February 7, 2006

Finding New Sources of Energy: Contrasting How Free Markets Allocate Economic Resources Without the Perverse Outcomes Generated by Government Meddling in the Marketplace

An earlier posting, Government Makes Us Pay Higher Gasoline Prices, offered another example of the perverse economic incentives that arise when the government meddles in the marketplace, violating our Founders' guidance about the importance of limited government.

Another posting, Government Meddling Creates Marketplace Distortions, Increasing Long-Term Costs, makes it clear that a meddlesome government can wreck havoc in other important areas of our lives like health care.

Returning to the issue of energy, do you recall how Congress worked itself up in the Fall of 2005 over allegations of "excessive profits" by the oil companies? How they brought oil company executives in for a public grilling?

As the current tensions with Iran are expected to continue, the price of oil is unlikely to decrease and that means the issue of oil industry profits will be with us for a while.

Once again, the public story about "high" oil industry profits masks another perversion created by government meddling in the energy marketplace. Scott Hodges and Jonathan Williams wrote about this in Who Profits at the Pump? Our government, for one:

Over the past quarter century, oil companies directly sent more than $2.2 trillion in taxes, adjusted for inflation, to state and federal governments — three times what they collectively earned in profits over the same time period. Yet some politicians say this is not enough and are proposing a new “windfall profits” tax to raise billions more for federal coffers.

Of course, as most economists agree, corporations don’t pay taxes, people do. Folks like us will really pay those new taxes, either through higher prices at the gas pump or through lower returns in our 401(k)s. Smaller profits for companies means smaller returns for our retirement funds.

...At a minimum, both politicians and the media are guilty of biting the hand that feeds them and, perhaps, a bit of hypocrisy: Oil companies hand over more than $35 million per year to newspapers for advertising, while the government profits far more from each gallon of gas sold than do the oil companies.

Today, Americans pay an average of 45.9 cents in taxes per gallon of gas. The federal gas tax is 18.4 cents per gallon while the average state and local tax is 27.5 cents. These taxes pumped more than $54 billion into federal and state coffers last year alone. Diesel taxes totaled $9 billion more.

Almost all gas taxes are levied at a flat rate per gallon, regardless of whether a gallon of gas costs $1.49, $2.49, or $3.49. So while industry profits go through booms and busts, government profits grow steadily larger.

While politicians decry large corporate profits, those profits generate large corporate income-tax payments. We estimate that over the past 25 years, the major domestic oil companies paid about $518 billion in corporate income taxes to Uncle Sam and state governments. Oil companies pay billions more to governments in off-shore royalties, severance taxes, property taxes, and payroll taxes — and the list goes on.

The last time this country experimented with a windfall profits tax was in the 1980s. Back then, the tax depressed the domestic oil industry, increased our reliance on foreign oil, and failed to raise a fraction of the revenue forecasted...

Because it receives so much tax revenue from this one industry, the government is subject to the same risk as any parasitic organism: If it eats too much it will kill the host...

Check out the graph in the referenced article for a visual on taxes paid by the oil companies.

So exactly what level of profitability constitutes "windfall profits"? Since most people have no clue what the actual rate of profitability (profits per dollar of sales) is for the oil industry, clarifying that basic information is a crucial first step toward having a rational debate.

Picking the starting and ending dates for calculating such rates of profitability can greatly influence the answers. The three studies highlighted below cover different periods of time and provide some sense of perspective.

First, ConocoPhillips offers these insights into the rate of oil industry profits:

An industry-wide study in the late 1990s [1997-1999] showed that oil industry profits amounted to an estimated 7.3 cents on each gallon sold...A multitude of factors can affect an individual oil company's profit on gasoline sales. Profitability factors include the efficiency of the firm's refining, distribution and marketing system, as well as its source of raw material. In times of rising oil prices, companies that own and produce a considerable portion of the crude oil used in their refineries may benefit more than other companies that must purchase most or all of their supplies on the open market...

The article also contains a graphic, based on a 2005 U.S. Department of Energy study, which notes that the cost drivers at the gas pump are affected by crude oil (53%), government taxes (20%), refining (18%), and distribution (including pipelines and trucks) & marketing (including service stations) (9%).

Second, this study of oil industry profitability, using Business Week data and based only on Q3 2005 peak profits when the price of oil was quite high, shows that even then the industry profitability of 8.2 cents on the sales dollar was both not significantly higher than the American industry average of 6.8 cents on the dollar and was below the profitability rates for 9 other major industries.

Third, scrolling down the ConocoPhillips link above shows that the 5-year average profitability during 2000-2005 for the oil industry was 5.8 cents on the dollar versus an average of 5.5 cents for all industries.

In other words, oil industry profits are not all that dissimilar from other industries in America. And that does not equal windfall profits.

Furthermore, the oil industry is fraught with high levels of technical risks and geopolitical risks which the marketplace typically rewards by providing higher rates of profitability. What makes the industry so risky? Developing new sources of energy involves lots of capital, long lead times, and high failure rates. These facts mean the industry is plowing some of the cash generated as current accounting profits back into long-term capital projects required to develop such sources. While these investments typically only show up in later years as expenses which reduce profits, that does not mean the cash is not being spent now. Any windfall profits tax would mean less current cash to invest in developing new energy sources.

(As an aside, with all the controversy about lobbying these days, this article notes how even a windfall profits tax bill could be twisted in the legislative process:

Even if the tax passes, though, it's not clear how much money it would raise. Companies could deduct the cost of exploration, investment in refineries or in alternative sources of energy, so they might never have to pay any "windfall" tax.

It is yet another example of how perverse government incentives can distort economic behaviors and outcomes.)

The free market is capable of allocating resources more efficiently. As the hysteria built last year in Washington, D. C. about oil company profits, John Tamny offered thoughts on The Boon of Big Oil Profits: Lawmakers must understand that cheaper fuel is on the horizon, describing how free markets allocate economic resources with an effectiveness never achieved by government:

Last week’s news that ExxonMobil had achieved record profits predictably elicited negative responses from special-interest groups and politicians. Anna Aurilio, legislative director at Public Interest Research Group, said "oil companies are making profit hand over fist as consumers are suffering."...

...the political class is at least publicly choosing to misread this very positive news. That ExxonMobil is presently thriving means it is successfully doing its part to help ease today’s oil shortage. Subpar earnings would logically be of greater concern to politicians given that low earnings would indicate big oil’s indifference to today’s high prices, and market belief that the problem cannot be solved.

But ExxonMobil’s profits, and the rise in its stock price since oil hit a low of $10 in 1998, indicates very clearly that the markets are aggressively solving the existing oil shortage through the reallocation of investment toward the oil industry. To stifle or tax earnings would be to distort the process by which expensive oil will in time become cheaper.

Back in 1980, in the midst of the last era of expensive oil, oil companies represented 28 percent of the S&P 500’s value. This investment boom stimulated exploration and led to an oil "glut" in the 1980s and ’90s. In this new environment, cheaper oil and lower oil-company profits meant that investment moved elsewhere, and with this asset redeployment, oil-company share of the S&P 500 fell to 7 percent. The latter number arguably foretold today’s energy prices to the extent that they’re a demand, as opposed to a weak-dollar, phenomenon.

Notably, oil companies now comprise 10 percent of the S&P’s value, and the number will presumably rise as oil companies report earnings and are subsequently rewarded with higher valuations. This change in the S&P’s makeup heralds cheaper oil in the future.

Also, record profits attract imitators and innovators. Canadian oil company Suncor Energy is an example of innovation at work. It has devised a way to extract crude from oil sands, and the consensus is that this process will greatly expand the amount of proven reserves around the world. Happily, investors have rewarded Suncor; its stock is up 400 percent over the last five years, a timeframe in which the Dow has been flat while the S&P 500 and Nasdaq have been down.

Returning to the political response in Washington, leaders on both sides of the aisle will hopefully realize that they’re on the wrong side of the oil issue. Rather than calling oil executives to the carpet when they’re making "too" much money, they should instead celebrate the ability of markets to apportion investment properly such that scarcity is dealt with effectively.

Tar Sands Make Canada Energy Powerhouse is a specific example of what can happen when the government doesn't meddle in the marketplace:

Canada has become an energy powerhouse by separating petroleum from sand. Oil sands — also called tar sands — are found in an area almost half the size of Colorado spread across central Alberta, 240 miles northeast of Edmonton. The deposits account for roughly half of Canada's crude oil output, or about 1 million barrels of oil a day.

Canada estimates the sands will yield as much as 175 billion barrels of oil, making it second only to Saudi Arabia in crude oil reserves and enough to satisfy U.S. demand for at least a generation.

A group of congressional staffers recently toured Alberta, eager to learn whether the unusual oil industry here can somehow serve as a model for oil shale production in Utah, Colorado and Wyoming.

"If they can do it, we in Utah can do it," said Sen. Orrin Hatch, R-Utah. "Unconventional fuels like tar sands and oil shale are the real thing."

Unconventional oil — petroleum in any form other than the familiar fluid — has sat on the sidelines of the oil industry for decades. The major source of unconventional oil in the U.S. is shale, but all sources are getting a new look.

"Unconventional was a key word for 'uneconomic' in the past," said Tom Ahlbrandt, world energy project chief for the U.S. Geological Survey in Denver. "They are clearly not uneconomic any more."

Altogether, oil from oil sand costs somewhere between $15 and $20 a barrel to produce — on average, at least a few dollars more than pumping liquid oil.

But with oil prices above $60 a barrel and technological breakthroughs making it easier to harvest oil from sand, business is booming. Jones said the only thing keeping companies from expanding even faster is a shortage of skilled labor and the right equipment.

The free market does solve many problems and it is certainly more effective at creating sustainable economic value than the government. Isn't it interesting, though, how many people still think that turning to the government for solutions is the best or only way? One counter-argument to that position is highlighted here.

In a Wall Street Journal editorial entitled The Upside of the Oil Curse (available for a fee), Marc Sumerlin offers additional perspective on why it is important to resolve successfully the policy issue of reducing our dependence on foreign oil imports, how the pricing mechanism in the market can drive that outcome in the long-term, and how limited government actions could incent the marketplace in the short-term to accelerate the realization of the positive long-term benefits of the price mechanism:

Of all the long-term challenges facing the country, none touches as many areas of our national life as energy, particularly our dependence on a variety of unstable oil-exporting nations. It impacts our global competitiveness, our environmental policy and our foreign policy, both in the Middle East and in our own hemisphere. Moreover, our nation's major strategic competitor, China, is responding to a similar challenge by acquiring global energy assets and targeting its foreign policy on befriending a variety of oil exporters.

...history shows us that the price mechanism is not the problem. Though it has downsides, particularly in the short run, it beats every alternative. And in the long run the price mechanism is a major part of the solution to our energy challenge.

The history of the '70s and early '80s also explains the advantages of the price mechanism to both energy efficiency and the environment. The most rapid gains in energy efficiency in the U.S. took place when prices were very high. In fact, a sharp break in the energy intensity of the American economy appears to have occurred in 1973, the year of the first price spike. Prior to that date, the energy intensity of the economy was fairly stable, declining at just 0.4% per year. Since that date, the amount of energy needed to produce each real dollar of GDP has fallen by 50%, a decline of 2% per year. Unfortunately, the pace of progress slowed after prices dropped markedly in 1986.

Today, we are again seeing the positive incentive effects of high oil prices. The recent run-up has encouraged a new class of entrepreneurs and scientists to search for technological solutions. Nanotechnology is improving battery life, which will make hybrids cars and solar electricity more realistic. Historically costly alternative fuels like ethanol are suddenly looking practical, especially with advances in biotechnology and new processing technologies. A look to Latin America shows that rapid change can happen faster than commonly thought. Over the last three years in Brazil, the share of new car sales that can run on high-content ethanol fuel has risen from 4% to 67%. Its sugarcane-based ethanol is priced competitively with gasoline.

There is little doubt that technology and innovation, along with steps toward conservation, will ultimately solve the oil supply problem. But given the instability in the countries northwest of the Strait of Hormuz...it's less certain that this will come before an economy-crippling crisis.

It is here where Sumerlin proposes a government policy that, if done well (can this really occur?), could create the proper incentives in the marketplace:

Capital flows into new technologies and domestic production would be stronger if investors had more certainty about their potential return...Domestic oil producers, venture capitalists and entrepreneurs don't know whether the price of oil in the next decade will justify the costs of investments they must make today in new technologies and new production techniques...

Ironically, the best way to cap the upside to the oil price is to encourage new energy producing technologies by limiting the potential downside to the price...

The U.S. government could approximate a guarantee by taxing oil imports (and other petroleum products) dollar for dollar when the world oil price falls below $35...This policy has several advantages to our policies after the last energy price shock. It provides more certainty to private sector investors, which can provide a powerful multiplier to investment. It is likely to be used infrequently given the rapid development of Asia -- yet the plan still provides an incentive effect.

He also notes that this incentive-laden approach eliminates any reason for politicians and government bureaucrats to attempt to identify the best energy solutions independent of market forces:

The tax is neutral on how we move toward independence -- everything from domestic tar sand production to hydrogen to solar power would have an equal chance to succeed. New alternative technologies would lower carbon emissions without the drawbacks associated with hyper-complex worldwide regulatory schemes. Politically, the tax would be spread more evenly than the gas tax, since home heating oil used in the Northeast would be included as well as the gasoline used in the West. Finally, this policy would allow a reduction in inefficient regulations and subsidies that try to pick winners among competing technologies.

...the policy would increase the number of competitors oil companies face. Others would argue this is government interference with the market. True, but oil consumption comes with many externalities, from pollution to geopolitical concessions to the military expenditures needed to protect global supplies. Incorporating externalities into the price can increase efficiency. Others would object that this is a potential tax increase. If the tax were to kick in though, much of the burden would fall on foreign producers, especially if OPEC has pricing power. Even if the U.S. were in a period of economic weakness, the Congress could assure that consumers were held harmless by reducing another federal tax.

Allies...would benefit substantially from lower U.S. oil consumption when world prices fell and also from lower global pollution...the loudest cries would come from foreign oil producers, some of which are also important allies. But economic history teaches us that dependency on oil is harmful to the producers as well. The so-called "oil curse" has fostered corruption and made it hard for non-energy businesses to develop in these nations...

All Americans would be better off if our nation's economic, foreign and environmental policies are freed from dependence on unstable sources of oil. Our competitors abroad, and our enemies, doubt that we have the will to make such a break...

There is little evidence to suggest that such an effective public policy could be implemented successfully or, if done well upfront, could avoid the subsequent manipulations which adversely alter the incentives. Nonetheless, given the increasing risks with Iran and Venezuela as well as issues with Saudi Arabia, it would be worthwhile to debate publicly whether such a policy could provide a short-term bridge for our country when the risks of an energy supply disruption are highest to where the long-term power of the free market pricing mechanism could lead us to energy independence.

As additional reading material, Inviting a More Balanced Debate About America's Energy Policy provides further background on broad energy industry issues while all energy postings on this blog site, which can be found here, provide even more information on a variety of relevant energy policy issues.