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A Windfall of Bad Ideas

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A Windfall of Bad Ideas

Lewis Op-Ed in Tech Central Station

In the third-quarter of 2005, the major U.S. oil companies—ExxonMobil, Chevron, ConocoPhillips, BP America, and Shell Oil Company—collectively earned almost $26 billion in profits, an all-time record.[1] In September and October, gasoline prices also hit historic highs, exceeding $3.00 per gallon in many locations. 

Predictably, many politicians, pundits, and activists accused oil companies of "price gouging" and urged Congress to impose "windfall profits" taxes on the majors. Some even argue that oil companies should be regulated as public utilities. Rather than allow supply and demand to determine oil company profits, these advocates want Congress to establish "reasonable rates of return" based on the oil companies' costs of production.[2]

On November 17, 2005, during debate on its tax reconciliation bill,[3] the Senate rejected three amendments to assess "windfall profits" taxes on the oil industry.[4]  

However, the Senate did approve changes in accounting rules that would add $5 billion to the majors' tax burdens over the next two years. Unlike all other U.S. firms since the 1930s, the majors would no longer be able to use the Last-In, First-Out (LIFO) method[5] to calculate business costs and taxable income. This $5 billion tax penalty is a "windfall profits" tax by another name.

More fundamentally, all targeted tax hikes on energy-company profits are energy taxes no matter how they're labeled. As every policymaker should know from Economics 101, when government taxes something, the economy produces less of it, and when supply falls relative to demand, consumer prices go up. Thus, "windfall profits" taxes or their accounting-gimmick equivalents are bound to make energy less affordable. Yet the leading proponents claim to be "consumer advocates."

 Are proponents confused, or is consumer protection a rhetorical cover for other agendas? More precisely, are "windfall profits" a real problem or a pretext for energy suppression, anti-capitalism, and political demagoguery?

The House will soon weigh in. And although "windfall profits" tax proponents were mainly rebuffed in the Senate, they remain on the attack. In what follows, I'd like to offer a multi-faceted critique of "windfall" taxes by answering twelve of the major questions people have about oil and profit.  

1. Are oil companies' record-breaking profits "windfalls"?

Calling such profits "windfalls" is meant to de-legitimize them. Proponents appeal to an age-old prejudice that economic rewards should be proportional to effort. Since the oil companies made no "special" effort or investment to generate such large profits, we are told, those gains are "unearned" and, hence, undeserved. This line of attack embodies two colossal untruths.

First, it is untrue that the oil company profits are unrelated to effort or investment. The oil industry is highly cyclical. Oil prices hit $70 a barrel this year but fell to $10 a barrel in the late 1990s. Only those who make smart long-term investments are able to ride out lean years, e.g. when petroleum prices plummet, and reap a bonanza in fatter years, when prices rise. Although no one can predict the exact timing of such peaks and troughs, oil companies invest in the expectation that booms will follow busts, and only those who have invested billions and managed their resources wisely are able to profit from the booms when they come.[6] This means there really are no windfalls. When the market shifts in their favor, oil companies are in a position to profit precisely because of continuous effort and long-term investment strategies.  

Second, it is untrue that profit is, or should be, a function of effort. Whether proponents realize it or not, they invoke something like Marx's labor theory of value. Profit, in this view, is a measure of sweat-equity. Firms should not profit just because the market moves in their favor; rather, under this view, firms should have to take specific, identifiable actions to justify the payoffs they receive. But a moment's reflection reminds us that much effort in life is wasted. Part of the genius of capitalism is that it penalizes waste. It puts constant pressure on firms to minimize their costs, enabling some to realize extraordinary profits when changes in supply or demand drive up the selling price of their products.  

In contrast, economic systems ostensibly set up to reward effort—i.e., socialist economies—are notoriously wasteful. Similarly, public utility regulation promotes inefficiency by shielding firms from competition and guaranteeing "reasonable rates of return" based on production costs.

The market does not reward effort per se; rather, it rewards intelligent risk-taking. Oil is a high-risk industry. The production platforms, refineries, and pipelines required to produce and deliver petroleum products are all multi-billion dollar investments. Profits, if any, do not materialize until years after investments are made. Even the best-laid plans can founder on unpredictable facts of geology, politics, and global economics. To the extent that Congress seizes oil companies' "windfall profits," it sunders reward from risk and removes anyone's chief incentive to invest in oil companies.  

2. Should government tax so-called windfall profits?  

At bottom, this debate is not about oil companies but about whether markets or politics should determine economic rewards. Once one accepts the principle that reward must be proportional to effort or investment, one opens the door to all manner of confiscatory mischief.  

Many individuals and firms—not just oil companies—reap extraordinary profits in a capitalist economy. These include inventors, authors, and Hollywood moviemakers. The patents and copyrights they hold "create monopoly rights which can produce monopoly rents which, by definition, are abnormal profits."[7] If the patent or copyright holders are lucky enough to be at the right place at the right time, they may get very rich. Of course, most risk-takers bomb several times before they succeed. But that is the point. Without the prospect of an occasional bonanza to make the risks worth taking, far fewer people would invent new products, write books, or make movies.

Housing markets exhibit capitalism's risk-reward nexus in spades. People who buy homes when the real estate market is soft and later sell them at two and three times what they paid might also be said to reap a "windfall." Housing is as basic to human welfare as motor fuel. So should Congress set "reasonable rates of return" on housing sales and tax away the difference as "unearned" gains? Fortunately, you don't need a Ph.D. in economics to foresee that such a policy would destroy the investment value of most people's homes and crash real estate markets nationwide. It should also be obvious that assessing "windfall profits" taxes on oil companies would depress energy infrastructure investment and the value of oil company stock.  

Economists Robert J. Shapiro and Nam D. Pham estimate that Senator Byron Dorgan's (D-N.D.) "Windfall Profits Rebate Act of 2005" would reduce the shareholder value of oil company stock by as much as $122 billion.[8] This estimate only looks at the direct effects of Dorgan's plan on oil company stock values. Shapiro and Pham do not factor in the psychological impacts on financial markets of a high-profile congressional decision to punish and humiliate America's leading energy companies. Be that as it may, the financial losses from "windfall profits" taxes would be widespread, because mutual funds and retirement accounts hold approximately $267 billion worth—about 41 percent—of oil company stock.[9]

3. Do oil companies profit "at the expense" of consumers?

"Windfall profits" tax proponents frequently imply and sometimes even claim that gasoline prices are high because oil company profits are high. They have it exactly backwards. Profits are high because prices are high. Wittingly or otherwise, they confuse cause and effect—a poor basis for legislating energy policy.  

High energy-prices do hurt the economy. However, those prices would hurt the economy a lot more if nobody profited from them. The economy has remained strong in spite of high energy-prices partly because the energy sector is flourishing. Also, oil companies invest today's profits in tomorrow's energy infrastructure. That will help expand supply and lower consumer prices.

4. Why are gasoline prices high?

Price is a function of supply and demand. During 2004, thanks partly to U.S.-led global economic growth, world petroleum demand grew by 3.2 percent[10]—more than twice as fast as most experts predicted.[11] Demand remained strong through most of 2005. That is the main reason crude oil prices rose to over $60 a barrel in June. Then in September and October, hurricanes Katrina and Rita shut down about one-third of U.S. domestic oil and gas production and one-quarter of U.S. refining capacity. The hurricanes also partly closed the network of pipelines that distributes Gulf Coast oil and gas to the Midwest and Northeast. The recent record-high gasoline prices were chiefly a consequence of surging global demand combined with severe hurricane-induced supply disruptions in the United States.

Gasoline prices have fallen to pre-Katrina levels as energy companies have brought production, refining, and pipeline operations back on line—exactly what textbook economics tells us to expect. Prices should continue to fall as oil companies invest part of this year's profits in capital projects to increase oil and gas supplies.

5. Do U.S. oil companies manipulate markets to "gouge" consumers?

According to the Federal Trade Commission (FTC), about 85 percent of the price of gasoline is explained by the cost of crude oil, a globally traded commodity with prices set in international markets.[12] U.S. oil companies account for only about 3 percent of world crude oil production, so they cannot possibly manipulate crude oil prices.

Some "windfall profits" tax proponents claim that, as oil companies have merged, they have shut down smaller refineries to restrict output and drive up consumer prices. This is nonsense. Mergers create economies of scale that enable refiners to make gasoline more efficiently. Most of the units closed were smaller, less efficient plants, and oil companies have found it cheaper and quicker to expand capacity at existing plants than to build new plants from scratch. Overall U.S. refining capacity has grown from 65,300 barrels per day in 1983 to 113,400 barrels per day in 2004[13]—an increase of 73 percent.

"Windfall profits" tax advocates fixate on the surge in gasoline prices during 2004-2005, which, as previously explained, was due to large unexpected changes in global demand and national supply. They conveniently ignore the fact that real average annual gasoline prices were lower during 1986-2003 than during the previous 65 years.[14] Prices would surely be higher today if politicians had prevented oil companies from merging or required them to build new refineries rather than expand existing units.

6. What is the oil industry's earnings rate, how does it compare to those of other industries, and why are oil company aggregate profits large? 

In the second quarter of 2005, U.S. oil companies earned about 7.7 cents for every dollar of sales. That is slightly below the average for all U.S. industries (7.9 cents), and considerably below the earnings rates of several other industries including banks (19.5 cents), pharmaceuticals (18.6 cents), software and services (17 cents), semiconductors (14.6 cents), diversified financials (11.3 cents), and household and personal products (10.9 cents).[15] Third quarter oil industry profits rose to 8.1 cents per dollar of sales—still in line with the U.S. industry average.[16]

Oil industry profits are large in absolute terms because the customer base is large. Oil companies sell astronomical quantities of fuel—the equivalent of about 230 million barrels of oil every day.[17] The amount of money they earn per gallon of gasoline sold is relatively small—a profit of 9 cents per gallon in the third quarter of 2005. Although that is almost double the 5 cents per gallon profit they earned in the third quarter of 2004,[18] it is still well below the 18.4 cents per gallon that the federal government collects in gas taxes, or the 44.5 cents per gallon that the State of New York collects.[19] Oil companies achieve multi-billion-dollar profits by making modest returns on gigantic sales volumes—not by "gouging" their customers.

7. Do oil companies pay too little in taxes?

Exxon Mobil's third-quarter financial statement reports that the company's year-to-date tax payments total $72.9 billion. That is almost triple the $25.4 billion the company earned in year-to-date profits.[20] By what reasonable metric can it be argued that ExxonMobil's tax payments are deficient in relation to its profits, or that its profits are excessive in relation to its tax payments?

According to the Tax Foundation, between 1977 and 2004, the 29 largest U.S. energy firms collectively earned $630 billion in net income after adjusting for inflation. During that same period, those companies paid more than three times as much—over $2.2 trillion—in royalties, state and federal motor fuel taxes, and corporate income taxes.[21]

Thus, a good case can be made that it is politicians and other tax consumers, not the oil companies, who harvest "windfall profits" from the oil business. In any event, because oil companies pay corporate income taxes, their tax payments will rise substantially this year even without "windfall profits" taxes.

8. Do oil companies invest too little of their profits?

Critics claim that oil companies do not invest their profits in ways that benefit consumers; hence, we are told, Congress should seize the profits and invest them "in the public interest." The numbers tell a different story. Since 2002, Chevron invested $32 billion in capital projects worldwide. Its earnings during that period were $31.6 billion—the company invested more than it earned.[22] Other majors have done likewise. During 1995-2004, ExxonMobil's annual average capital expenditures—$14 billion—slightly exceeded the company's annual average profits-$13.8 billion.[23] During 2003-2005, ConocoPhillips projects earnings of about $26 billion and investments of slightly more than $26 billion.[24] There is simply no case to be made that oil companies are under-investing in capital projects.

9. Was the first (1980-1988) "windfall profits" tax a policy success or a policy failure?

According to the Congressional Research Service, the "windfall profits" tax Congress enacted in 1980 diverted $79 billion from potential investment in energy infrastructure, reduced domestic oil production by as much as 6 percent, and increased petroleum imports by as much as 16 percent.[25] When oil prices fell in the mid-1980s, the tax cost more to administer than it generated in revenues.

 History suggests that a new "windfall profits" tax would similarly discourage investment in energy production, increase oil imports as a share of total consumption, and produce less revenue than anticipated. Those who decry America's growing "dependence" on foreign oil have no business touting "windfall profits" taxes, which are a proven means to increase oil imports at the expense of domestic production.   

10. How can policymakers mitigate supply shocks from future natural or man-made disasters?

Hurricanes Katrina and Rita revealed that America is too energy-dependent on a single region of the country. One reason so much energy infrastructure is concentrated in hurricane-prone Texas and Louisiana is that politicians—including most "windfall profits" tax proponents—have banned oil and gas exploration and development in other energy-rich areas: the Atlantic, Pacific, and Alaskan Outer Continental Shelf (OCS) regions, the eastern Gulf of Mexico, and the Arctic National Wildlife Refuge (ANWR).

The U.S. government estimates that Pacific, Atlantic, and Alaskan OCS regions contain 76 billion barrels of technically recoverable oil,[26] with another 10.4 billion barrels in ANWR.[27] The amount of oil temporarily shut in by Katrina and Rita—about 1.5 million barrels per day—is a drop in the bucket compared to the vast reserves that U.S. companies are not allowed to explore and develop for the benefit of U.S. consumers. A genuine, consumer-friendly energy policy would remove political barriers to oil and gas exploration and development in the OCS, the eastern Gulf of Mexico, and ANWR.

11. Would Sen. Dorgan's "windfall profits" bill increase investment in domestic energy production?

Dorgan's bill would impose a 50 percent excise tax on the difference between the sale price of petroleum products and a baseline price of $40 a barrel. Because the bill would exempt profits invested to develop "new" sources of oil and expand "domestic" refining capacity, Sen. Dorgan claims it provides "the most significant incentive for increased production of oil and gas in this country."[28] In reality, Dorgan's plan would stifle investment and drive production overseas, for three reasons.

First, notwithstanding the exemption for "qualified" domestic investment, Dorgan's bill is still first and foremost a "windfall profits" tax—a policy every candid observer knows is intended to penalize and stigmatize America's leading energy companies. Congress cannot single out U.S. oil companies for hostile treatment without increasing the already formidable political risks facing the industry and scaring off investors.

Second, at a minimum, Dorgan's bill would saddle U.S. oil companies with a potential tax penalty not faced by non-U.S. firms, giving foreign producers a competitive advantage in global capital markets.

 Third, the Dorgan bill presumes to tell oil companies how to invest their profits. It would hit them with multi-billion dollar tax penalties if they decide to invest their profits in more lucrative operations overseas or in domestic oil and gas fields that are not "new" but known to be productive and profitable. How could that not discourage investment in U.S. oil companies, or not encourage U.S. oil companies to shift assets and operations to less regulated jurisdictions?

 12. Would Sen. Dorgan's plan benefit consumers?

The bill seems consumer-friendly, because the "windfall profits" tax would fund "energy rebates" to consumers. But the long-term costs to consumers from reduced energy supply and higher energy prices would more than offset the short-term pocket change they might collect in rebates.

 The Dorgan bill would assess a 50 percent excise tax on oil companies' "windfall profits," defined as the difference between a baseline price of $40 a barrel and the actual price at which petroleum products are sold. However, the majors are paying more than $40 a barrel to buy crude oil in the global marketplace. Consequently, as Sen. Pete Domenici explained during the Nov. 17 debate, the Dorgan plan could easily end up forcing the majors to lose money on every barrel of oil they sell.

 Suppose, for example, that Saudi Arabia sells crude oil for $55 a barrel, and a U.S. firm also sells it for $55, earning no profit whatsoever. Under the Dorgan plan, the U.S. firm is nonetheless assumed to have made a $15 profit ($55 sale price - $40 baseline price = $15 profit). The firm would then have to pay a 50 percent tax on $15 of the sale, or $7.50 a barrel, even though it sold the oil at cost. The firm would lose $7.50 on every barrel of oil it sold. "How," asks Sen. Domenici, "could that do anything to encourage production or investment?" Indeed, we might ask, how could firms forced to endure such losses survive?

 Ironically, as Sen. Domenici also points out, Dorgan's plan would create incentives for oil companies to "gouge" consumers. Assume again that U.S. firms are paying $55 a barrel for crude oil in the global marketplace. The firms would have to collude to charge $70 a barrel just to break even. Only by jacking up the price to $70 a barrel would their actual profit ($70 - $55 = $15) cover the tax they would pay to the government ($70 - $40 = $30 x .5 = $15).

 Since collusion to fix prices is illegal, Dorgan's plan would more likely render U.S. domestic oil operations unprofitable. To the extent that global crude oil prices exceed $40 a barrel, a U.S. oil company would lose money on each barrel sold in the United States. To keep from going broke, firms would sell less oil in domestic markets. "Pretty soon we would have a shortage in the United States," Sen. Domenici warns. If less oil is available, then gasoline prices will go up. "Under the guise of a good bill to help American consumers, we get one that clearly will scalp them."[29]

 Conclusion

U.S. oil companies' record-breaking profits are not "windfalls" but rewards for prudent risk-taking in a highly cyclical industry. Proponents wrongly blame high oil company profits for high gasoline prices, confusing cause and effect. Oil company profits are large because the industry's customer base is large. The industry's rates of return are actually quite modest. U.S. oil companies typically invest all of their profits and then some in capital projects to find and expand energy supplies. Oil companies' tax payments already substantially exceed their profits.

"Windfall profits" taxes are a failed policy that Congress wisely terminated in 1988. Taxing alleged "windfalls" subverts the risk-reward nexus on which the dynamism of the U.S. economy depends. "Windfall profits" taxes are just energy taxes by another name, and cannot but stifle investment and increase U.S. dependence on foreign oil. The Dorgan plan in particular has a high potential to render U.S. oil companies unprofitable, reduce domestic supply, and inflate consumer prices. Policymakers looking for real ways to help consumers should remove political barriers to oil and gas exploration and development in the OCS, the eastern Gulf of Mexico, and ANWR.

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[1] Chris Isidore, "Big oil CEOs under fire in Congress: Lawmakers spar with execs from Exxon, Chevron over high prices, record profits, and consumer pain," CNNMoney, November 9, 2005, http://cnn.com/2005/11/09/news/economy/oil_hearing/?cnn=yes.

[2] During a November 8, 2005 televised debate with the author on the C-SPAN program, "Washington Journal," Tyson Slocum of Public Citizen advocated imposing cost-based, reasonable-rate-of-return, public utility regulation on major U.S. oil companies.

[3] A reconciliation bill adjusts current law to keep projected tax receipts and expenditures in line with the levels approved by Congress in its annual budget resolution.

[4] Mary O'Driscoll, "Senate moves tax package with $5 billion levy on oil industry," Greenwire, November 17, 2005. Sen. Jack Reed's (D-R.I.) proposal to assess a "windfall profits" tax on the oil industry to fund the Low Income Home Energy Assistance Program (LIHEAP) failed on a 50-48 procedural vote. Sen. Chuck Schumer's (D-N.Y.) proposal to fund $100 consumer rebates from "windfall profits" taxes failed by a vote of 33-65. Sen. Dorgan's (D-N.D.) proposal to impose a 50 percent excise tax on the difference between the sale price of petroleum products and a $40-a-barrel baseline price failed by a vote of 35-64.

[5] Investopedia.com, Last In, First Out - LIFO: "An asset-management and valuation method that assumes that assets produced or acquired last are the ones that are used, sold or disposed of first. LIFO assumes that an entity sells, uses or disposes of its newest inventory first."

[6] Robert J. Shapiro and Nam B. Pham, The Economic Impact of a Windfall Profits Tax For Savers and Shareholders, Sonecon, November 2005, p. 2.

[7] Shapiro and Pham, p. 3.

[8] Shapiro and Pham, p. 5

[9] Shapiro and Pham, p. 11.

[10] Energy Information Administration (EIA), Short-Term Energy Outlook, November 8th, 2005 Release, http://www.eia.doe.gov/emeu/steo/pub/contents/html.

[11] Federal Trade Commission (FTC), Gasoline Price Changes: The Dynamic of Supply, Demand, and Competition, 2005, p. vi, http://www.ftc.reports/gasprices05/05070gaspricesrpt.pdf.

[12] FTC, Gasoline Price Changes, p. iv.

[13] FTC, Gasoline Price Changes, p. 52.

[14] FTC, Gasoline Price Changes, p. viii.

[15] Statement of Lee R. Raymond, Chairman and Chief Executive Officer, Exxon Mobil Corporation, Joint Hearing of the Senate Committees on Energy and Natural Resources and Commerce, Science and Transportation, November 9, 2005, Appendix C, API calculations based on filings with the federal government as reported by Business Week and the Oil Daily.

[16] Sen. Craig Thomas (R-WY), Congressional Record, November 17, 2005, S13078-79.

[17] Raymond, p. 3.

[18] Statement of James J. Mulva, Chairman and Chief Executive Officer, ConocoPhillips, Joint Hearing, November 9, 2005, pp. 20-21.

[19] American Petroleum Institute, Domestic Gasoline Taxes, August 2005 Update.

[20] ExxonMobil, "Exxon Mobil Corporation Announces Estimated Third Quarter 2005 Results," Press Release, October 27, 2005, p. 8.

[21] Jonathan Williams and Scott A. Hodge, Oil Company Profits and Tax Collections: Does the U.S. Need a New Windfall Profits Tax? Tax Foundation, November 9, 2005, p. 2.

[22] Statement of David J. O'Reilly, Chairman and CEO, Chevron Corporation, Joint Hearing, November 9, 2005, p. 5.

[23] Raymond, p. 6, Appendix D.

[24] Mulva, p. 23.

[25] Salvatore Lazzari, The Windfall Profits Tax On Crude Oil: Overview of the Issues, CRS report for Congress, Congressional Research Service (September 12, 1990), p. 3.

[26] Minerals Management Service, Assessment of Undiscovered Technically Recoverable Oil and Gas Resources of the Nation's Outer Continental Shelf, 2003 Update, p. 2, http://www.mms.gov/revaldiv/PDFs/2003NationalAssessmentUpdate.pdf.

[27] EIA, Potential Oil Production from the Coastal Plain of the Arctic National Wildlife Refuge: Updated Assessment, http://www.eia.doe.gov/pub/oil_petroleum/analysis_publications/arctic_na....

[28] Sen. Byron Dorgan, Congressional Record, November 17, 2005, p. S13099.

[29] Sen. Pete Domenici, Congressional Record, November 17, 2005, p. S13081.