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Daily Intelligence Briefing

Thursday, June 16, 2022

Identifying Change-Driven Investment Themes

Please note that we are ADDING LONG PHARMACEUTICALS to our list of Active Themes
See the Active Thematic Ideas Section below for details

I. Today’s Thematic Investment Idea

A deep dive into a market driver with alpha generating potential.

The Daily Intelligence Briefing is published by McAlinden Research Partners. The report is provided to Hedge Connection blog readers once per week for free. Below is just one of the five sections that delivers Change-Driven Investment Themes everyday.

White House Steps Up Demands For More Oil & Gas, Windfall Tax Proposals Being Reviewed

Summary: Elevated oil and gas prices have foisted the prospect of windfall taxes and executive action into the spotlight. Following the release of a strongly-worded letter to big oil executives from President Biden’s office, specifically addressing refineries’ output of gasoline, the White House went even further in stating they would consider expanding the Defense Production Act that’s already been utilized to address shortages of baby formula and tariffs on solar panels. Refiners are currently running at 94% capacity.

The concept of windfall taxes on large oil and gas firms, potentially doubling their tax bill, are also gaining steam in Congress. Though prospects for passage of bills including taxes on oil profits are low in the Senate, the rising threat of emergency action from the President, and the revelation that the White House has been actively reviewing windfall tax proposals to fund a potential consumer rebate, shows these ideas cannot be written off at this point by investors.

Related ETFs: Energy Select Sector SPDR Fund (XLE), VanEck Oil Refiners ETF (CRAK), VanEck Oil Services ETF (OIH)

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With benchmark oil prices now well-into triple digits for the better part of the last four months, the concept of a windfall tax on oil and gas industry profits is becoming popular among members of the US Congress and a bill is expected to be proposed soon.

The theory is that the energy industry is intentionally suppressing output in a time of international crisis to capitalize on a sudden global shortage of oil and gas, driving up inflation. Therefore, those companies should have to give up a portion of their supposed ill-gotten gains and have that capital redirected back to American consumers. While the prospect of passage for such a bill would not be particularly strong in the Senate, President Biden appears prepared to step in on his own to enact new measures aimed at reigning in profit margins and expanding gasoline output. 

“At a time of war, refinery profit margins well above normal being passed directly onto American families are not acceptable,” Biden said in a letter sent Wednesday to top oil companies. The letter went on to say that the President was considering “all reasonable and appropriate Federal Government tools and emergency authorities to increase refinery capacity and output in the near term.” Bloomberg reports the letter was sent to a laundry list of companies including Marathon Petroleum Corp., Valero Energy Corp., Phillips 66, BP Plc, and Shell Plc.

In a press conference the same day, White House Press Secretary Karine Jean-Pierre added that the administration is willing to use the Defense Production Act it invoked to increase the production of baby formula and bolster solar manufacturing to boost the nation’s supply of gasoline. She did not elaborate on what measures could be taken if the Defense Production Act was enacted by Biden.

It was only a matter of time before the White House got involved in the controversy surrounding the energy industry and high gas prices as it was reported early this month that the White House was reviewing congressional proposals that could tax oil and gas producers’ profits in order to provide a rebate to consumers struggling with higher energy prices.

Oil executives contend that a windfall tax would damage the domestic industry financially and constrain any incentive to drill more or develop new technologies to make drilling more efficient. It is worth noting that energy firms have returned some $9.51 billion to investors in the first quarter, according to energy consultancy Wood Mackenzie, but that comes after a 13-year period (2006-2019) where the top 50 US oil producers abstained from rewarding shareholders and spent $170 billion more in capital expenditures than they collected from operations, estimates independent oil analyst Paul Sankey.

It should also be noted that more than 100 oil and gas firms went bankrupt in 2020 in the wake of COVID-19. notes 46 exploration and production companies and 61 oilfield service companies filed for Chapter 11 bankruptcy during the year, according to Haynes and Boone data. Not only has that materially constrained US energy capacity, it shot a major warning across the energy economy that profitability must be maintained over rapid production increases. As far back as 2018, MRP had been warning about the dangerous level of debt shale drillers had been racking up to expand production and capture market share while bringing in virtually no profits, leading to perpetually rising bankruptcies that peaked in 2020. In retrospect, what really kept oil prices relatively suppressed in the 2016-2019 period was unsustainable, debt-fueled shale expansion that mostly never materialized into profit.

Moreover, when it comes to refineries, US refiners are already producing near-peak levels of fuel processing – currently running at 94% of full capacity. As of March, Reuters reports refineries were processing about 17.9 million barrels per day (bpd). Though that is well-below April 2020’s record rate of just under 19 million bpd, several refineries were forced to shutdown in the wake of COVID-19 and many eventually went into full closure. In the past two years, 5 US refineries have been permanently closed down and at least one more, run by LyondellBassell in Houston, TX, is set slated to close by the end of 2023. The Institute for Energy Research notes The US refining industry has already lost 800,000 barrels of production capacity over the last several years and this closure will add over 200,000 barrels per day to it.

Chevron CEO Mike Wirth has been particularly explicit in his warning that an unfriendly attitude toward the oil and gas industry will only make things worse. “There hasn’t been a refinery built in this country since the 1970s… I personally don’t believe there will be a new petroleum refinery ever built in this country again,” said Wirth. He added that “Capacity is added by de-bottlenecking existing units by investing in existing refineries, but what we’ve seen over the last two years are shutdowns. We’ve seen refineries closed… we live in a world where the policy, the stated policy of the US government is to reduce demand for the products that refiners produce.”

One bill that gives the Federal Trade Commission (FTC) the authority to investigate energy companies for alleged price gouging has already passed the House of Representatives. With the 217-207 vote splitting almost strictly down party lines, it appears unlikely that an even narrower Democratic majority in the Senate (split 50-50 between Republicans and Democrats, plus two Independents who caucus with the Democrats) would be able to get the 60 votes needed to pass the Senate.

Per Reuters, US Senate Finance Committee chair Ron Wyden (D-OR) is planning to introduce more aggressive legislation setting a 21% surtax on oil companies who make more than $1 billion in annual revenue and are making profits considered “excessive”. Wyden’s bill would apply the tax based on profit margins, specifically taxing all energy earnings above a 10% return. When combined with the corporate tax rate of 21%, the cumulative tax rate on oil companies covered by the legislation would come out to 42%.

Per the Wall Street Journal, a previous proposal for a windfall tax from Sen. Sheldon Whitehouse (D-RI) and Rep. Ro Khanna (D-CA) would put a 50% tax, charged for a barrel, on the price difference between the current cost of a barrel of oil and the average cost for a barrel between 2015 and 2019. At $120 per barrel, that would raise an estimated $45 billion per year and, theoretically, split up into an annual payment of $240 for single filers earning less than $75,000 and $360 for joint filers earning less than $150,000.

It should be noted that windfall taxes on oil and gas have been enacted in the US before. In the 1980s, Jimmy Carter’s administration enacted a similar tax regime on oil producers that was initially projected to raise almost $400 billion. Instead, the Congressional Research Service found it raised less than 20% of that amount — just $80 billion. Further, throughout the 8 years the tax was in effect, it appeared to weaken domestic oil output and increase dependence on foreign oil by as much as 13%.


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