The U.S. oil and gas sector may face a tougher operating environment under a number of Democratic presidential candidate Joe Biden's policy proposals, but his plan to raise corporate taxes is not one of them.

The Biden plan calls for raising the corporate income tax rate from 21% to 28%, partially reversing the cut from 35% that President Donald Trump and congressional Republicans secured as part of the federal tax overhaul of 2017. For most U.S. companies, that would result in lower after-tax profits.

The gas and utilities sectors are different. The upstream segment cannot be taxed on what it does not earn, meaning it is insulated by a lack of profits and years of losses stored as future tax deductions. Midstream companies and utilities, meanwhile, have a buffer because they pass on tax expenses to other entities and deduct accelerated depreciation of their pipes and other hard assets.

A reversal would present a unique challenge for utilities, though, as increased tax costs would be borne by ratepayers at the same time regulators try to keep electric and gas rates low amid the economic fallout from the COVID-19 pandemic.

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By and large, oil and gas exploration and production companies, or E&Ps, in 2019 reported losses with little tax liability, largely because of prolonged low commodity prices. The three U.S. supermajors — Exxon Mobil Corp., Chevron Corp. and ConocoPhillips — paid the lion's share of taxes in 2019, but mostly to other countries. Only ConocoPhillips had a federal tax bill, for $18 million, according to SEC filings.

Slack profits from U.S. upstream firms and associated tax impacts have been the expected norm, though. "Large pre-tax losses, which have helped shield E&Ps from meaningful U.S. cash taxes, will limit the benefit of lower rates," Barclays oil and gas analyst Thomas Driscoll said on the eve of the tax act's December 2017 passage. "Based on our $50 [per barrel] oil price assumption, we do not see most E&Ps becoming substantial taxpayers in the near future."

Taxes do affect corporations in diverse ways that make it hard to generalize, Deloitte's U.S. Oil, Gas & Chemical leader and partner Jeff Wright said Aug. 19, but companies do not generally pay current U.S. taxes on losses. "Given the commodity price drop, many companies have been losing money. When losing money, the lower tax rate typically provides no immediate benefit," Wright said.

Among 94 upstream and integrated companies incorporated in the U.S. and traded on major exchanges, only 23 firms had 2019 earnings for which they had to pay U.S. federal taxes at the 21% rate. Most of those 23 were big Permian and Bakken Shale oil drillers such as EOG Resources Inc. and Continental Resources Inc., along with Appalachian shale gas driller Cabot Oil & Gas Corp. With 2020 expected to be a wash for the whole sector because coronavirus-related demand destruction and low oil and gas prices, it is reasonable to expect that even fewer U.S. E&Ps need to worry about paying taxes, much less a higher 28% rate, no matter who wins the election.

The industry is more concerned with preserving the deduction for intangible drilling costs, which significantly lowers the earnings exposed to taxes. Although other manufacturing and extraction industries have a similar ability to deduct the costs of doing business, rescinding the deduction is a juicy target, particularly when oil and gas prices are high and the industry appears robust.

"Rescission could be a heavy lift, in our view," veteran energy policy analyst Kevin Book with Clearview Energy Partners LLC told clients Aug. 21 in a note examining the upshots of a Biden victory and a Democratic sweep.

Limited midstream impact

The master limited partnership structure that dominated the pipeline sector for years does not pay corporate taxes, but rather passes them on to individual shareholders who pay taxes on the payouts they receive. The 2017 federal tax overhaul dulled the MLP structure's decadeslong advantage.

Theoretically, Biden's tax plan would "meaningfully improve" MLPs' advantage over C-corps even though it could raise individual taxpayer rates and erase the 20% pass-through deduction for qualified business income and unit sales that the federal tax overhaul added, according to CreditSights analyst Charles Johnston.

"The all-in tax rate for an MLP would increase by around 10 percentage points to close to 40% ... meanwhile, the corporate tax rate jumps around 20 percentage points to 56%, so the tax advantage for the MLP structure increases from around seven percentage points to 17," Johnston said in an interview.

Midstream C-corps, however, can typically defer paying federal taxes by writing off their assets' decreasing fair value as that infrastructure depreciates. The federal tax overhaul allows companies to write off entire growth projects up-front instead of over time, but even though that particular benefit will begin to phase out in 2023, pipeline executives do not seem overly concerned as the sector enters a slower-growth period.

Oneok Inc., for example, does not anticipate being a "meaningful taxpayer ... for several years," Executive Vice President and COO Kevin Burdick said in July. Williams Cos. Inc.'s merger with its MLP in 2018 extended the pipeline giant's expected nonfederal cash taxpayer status through 2024, and the new consolidated Antero Midstream Corp. also does not expect to pay "material" federal taxes until 2025 at the earliest. If a Biden administration did increase the corporate tax rate, Kinder Morgan Inc. CEO Steven Kean said in July that the midstream heavyweight, which anticipates paying no federal taxes through 2026, has "some cushion to be able to absorb a change."

The sector moved away from the MLP structure in recent years, but a walk-back of the 2017 tax change likely would not affect corporate structures as it was not the driving force behind a wave of corporate reorganizations that ramped up in 2018.

"The tax reform was pointed to as a reason for some of the consolidation we saw, but I don't think the lower corporate tax rate was really the primary driver there and I think sometimes it's given too much credit," Stacey Morris, director of research at information services firm Alerian, said in an interview.

A Federal Energy Regulatory Commission 2018 decision to extinguish a tax benefit for oil and gas pipelines organized as MLPs, which did spur that rush to consolidate, was not affected by the recent tax overhaul either, Gibson Dunn & Crutcher LLP tax attorney James Chenoweth said in an interview.

Gas utilities can absorb higher taxes

Tax rate changes have a unique impact on utilities because regulated gas distributors pass on tax expense to ratepayers. With regulators trying to keep rates low during a time of financial strain, higher tax expense could force utilities to look for savings elsewhere, including through reduced investment in energy efficiency, renewable energy and infrastructure investment.

The old 35% tax rate was baked into utilities' rates, but no longer reflected their actual tax expense after the federal tax overhaul became law. State regulators typically ordered them to defer excess revenues, book them as regulatory liabilities and return the funds to ratepayers, according to Lillian Federico, energy research director at Regulatory Research Associates.

The tax change also caused companies that booked accelerated depreciation of assets to run up accumulated deferred federal income tax balances that exceeded levels permitted by accounting standards, Federico said. These excess balances became liabilities, and commissioners ordered utilities to return them to customers over time, she explained.

Should tax rates increase under a Biden administration, regulators could allow companies to adjust those plans, with excess deferred tax liabilities essentially absorbing the higher taxes, AltaGas Ltd. President and CEO Randy Crawford said on a July 30 conference call.

Companies are returning the vast majority of excess deferred tax liabilities over several decades, according to Sal Montalbano, a U.S. power and utilities tax practice leader at PwC U.S. "We've only had two or three years' worth of reversals of that so far, so most of that would be able to absorb a rate increase for most gas utilities," Montalbano said.

Consultants said some aspects of a reversal will be relatively straightforward. However, reversing regulatory policies established to deal with the federal tax overhaul "will be somewhat of a regulatory nightmare," Brattle Group partner Bente Villadsen said.

Regulators want rates to remain low, so they will have to pull levers to mitigate the impact of tax rate increases on ratepayers, and that could be challenging, PwC U.S. power and utilities leader Casey Herman said.

In theory, tax cuts translate into savings for ratepayers, but in reality, they offset upward pressure on rates caused by investments in infrastructure, renewable energy and other areas, Brattle Group senior associate Mike Tolleth said.

"If you started talking about reversing that, the utilities would perceive a need to increase their rates to make sure they're recovering their tax costs, and you're looking at trying to file for a rate increase right now, still in the clutches of the pandemic and the economic fallout from that," he said. "That becomes a challenging thing there."

Regulatory Research Associates is a group within S&P Global Market Intelligence.