Redirecting the Incentives

As the front page of today's Washington Post reminds us, one of the top priorities of the new Democratic majority in Congress will be the realignment of federal energy incentives, shifting them away from the oil and gas industry and toward alternative energy. On the face of it, this action aligns nicely with the need to address growing concerns about climate change and US energy security. Renewables are mostly home-grown, and they generally reduce emissions of greenhouse gases, relative to conventional fuels. Furthermore, many alternative energy technologies are at stages of development that still require government incentives to be competitive, while the oil and gas industry is reaping record profits, thanks to sustained high oil prices. Closing the royalty loophole and reversing a manufacturing tax break for oil companies makes eminent sense, viewed from the current vantage point. However, it ignores both the context that gave rise to the waiver, and the relative medium-term contribution of these energy sources to energy security.

The royalty waiver in question relates to contracts signed with oil companies in 1998-99. Instead of phasing out the waiver of royalty payments, when oil prices rise above some threshold, these contracts waived them altogether. The Congressional leadership estimates lost revenue at $9-11 billion over time. But with current oil prices still over $55/barrel, it's easy to forget that the average price of West Texas Intermediate crude oil in 1998 was only $14.40/barrel, and the average for the two years was $16.85. Price forecasts at the time were consistently low, with small probabilities assigned to any scenarios above the $20-25/barrel historical price band--which itself seemed quite a stretch. The risked contribution of any royalty-free prices above $30 to the economics of oil projects that were in the planning stages in the late 1990s would have been small, but still important in approving expensive new deep-water drilling platforms at a time when the industry's future seemed in doubt. The projects that were approved in that period were thus predicated in some small but crucial way on the royalty relief that is so controversial today. Many of them have come on stream in the last couple of years, providing a much-needed boost in domestic production. I don't know how many of these platforms would have been deferred or canceled without full royalty relief, but it's not zero.

The other consideration here is the future value of the lost royalties. If the estimates cited above are based on the assumption that prices will remain near current levels, then they could prove as disappointing as the estimates of future federal budget surpluses made during the height of the Dot-Com Boom. In order to believe that oil prices will not revert to levels closer to their long-term historical range sometime during the next five years, you have to be convinced that there will be no economic slowdown in the US or Asia within that timeframe, that most new production projects will be delayed or disrupted by geopolitical factors, or that global oil production is very close to a Hubbert Peak--if not already past it. From my own experience of 27 years in this industry, having repeatedly seen prices spike when least expected, or dive when the conventional wisdom was certain they would remain high forever, that's a shaky bet.

On balance then, we need to weigh the benefit of some uncertain number of billions of dollars in extra revenue from revising the terms of the contracts in question, against the risk of undermining confidence in the industry that still accounts for 46% of our domestic energy production. There's no question that transferring these incentives to alternative energy efforts will spur significant new development in wind, solar and biofuels. But if repealing the lower tax rate and closing the royalty loophole make US oil and gas projects less attractive, then our imports of these commodities will increase further. Even at the current high growth rates for renewable energy sources, their low base of 3% of total US energy is too small from which to compensate for a higher decline rate in domestic oil and gas production. The medium-term result of this exchange would be a net reduction in energy security.

Ultimately, if these measures are enacted, the industry will have contributed significantly to their justification. Perhaps because the big oil companies were burned by poor returns on investments made prior to the late 1990s price collapse--when everything seemed rosy, until suddenly it wasn't--they were slow to boost reinvestment when prices began to climb in 2003. They have returned as much or more money to shareholders via stock buybacks and dividends as they plowed back into the business. That may have been smart economics, laying the groundwork for solid profits, but it has also set up a populist backlash that could go well beyond the modest measures under consideration this week. As a result, the only ones left smiling will be developers of alternative energy, who are about to get their turn at the federal spigot.