Stronger dollar would in turn tend to depress the price of crude worldwide
By John Kemp
Hedge funds seem to be quietly positioning for the possible imposition of a border tax adjustment on imports of crude oil into the United States.
The principal impact of a border tax adjustment would be to raise the price of domestic crude compared with international grades such as Brent.
Hedge funds have started to anticipate the possibility of a tax being imposed by increasing their exposure to futures and options linked to WTI rather than Brent.
In the two weeks between Jan. 10 and Jan. 24, hedge funds added 62 million barrels of extra long positions in WTI while cutting long positions in Brent by 6 million barrels.
The increased exposure to WTI included 50 million barrels of extra long positions added in the week to Jan 17, the largest one-week increase for more than six years.
Hedge funds have been progressively adding to their net long position in both of the major crude benchmark grades since the middle of November.
But bullish positioning in WTI has been rising much faster than Brent, according to an analysis of records published by regulators and exchanges.
On Nov. 15 hedge funds held a net long position of 266 million barrels in Brent and 159 million barrels in WTI, a ratio of 1.67:1.
By Jan. 24, hedge funds held a net long position of 448 million barrels in Brent and 395 million barrels in WTI, a ratio of just 1.13:1.
PROPOSED TAX CHANGES
The intentions of hedge fund managers adding positions in WTI rather than Brent will always remain a mystery since no data is collected on the thinking that lies behind reported positions.
But the increase in hedge fund positions in WTI relative to Brent is consistent with preparations for the imposition of a border tax adjustment.
A border-adjusted tax would eliminate corporate income taxes on crude exported from the United States while preventing U.S. refiners from deducting the cost of imported crude from their taxable net income.
The plan aims to create a level playing field with other countries which impose value-added tax on imported items while zero-rating exports.
Since the United States imports more goods and services than it exports, imposing extra taxes on imports while cutting them on exports would also raise net tax revenues for the Treasury.
Border adjustment has been included in some tax reform plans promoted by Republican lawmakers in Congress (“The House GOP’s destination-based cash flow tax explained”, Tax Foundation, Jun 2016).
But legislators appear divided on the issue and the Trump administration’s position on the issue remains unclear.
The U.S. business community is deeply split, with exporters and import-competing firms in favour, while importers are fiercely opposed.
The probability of a border-adjusted tax being imposed is highly uncertain. Even if a general adjustment is approved it may exempt crude oil imports.
But the probability of a border adjustment on crude oil is not zero and if it happens it will help drive WTI to a premium over Brent.
Researchers at Goldman Sachs put the probability of a border tax adjustment with no oil exemption being introduced at just 20 percent.
But if a tax adjustment is introduced it could result in an immediate appreciation of WTI relative to Brent of around 25 percent (“Destination-based taxation and the oil market”, Goldman Sachs, Jan. 2017).
So it makes sense for hedge funds to prepare for the possibility by increasing their relative exposure to higher WTI rather than Brent prices.
Border tax advocates claim the impact of higher import costs and perceived subsidy for exports would be a rise in the real exchange rate of the U.S. dollar.
A stronger dollar would in turn tend to depress the price of crude worldwide but the main impact would probably be felt on international grades linked to Brent.
Domestic grades would benefit from the improvement in their competitive position and should be relatively insulated from any decline in international prices.
So even if a border tax adjustment depresses the dollar price of oil worldwide, other things being equal, it would still make sense to hold long positions in WTI rather than Brent.