U.S. Inflation Reduction Act Will Have Mixed Impact On Oil, Gas Markets

The Inflation Reduction Act, which will likely be passed by Congress this week, contains multiple provisions impacting the energy industry in the U.S. Here is how traders and investors in energy and related companies can expect the legislation to impact oil, natural gas and energy equities.

1. Tax credits for carbon capture, hydrogen and biofuel initiatives

These credits appear in areas of the energy industry that big fossil fuel producers like ExxonMobil (NYSE:XOM) and Occidental Petroleum (NYSE:OXY) are investing in, without any expectation of a return in the short term. Cost-effective carbon capture technology is still years away from implementation, the market for biofuels is still in its infancy and the market for hydrogen is even farther away. Big oil and gas producers in the U.S. make their money producing and selling fossil fuels, but they can afford to invest in expensive carbon capture projects and biofuel research that will, under this legislation, allow them to take advantage of big tax breaks. Smaller oil and gas companies don’t have money to spend on fanciful initiatives that may not ever be profitable, so they won’t be able to take advantage of these tax breaks the way Big Oil can.

This is relevant to traders and investors because independent oil producers produce 83% of U.S. oil and 90% of U.S. natural gas, according to the Independent Petroleum Association of America. This legislation will make it even more difficult for smaller companies to compete and for new companies to enter the market. U.S. oil production could also suffer.

2. Tax Credits for Electric Vehicles

The legislation includes what seems like a very significant tax credit for electric vehicle (EV) purchases—$7500. On the surface, this seems like it could provide significant stimulus to the EV industry and potentially send the stock prices of companies that produce EVs (such as Tesla (NASDAQ:TSLA) and Rivian (NASDAQ:RIVN)) higher. However, in order for an EV to qualify for this tax credit the battery must be built in North America with minerals that were mined in North America or made from materials that were recycled in North America. It is possible that EV manufacturers will find a way to circumvent this provision, but as of now, the automotive industry says that 50 out of the 72 electric, hydrogen and plug-in hybrid model vehicles available in the U.S. won’t qualify for the credit.

The credit is designed to incentivize domestic battery manufacturing and domestic mining for minerals, like cobalt, that are components of EV batteries. However, the hurdles to building battery factories and opening new mines are much more significant than a $7500 tax credit can satisfy. EV sellers may find a way to get around this provision, perhaps by adding a domestically manufactured part to foreign-made batteries and branding it North American-made, but as of now, this tax incentive won’t help sell more EVs. Traders factoring in growing EV use into their oil demand forecasts should not expect that this legislation will result in increased EV purchases, at least not in the short term. Investors looking to see EV revenues get a bump from this provision should be wary.

3. Methane Fees

The legislation calls for fees to oil and gas producers for methane emissions from their operations. Companies that vent or leak methane into the atmosphere would be charged $900 per ton in 2024 with rates increasing to $1500 per ton by 2026. To put this in context, it is about twice the current market price of natural gas. Environmental groups claim these fees would push oil and gas companies to reduce their emissions as quickly as they can to avoid the fees. However, the fees would only apply to companies that aren’t in compliance with EPA methane regulations, and these regulations haven’t yet been finalized and aren’t likely to be finalized until early 2023.

Practically, this means that some companies will be at a huge disadvantage. Such businesses include those that haven’t implemented costly methane monitoring systems, haven’t built systems to capture and use methane to fuel their own operations and are not connected to pipeline networks that enable them to funnel excess methane to the natural gas market.

It also means that producers won’t be able to quickly drill new wells and bring new production online like they used to be able to do in shale oil regions. U.S. producers in these regions used to be able to respond to market forces by increasing or decreasing production quickly. With these new regulations, production will not just cost more but will take longer to come online, because more infrastructure will need to be in place to deal with the methane before drilling can commence. The Permian, or any future shale oil regions that are discovered, can no longer be the nimble oil producing region it once was. Traders should understand that these limitations will make U.S. production less responsive to market conditions in the future.