Market Insider

How Washington could hurt the oil recovery, just as US drillers are pumping again

2017 still the year for dollar strength: Strategist

The unintended consequences of a congressional tax proposal could end up being bad news for oil prices.

The House of Representatives is expected to start the debate on a controversial plan to impose a new border-adjusted tax on all imports, and a side effect of that, if approved, could be a surging dollar.

That stronger dollar could backfire on some U.S. industries, and one of them very well could be energy, according to Francisco Blanch, head of global commodities and derivatives research at Bank of America Merrill Lynch.

That's because a higher dollar disproportionately hurts the economies of the emerging markets, which are the only new area of growth for the oil industry. Dollar-denominated debt becomes more expensive to service for the developing world, and the cost of everything else rises.

Makes sense to be 'little bit cautious' about EM: Expert

That includes oil, and what's bad for emerging markets is bad for the price of crude, since all new demand — this year 1.2 million barrels a day — is expected to come from the emerging world, according to Blanch.

"The combination of a very strong dollar ... of trade barriers, and higher interest rates is a bit of a toxic mix for emerging markets," he said.

Blanch sees oil rising to $70 a barrel by the summer, and he sees a supply shortfall, after years of surplus in the crude market. That deficit could reach 650,000 barrels a day by the second half of this year, he said.

He expects new demand to come mainly from Asia — with 200,000 daily barrels of new demand from China, 300,000 from India and another 200,000 from other parts of Asia. The Middle East should see demand grow by 150,000 and Africa, just under 200,000 barrels a day, he said.

According to the International Energy Agency, world oil demand in the fourth quarter was just under 97 million barrels a day.

The growth in the demand side of the equation is key to Blanch's forecast for oil prices, and that's why he is concerned about a dollar surge.

"The issue the emerging markets have is they won't be able to put up with the dollar pressure," he said.

How a tax boosts the dollar

President-elect Donald Trump has not yet weighed in on the idea of border adjusted taxation, but he has discussed other tariffs. High on his list of targets are China and Mexico.

A corporate tax overhaul proposal in the House of Representatives would rely heavily on the border-adjusted tax to fund a big cut in the corporate tax rate from 35 percent to 20 percent. The proposed tax would raise $1.1 trillion over 10 years, according to research firm Strategas — though that would cover only part of the corporate tax break.

Proponents of the tax say it should refocus American industry on domestic production — because it taxes imports but not exports — and help create more U.S. jobs. They say the dollar should rise in response, and that should eliminate inflationary pressures from the higher cost of imports. But retailers, refiners and auto makers all see a downside, since they all rely on imports.

The amount of the expected bump up in the dollar — if goods are taxed at 20 percent — is estimated to be as high as 25 percent. However, economists are not in agreement on that, and some say the dollar may not act the way proponents expect it to, resulting in an immediate jump in the price of imported goods.

But any dollar spike would hurt emerging economies. "I think this incoming presidency could accidentally damage the economic tissue of the emerging markets. Emerging markets are very frail," said Blanch.

Oil production is also obviously important to price, and higher prices means that oil that is more expensive to produce can come back to the market. Oil priced above $50 per barrel has helped U.S. shale producers increase output. In the US. last week, producers raised output by nearly 190,000 barrels a day, bringing it to 8.9 million barrels a day.

OPEC and non OPEC producers recently agreed to cut back production to support oil prices, and that has been helping keep oil in the low to mid $50s per barrel. "There's still real questions about the OPEC/non-OPEC deal. It's only getting about 60 percent of compliance. That's what the observations are to date, based on shipping and other monitoring," said John Kilduff of Again Capital.