Certain sectors of the energy industry may have struck it rich in the tax overhaul following passage of the Tax Cuts and Jobs Act late last year, but many U.S. oil companies are in no rush to make major strategic shifts to their business as a result of new tax changes.
Instead, companies are approaching the impacts of tax reform on the energy industry with caution and discipline. With low oil & gas prices still fresh in the minds of investors, many energy companies are looking to invest conservatively this year and use any influx of cash as a result of tax savings to pay down debt, expand drilling activity and explore acquisition opportunities.
In a recent Grant Thornton/Hart Energy pulse survey of 113 energy leaders to gauge the impact of the Tax Cuts and Jobs Act on energy companies, only a little more than a third (34.8%) of respondents indicated tax reform would have a very high (10.7%) or high (24.1%) overall impact on their 2018 business strategy while another 30.3% reported tax reform would have a medium impact. Indeed, nearly a quarter (23.2%) reported tax reform would have a low impact or none at all (11.6%) on their business strategies this year.
This tempered reaction to the impact of tax reform can be attributed, in part, to some of the core provisions of the legislation which offer the industry both benefits and challenges.
“Due to the large number of energy companies incurring tax losses, the effect of the new tax legislation on the energy industry is less significant than many other industries,”
- Michael Osina, Tax partner, Grant Thornton Energy Practice
The new rules also allow businesses to offset no more than 80% of a year’s earnings with losses incurred after 2017. Losses incurred before 2018 are still allowed to fully offset future income. In addition, the legislation includes a repeal of the alternative minimum tax for businesses. However, previously earned AMT credits will become refundable if not utilized to offset regular tax.
“Due to the large number of energy companies incurring tax losses, the effect of the new tax legislation on the energy industry is less significant than many other industries,” explained Michael Osina, tax partner, Grant Thornton Energy Practice. “While the additional benefit of the lower rate and full expensing is attractive, most E&P companies were already paying little or no cash taxes so the only real impact has been on the financial statements.”
Yet, the new tax legislation offers some in the energy industry business wins. The steep cut in corporate tax rate from 35% to 21% was cited by more than 40% of survey respondents as having the greatest impact to their company. In addition, the new tax reform provision to provide a 20% deduction against qualifying pass-through income was also acknowledged by 35% of respondents as providing a significant impact.
Looking beyond 2018 to the next 3-year period, energy leaders may still feel uncertain of the true impact that tax reform will have on their company’s operations. While less than a fifth of respondents indicated that tax reform could have a high impact on increasing their focus on technology to drive more efficient drilling and production methods and a desire to focus on a few core areas, nearly half believe that tax reform will have no impact on decisions related to asset portfolio diversification across multiple plays/basins (46.7%) or restricting their asset portfolio to a pure-play strategy (48.1%).
M&A: Slow, targeted growth
An increase in mergers and acquisition activity has been targeted as a key result of new tax changes; yet less than a third (30%) of survey respondents indicated tax reform would impact their 2018 plans for acquisitions and divestitures. With tax reform still brand new, many companies may be opting for a wait-and-see attitude before implementing a more aggressive M&A strategy. The U.S. continues to account for 40% of last year’s M&A activity in terms of value so it’s likely that tax reform will ultimately stimulate more acquisitions and divestitures despite an initial slow start.
Following several years of underinvestment, slowly switching on the acquisitive growth mode, especially when there is extra cash to invest in acquisitions, will eventually be the motto of the post-crisis oil industry. The industry had a wake-up call following the downturn but now can appreciate there’s capital to be had as energy companies focus on low-cost, high-quality assets.
There are other issues besides tax reform at the top of the industry’s agenda that will impact M&A strategy. Indeed, the Grant Thornton/Hart Energy survey revealed that nearly 40% of energy leaders reported that competitive prices rather than tax reform will most significantly impact their company’s plans for acquisitions and divestures in coming months.
Strategic spending of tax cash
As the energy industry looks to leverage the bottom-line benefits served up by tax reform, they’ll do so through the lens of capital discipline driven by purposeful growth. U.S. companies, especially those with foreign operations, no doubt have spent the first few months of the year running the numbers and evaluating their options in this new post-tax reform environment.
The tax overhaul comes at a time, after all, when crude prices have jumped 54% since mid-last year. This price increase alongside a new tax code makes 2018 the right time to strategically plan for ways to increase efficiencies and drive growth.
Faced with an influx of capital thanks to tax reform savings, survey results indicated that energy companies are not focusing exclusively on one area to target those investment dollars. A nearly equal number of respondents indicated they would invest the additional dollars in one of three key areas: expansion of exploratory and developmental drilling; acquisitions and paying down debt. Approximately 11% of respondents are targeting additional dollars for increases in hiring while nearly 10% report they will return tax savings to shareholders as profit. More than a third (39%) of respondents indicated they planned to increase capital spending up to 20% as a result of tax reform legislation.
The message for the energy industry seems one of cautious optimism. Will the tax overhaul live up to its promise for the E&P industry or will the Act’s drawbacks diminish its allure? Only time will tell. In the meantime, energy companies will likely approach this year with an eye on strategic growth focused on a few core areas and a disciplined capital spending strategy targeting operational efficiencies and increased drilling and development.
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