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Texas effects of oil price decline

Hydrocarbon Engineering,

According to Fitch Ratings, the dramatic decline in oil prices over the past six months may have implications for economic and revenue trends for certain cities, counties and school districts.

The state overall and many of the larger municipalities have well diversified economies, and Fitch expects any losses in oil revenue to be limited and offset to some degree by increased consumer spending based on current forecast scenarios. However, a number of local governments in the three major production areas of the state will likely see declines in taxable values and weaker economic activity if oil prices do not recover and exploration slows, leading to declines in property tax and economic activity if oil prices do not recover and exploration slows, leading to declines in property tax and economically sensitive revenues and possible budgetary pressures.

The state comptroller’s biennial revenue estimate released yesterday anticipates oil prices at US$64.35/bbl in fiscal 2015, 33% below the fiscal 2014 level, with prices remaining near this level through the forecast period ending 31 August 2017.

The explosive growth in oil and gas drilling in the Eagle Ford Shale and Permian Basin regions over the past several years (and to a lesser extent the Barnett Shale region in north Texas) has generated an economic and financial boon for these areas through increased sales tax revenues, increased tax base valuations, construction and permit revenues, and other sector related business activity. Likewise, the state has benefited from this higher taxable activity, most notably as production taxes soared and helped bring the state’s rainy day fund to historically high levels.

Extraction activity for wells that are in place is expected to continue despite the recent oil price declines, but new drilling is expected to slow in 2015. This slowdown will affect employment, hotels and restaurants, retail, and construction and other related businesses. Cities will feel the impact in reduced sales tax receipts, building permits and other economically sensitive revenues.

The impact on taxable values also will present challenges. Persistently lower mineral values will require tax rate increases by some cities and counties to maintain steady property tax revenue streams. Texas cities and counties typically maintain tax rates well below statutory and constitutional limits, providing the legal ability to increase rates (although not necessarily the political ability given the consequent shift of tax burden to residential taxpayers).

In addition, those Texas school districts in exploration regions with debt service tax rates at or near the US$0.50 per US$100 of AV statutory maximum for new issuance may be unable to issue new tax supported binds if valuations decline materially and tax rates increase beyond the US$0.50 cap. The risk to school district operational funding is limited, as the vast majority of Texas school districts function within the target revenue system for operations. Under this funding approach, the state would make up for losses in locally generated (property tax) revenue to meet established per pupil revenue targets.

Additional downward pressure on taxable values likely will come from the loss of oil field service and other related companies, and a softening in Texas’ housing market – which has witnessed recent sharp price increased in a number of cities. Preliminary 2015 tax base estimates for Texas local governments will be available in April and will offer an initial glimpse into possible tax base changes at the local level.

Local governments that have witnessed sharp increases in tax base and/or economic concentration as a result of the exploration boom have more exposure to the effects of a downturn. Fitch believes the current ratings of these entities reflect this additional risk, and also notes that a number of these governments have built up significant reserves during the boom that may be needed to close any revenue gap before spending adjustments can be made.

The state, by contrast, appears well positioned to absorb the impact of the oil price declines experienced to date, although it will be affected modestly. The state’s economic base is vastly larger and more diverse than during the 1980s, when another plunge in energy prices precipitated a severe regional recession. The general revenue fund is shielded from much of the impact of spiking in oil and gas production taxes, with most of these collections diverted to the economic stabilisation fund (ESF, the state’s rainy day fund), highway capital, and other one time needs.

At present, the ESF holds US$8.45 billion, and the comptroller forecasts a balance of nearly US$11.1 billion at the end of fiscal 2017 biennium, even with lowered oil price expectations. Fitch believes this balance provides the state with significant flexibility to respond to near term fiscal shocks. As noted earlier, the state’s target revenue system will expose it to higher school funding needs in certain districts. However, Fitch believes these effects are likely to be small relative to the overall size of the state’s education spending. Moreover, the state has demonstrated a very conservative posture toward fiscal management, including a willingness to make deep spending cuts in order to maintain budgetary balance.

In the broader Texas economy, Fitch believes increased consumer spending from lower fuel prices should help offset the expected decline in oil and gas related tax revenues. Also, the size and diversity of the state’s economy insulates the state’s finances from a contraction in the oil and gas sector, which plays a notably smaller role in the Texas economy than in the past. Likewise, Houston’s economy has diversified over the past several decades to such a degree that the impact from an oil and gas contraction – while not immaterial – should be manageable. Houston’s expansive petrochemical sector should benefit from lower energy prices, providing an additional economic buffer. Other petrochemical centres in the state should also benefit.

Fitch is to closely monitor budget performance and economic and tax base data in affected Texas communities over the coming months to determine if revenue pressures are sufficient to warrant rating action.

Adapted from a press release by Emma McAleavey.

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