector more than upstream energy companies, judging from Q417 earnings calls, says Fitch Ratings. The Tax Cuts and Jobs Act of 2017 is expected to be positive for most energy companies by lowering the future baseline statutory tax rate and thereby boosting reported earnings. It also creates one-time earnings impacts from the re-measurement of deferred tax assets and liabilities at the new lower rates.
However, the cash impacts of tax reform will not be uniformly distributed. U.S. refiners on average are better positioned to take advantage of these benefits than exploration and production (E&P) companies. This is because the refining sector has been in a cash tax paying position over the past several years, driven by above-trend crack spreads, strong economic growth, access to cheaper shale based crudes, and structurally cheap gas and power. Several refiners identified substantial reductions in cash taxes in Q417 earnings calls, including Marathon Petroleum (MPC, $400 million to $500 million), Phillips 66 (PSX, $400 million range) and Valero ($350 million after taking into account repatriation impacts).
By contrast, the oil price crash produced several years of losses in a row for the upstream sector beginning in 2015. As a result, many E&Ps have built up sizable tax shields and expect to see limited or no cash tax payments over the next few years, thus limiting the impact of a lower rate on cash flow. ConocoPhillips (COP) and Hess were representative on this point in Q417 earnings calls. COP noted that it did not expect to be a cash taxpayer in the U.S. until the early 2020s, while Hess stated it did not expect to pay any federal cash taxes in the U.S. over the next five years at least.
Fitch expects increased tax-related cash flows will partly be used to help support refiner distribution policies. MPC cited extra cash from tax relief as a factor in its decision to increase its dividend by 15%. Valero did not directly link its 14% dividend increase to the tax legislation, but did cite the cash tax benefit and noted that it had paid out above its target range for payouts in 2017: 63% of 2017 adjusted net cash from operating activities rather than 40% to 50%. PSX also did not explicitly link any increases to the legislation but noted that investment opportunities remained expensive.
Fitch does not expect to see any credit impact from increased distributions supported by tax reform and anticipates that refiners will largely remain committed to their current capital allocation frameworks. We would note that the sector has a track record of defending credit quality in downturns, especially during the last sharp sector downturn of 2009-2010 that saw extensive dividend cuts and eliminations. U.S. refiners have had a longstanding focus on returns, given that they have had capped secular growth prospects for many years (biofuels, RINs, CAFE standards). By contrast, a returns-based model is a newer focus for the E&P space, and bears watching to see how it might be modified in any future downturn.