The Windfall Profit Tax: Bad Idea

Today, the two British oil giants BP and Shell released their first quarter profit results and they were big. Together they made over $16 billion in one quarter alone — over $65 billion on an annualized basis. Bloomberg reports that:

“BP Plc rose the most in eight years and Royal Dutch Shell Plc had its biggest gain since 2005 after the oil companies reported $100 crude prices led to better profits than analysts estimated.

BP surged as much as 6 percent in London trading after Europe’s second-biggest oil company posted a 63 percent jump in first-quarter net income to $7.62 billion. Shell A shares in London also climbed 6 percent as Europe’s biggest oil producer said profit gained 25 percent to $9.08 billion.”

With oil prices edging up near $120 a barrel, isn’t it time for a Windfall Profits tax on oil companies in order to alleviate the burden of the high cost of oil? The short answer is no. Let me explain why.

Sections

Elimination of tax loopholes
Tax Holiday
Who sets the oil price?
Discrimination of domestic producers
Mis-allocation of capital investment
Return on capital

Elimination of tax loopholes
If we want to tax the oil companies for excess profit, the first place to look would actually be tax loopholes. The U.S. Government loses hundreds of billions of dollars due to corporate tax loopholes and corporate subsidies. An April 13th article from Parade.com sums up the problem with these government policies:

“A 2004 U.S. Government Accountability Office (GAO) study found that 61% of American corporations, including 39% of large companies, paid no corporate income taxes between 1996 and 2000. Last year, corporations shouldered just 14.4% of the total U.S. tax burden, compared with about 50% in 1940.

While companies are getting off easy, thanks to loopholes, ordinary wage earners are getting stuck with the tab. The tax burden on individuals is expected to climb from $1.16 trillion in 2007 to $1.21 trillion this year, according to the Congressional Budget Office (CBO), while corporate tax receipts are expected to decline from $370 billion to $364 billion. By 2013, the CBO estimates, ordinary taxpayers’ bills may climb to $1.86 trillion while corporate tax bills drop to $327 billion.”
–Parade.com

For example, oil companies get massive subsidies for drilling offshore leases in the Gulf of Mexico. The American Petroleum Institute (API), an oil special interests group, was instrumental in getting these tax breaks, pointing out the need to curb special interests in Washington. These subsidies only serve to distort the allocation of investment capital. They never should have been given in the first place and they should be ended immediately.

In Dec 19, 2007, the President signed the Energy Independence and Security Act of 2007 legislation to end nearly $8 billion of these subsidies. (see story). In its original form, the bill would bar companies from future lease sales unless they agree to renegotiate flawed leases issued in 1998-99 for deep-water drilling in the Gulf of Mexico. The National Council for Science and the Environment (NCSE), a pro-environment group, describes the bill like this:

“The CLEAN Energy Act of 2007 (H.R. 6) [later renamed the Energy Independence and Security Act of 2007] was introduced by the House Democratic leadership to revise certain tax and royalty policies for oil and natural gas and to use the resulting revenue to support a reserve for energy efficiency and renewable energy. Title I proposes to repeal certain oil and natural gas tax subsidies, and use the resulting revenue stream to support the reserve.

The bill originally sought to cut subsidies to the petroleum industry in order to promote petroleum independence and different forms of alternative energy. These tax changes were ultimately dropped after opposition in the Senate, and the final bill focused on automobile fuel economy, development of biofuels, and energy efficiency in public buildings and lighting.”

–Wikipedia

That is unfortunate because the oil industry needs to be taxed fairly and in line with other companies operating in the U.S. and subject to U.S. tax law.

But, what about the poor American consumer who is paying nearly $4.00 a gallon for gasoline? High oil prices also increase the price of all forms of energy as well as being passed through into the price of food and other goods we buy. How do we alleviate the burden on the consumer.

Tax Holiday
John McCain and Hillary Clinton are suggesting we declare a tax holiday for the summer driving season. But, unfortunately this is not a productive way of alleviating the burden high oil places on the economy. McCain and Clinton are either fishing for votes by pandering to the general public or they don’t know much about economics. During this election campaign, McCain admitted the economy is not his strong suit, but he and Clinton are playing politics, pure and simple.

For one, a tax holiday reduces the revenue of the Federal Government. And at a time of record budget deficits and over $9 trillion in Federal Debt, our government needs all the revue it can get. Cutting taxes is fiscally irresponsible.

Moreover, the revenue the government receives from gasoline helps to pay for the Federal Highway system begun by Eisenhower in the 1950s. As a result, the tax on gasoline goes directly toward financing the roads that make driving in the U.S. a direct alternative to other forms of transportation. Taxes on gasoline are extraordinarily low in the US. For example, gasoline prices in the UK are nearly $10.00 per gallon. Prices are nearly as high in all of Western Europe.

The Europeans believe that high taxation on gasoline not only funds their highway system but also alternative means of public transport, which is sorely lacking in the United States. While the huge increase in gasoline prices is a tremendous burden for the cash-strapped U.S. consumer, one needs to consider the poor state of our transportation infrastructure in the form of crumbling roads and bridges and poor public transportation systems. $4 a gallon is nothing compared to what consumers in most of the developed world pay.

Who sets the oil price?
We should also stop demagoguing the issue of high oil prices. The price of oil is set by the international oil markets based on supply and demand. Individual oil companies have no control over oil prices. Do you remember $12 a barrel oil and sub $1 gasoline? That was the state of affairs as few as 10 years ago. If Big Oil were so powerful, how did oil prices plummet to $10 a barrel?

The fact is that supply is not keeping up with demand. This is true for four reasons. First, new emerging economies like China and India are gobbling up oil in ever larger quantities. China, in particular, is very oil dependent for growth in manufacturing. It has looked far and wide, including Angola and Venezuela, to lock up oil for its booming manufacturing sector. Meanwhile, supply has not kept pace. After years of under-investment due to low oil prices, the oil industry is just not capable of pumping out enough oil to meet the rising demand. There is no spare capacity of oil left.

Second, the oil that is available in spare capacity is usually heavy sour crude. That means it’s high in sulfur and other metals. This requires a more complex refining capability than most refineries in the world are able to handle. In order to refine this heavy sour crude, refineries need to be upgraded or built. No new refinery has been built in the U.S. since 1976 because no one wants a refinery in their backyard. And adding complex new refining capacity costs money, leading to higher end-user prices. There is no way around this bottleneck.

Third, peak oil is a reality. M. King Hubbert devised a methodology of determining when oil supply would fail to meet demand in the U.S. lower-48 states. He correctly predicted 1970 as that fateful date. Since then, the U.S. has been a net importer of oil. The question then became when would this date arrive globally. Most experts put this date at sometime between 2000 and 2010, meaning we are already in the midst of a Peak Oil crisis.

As a result oil will spiral higher and higher until demand is curtailed, precipitating a global recession and economic and military conflict to secure oil supplies (Think Iraq). Peak oil doesn’t mean the oil is gone. It means that cheap oil is gone and that oil will be much more expensive because heavy or sour crudes, shale oil and synthetic oil are the only spare oil capacity left to tap until we can find alternative energy sources.

Fourth, the Fed’s inflationary monetary policy has likely precipitated a commodities bubble as commodities are the only reliable place to go for the excess liquidity central banks are producing. The demand for oil futures contracts is outstripping the supply in the commodities market. So, from a purely monetary perspective, supply is not keeping up with demand. This feeds through into inflation everywhere.

Discrimination of domestic producers
Then, there is the issue of discrimination of domestic producers. A windfall profits tax will be applied to oil production in the United States. This will act as a tax on U.S. oil companies and cause them to shift capital out of the U.S. to other places of production. An alternative is taxing oil imports as well, effectively creating tariffs. This, too, is a problem because it is a dis-incentive for oil suppliers to import into the US. Ultimately, this disincentive will find its way to the pump in the form of higher prices for consumers.

Mis-allocation of capital investment
As I noted earlier regarding subsidies, favoring one industry over another, one capital investment over another serves to redistribute capital to less effective uses. In effect, it is a hidden tax on the economy when capital is mis-allocated to less productive areas.

For example, it is fairly evident that the policies of the U.S. government and Federal Reserve induced a mis-allocation of capital in housing. The U.S. overbuilt residential housing when those monies might have been better spent fixing our crumbling physical infrstructure, re-building our declining school system or paying down the massive Federal debt. Farm subsidies have the same effect.

Taxing capital in the energy complex will only redistribute capital away from energy investment and make oil prices go even higher.

Return on capital
In finance, there is a term called the return on capital employed (ROCE). Investors try to maximize their ROCE in order to increase profits. Investments with low ROCE are less valuable and receive relatively less new investment as a result. Therefore, the ROCE is a benchmark used to compare companies, investments, and projects and allocate capital accordingly.

For example, if I invest $100 in a lemonade business, I would have a 20% ROCE if I were able to make $20. Investing that $20 back into the business increases my capital invested to $120 requiring I make $24 in order to have that same 20% ROCE.

I am still looking for the source and statistics, but I do know that the energy sector’s return on capital employed over the course of the last business cycle was no higher than in many other sectors of the economy. One reason the energy companies make so much money is because the size of the capital employed is enormous. For example, Exxon Mobil had over $120 billion in equity at the end of 2007. One can’t compare a company with this much capital to a much smaller one to compare results. One must use a metric which is valid irrespective of a company’s size. ROCE is that metric.

If we tax the sector at the peak of the cycle, it lowers their overall average return, making investment in that area relatively less attractive. Again, this distorts signals to the market about allocating investment capital. The end result is under-investment and higher prices.

Conclusion
The old adage that you can’t get something for nothing is true. By taxing oil’s ‘excess’ profits, we risk creating a situation with unintended consequences that reach far and wide: capital mis-allocation, higher end-user prices, favoring foreign over domestic producers to name a few. The most important thing we can do is remove any distortionary subsidies the oil companies are already receiving, rather than tax excess profits. The last thing America needs is the Federal Government deciding what level of profit is excessive and what level is not.

Sources
The Prize by Daniel Yergin
Twilight in the Desert by Matthew Simmons
The Party’s Over by Richard Heinberg
Out of Gas by David Goodstein
The Windfall Profit Tax, Editorial, NY Times, 9 Nov 2005
Windfall profits tax, Wikipedia