Tuesday, September 27, 2005

Spending the Windfall

Yesterday, I cited a recent survey showing that most Americans support taxing the extraordinary profits that oil companies are experiencing as a result of weather- and demand-related increases in the price of oil. The dollars involved are significant: in the second quarter the top five US oil companies earned after-tax profits at an annual rate of $60 billion, compared with $36 billion in 2003. When you add in the rest of the industry, including the US earnings of non-US companies like BP and Shell, the total could reach $90-100 billion. Given the cost of rebuilding after two major hurricanes and the constraints imposed by large budget deficits and an expensive war, the temptation to tax an unpopular industry may prove greater than politicians can resist. However, the industry's actions may play as big a role in determining the outcome of this debate as will those of the Congress.

When you consider the survey results, the message seems pretty clear. Consumers think that not enough is being done to reduce our vulnerability to foreign suppliers of oil and develop practical alternatives to it. The industry has contributed to both the perception and reality of this in several ways:
  • The international oil industry, including the US majors, was slow to step up investment in exploration and production as disruptions such as the Iraq War and Venezuelan strike, combined with increasing demand from China, eroded the global capacity cushion.
  • Investments in truly alternative energy--wind, solar, biofuels, and hydrogen--have represented only a small fraction of major company R&D budgets. Instead, companies rely heavily on external research (including the government labs) for new technology in this area, and on economics to drive the deployment of alternatives.
  • With a couple of notable exceptions, investments in this area are not highlighted in corporate advertising campaigns, with agencies focusing instead on generic, feel-good messages. Consumers, especially younger ones, see through this and extrapolate to assume that nothing substantive is behind them.

While all of the above represent justifiable strategic choices, they also increase the risk of a government response to limit profits. Make no mistake, a windfall profits tax would be a disaster, even if it were structured to provide dollar-for-dollar credits for all new E&P and alternative energy investment. Unfortunately, when you start digging into the mechanics of such a tax, you inevitably end up resurrecting some of the worst elements of the old, pre-deregulation inefficiencies. I started in the industry at the end of the last period of controls, in the 1970s, and I saw first-hand the distortions they created.

A large part of our current problem is the result of a decade of under-investment in energy by the equity markets--anyone who worked in a company making real products during the Dot-Com Boom knows exactly what I mean--and that's significant because energy projects typically have lead times of five to ten years. The projects that should be coming onstream right now would have been started at a time when the market only wanted to hear about "clicks vs. bricks", not barrels per day. A windfall profits tax would make energy company stocks look similarly unattractive today.

At the same time, though, I can understand the temptation that the industry profit pool presents to lawmakers faced with enormous bills, huge deficits, and an electorate with an aversion to higher income taxes on the only group with enough money to close the gap: the middle class. My best advice to my industry colleagues, if they want to head off this trend, is to crank up your capital budgets for traditional and new energy projects, even at the risk of driving down future profits through oversupply. Just as important is making sure that these actions are highly visible; consumers want to know about the billions you're spending to increase supply. The alternative is to lose a large chunk of your profits to an inefficient tax, and lose control of your own destiny in the process.

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