How Will Low Oil Prices Affect Municipal Bonds?
Key Points
- Falling oil prices could have a negative effect on municipal bond issuers located in areas that rely heavily on the oil and gas industry.
- Declining tax revenue leaves governments with less financial flexibility to meet debt payments.
- We don't believe low oil prices will lead to widespread defaults, but the phenomenon could prompt some ratings downgrades and lower prices for outstanding bonds.
Falling oil prices can be a welcome sight at the gas pump, but should they worry municipal bond investors? It depends on where the issuers of those bonds are located.
The price of crude oil has declined by more than 50% since mid-2015,1 sending shockwaves through many parts of the market. The creditworthiness of the state of Alaska recently was downgraded from the highest investment-grade rating, AAA, to AA+ with a negative outlook by Standard & Poor's, due primarily to the decline in oil prices.
We don't expect low oil prices to have a major impact on most municipal issuers. However, we do think they will be a negative for issuers in areas that are heavily dependent on the oil and gas industry, as local employment, property values and tax revenues all may decline as a result. States may suffer less than cities, counties and school districts where oil and gas extraction is a major part of the local economy. These localities could undergo credit ratings downgrades, but we do not expect that the impact will be widespread.
Most states will be unaffected by dropping oil prices
Because states tend to have diverse revenue streams with little to no reliance on the oil and gas industry, credit quality for most is unlikely to change due to lower oil prices. Oil and gas production in the U.S. is concentrated in a few states. Just three—Texas, North Dakota and California—account for nearly two-thirds of total U.S. oil production.
The larger oil-producing states receive revenue from the production of oil and gas, and the industry also contributes to their economic health. Most states charge a "severance" tax—a tax on the removal of non-renewable natural resources—on the extraction, production or sale of oil. At least 36 states impose some sort of severance tax and 31 states specifically levy taxes on the extraction of oil and gas, according to the National Conference of State Legislatures. States tend to tax the volume of production, its value, or a combination of both.
States with a greater reliance on severance taxes will feel the impact of low oil prices more than those with more diverse revenue streams. Texas, for example, is the largest producer of crude oil, but severance taxes account for only 11% of total tax revenue. Alaska, on the other hand relies on severance taxes for nearly three-quarters of its total tax revenue, and has already felt the pinch of low oil prices. The state’s governor, Bill Walker, recently proposed restructuring Alaska's finances to make it less reliant on oil and gas revenue.
States' reliance on severance taxes
Source: United States Census Bureau, as of 4/16/2015 and U.S. Energy Information Administration, as of October 2015.
Note: Chart shows only the top 15 domestic producers of crude oil.
How oil and gas production affects municipalities
Severance taxes, while generally collected by states, are often passed down to local governments within that state. This distribution of severance taxes to cities and counties varies, however. Some states—such as Colorado, Montana and North Dakota—distribute a large portion of state severance taxes to local governments. Other states, like Texas and Wyoming, pass on very little.
More critically, localities with a concentration of jobs in the oil and gas industry can be hurt when declining employment leads to reduced economic activity and potentially lower property values. For example, more than 20% of jobs in parts of southwestern Wyoming and west Texas are in the oil and gas industry. That may have seemed like a boon. Nationally, employment in the oil and gas industry surged by 28% from January 2010 to October 2014.2 But it has since fallen by 8.9%.3 The image below shows which counties rely heavily on the oil and gas industry for jobs.
Counties heavily reliant on oil and gas production may be more affected if it slows
Source: U.S. Bureau of Labor Statistics, as of 1/9/2015.
What's a muni investor to do?
We suggest using caution if you're considering investing in bonds issued by a municipality that relies heavily on the oil-and-gas industry—such as areas in Texas and Oklahoma, parts of Wyoming, and western Pennsylvania. We don't believe low oil prices will lead to widespread defaults, but an extended period of low oil prices could lead to ratings downgrades and lower prices for outstanding bonds.
Also, states that have built their budgets around aggressive oil and gas price forecasts, and kept financial reserves low, are more vulnerable to dropping prices. Without the projected rise in oil and gas prices, those states may have to adjust their budgets, limiting their flexibility to meet bond payments. In addition, states with lower reserve ratios have less flexibility than those with higher reserve accounts.
State budget assumptions for fiscal year 2017
|
State |
Oil Price assumption ($/barrel) |
Oil-related Revenue as % of Operating Revenue |
Reserves as % of Expenditures |
|---|---|---|---|
|
Oklahoma |
53.57 |
0.1% |
5.40% |
|
New Mexico |
49.00 |
12.0% |
8.00% |
|
Montana |
51.00 |
2.9% |
15.20% |
|
Texas |
56.52 |
6.0% |
28.00% |
|
Wyoming |
50.00 |
40.0% |
64.10% |
|
North Dakota |
42.00-53.00 |
5.0% |
91.00% |
|
Alaska |
56.24 |
67.0% |
245.00% |
|
Louisiana |
54.09 |
8.0% |
N/A |
Source: Standard & Poor's, as of 1/21/2016.
Note: Sorted by lowest reserves as a percentage of expenditures to highest.
Investors should consider the risks of owning bonds issued by smaller local governments in areas where the oil and gas industry is a major source of revenue. We suggest diversifying by issuer and region, with no more than 10% of your municipal bond portfolio allocated to any one issuer or area.
For additional help, consider the benefits of professional management or reach out to your local Schwab fixed income specialist.
1 Bloomberg, as of 2/9/2016.
2 Bureau of Labor Statistics, as of 2/5/2015. Percentage change in all employees in the oil and gas extraction industry from October 2014 to January 2016.
3 Bureau of Labor Statistics, as of 2/5/2016. Percentage change in all employees in the oil and gas extraction industry from October 2014 to January 2016.
(c) Charles Schwab
