Thursday, November 17, 2005

Clawing Back the Windfall?

No one who watched last week's Senate hearing on the oil industry will be surprised by the latest development. On Tuesday, the Senate Finance Committee voted to incorporate what amounts to a temporary tax on oil company profits in a bill designed to provide tax breaks for hurricane reconstruction. While this may go a small way towards satisfying irate motorists, the mechanism involved will make our already stretched energy infrastructure even more vulnerable to disruption.

The proposed change would affect the way that oil companies account for the value of their inventories for tax purposes. Most companies use the Last-In/First-Out (LIFO) method of inventory accounting. Under this system, the cost of goods sold is determined by the most recent purchases, not by cheaper product already in inventory. If the Senate version of this bill passes, any oil company with more than $1 billion in sales would have to recognize 75% of the increased inventory value between year-end 2004 and year-end 2005. If that were done based on yesterday's closing price on the NY Mercantile Exchange, it would amount to about $10.00/barrel of additional taxable earnings for every barrel of inventory held by these companies. In aggregate, the Senate expects this to generate approximately $5 billion in extra taxes from the affected companies.

The arguments against this are different from those against a simple surtax on oil company profits, which would act as a general deterrent to investment in the industry. In some respects, this kind of back-door tax is even worse, because it increases the existing disincentives for holding commercial oil inventories, while taxing income that hasn't yet occurred and may never, if prices fall again. Lower inventories will increase oil market volatility and translate directly into reduced flexibility in operations.

The less inventory a refinery carries, the less it is able to respond to sudden changes in the market or events that affect crude oil supplies, such as hurricanes or terrorist incidents. Hammering oil companies for the unrealized appreciation of their inventories--not unlike taxing you for the market appreciation of your house, even if you have no plans to sell it--sends a negative and unhelpful signal to an industry that has already seen its inventories decline from the equivalent of 27 days of average refinery throughput in 1990 to only 19 days in 2004.

There could also be other, unintended consequences. LIFO accounting creates all sorts of quirks. It's entirely possible that some of the companies subject to this provision have been hanging onto inventory they might otherwise not want, to avoid realizing the earnings associated with selling it. For example, a company might have a "LIFO layer" going back to when oil was $10/barrel. Liquidating it at $60 would generate cash but also a big tax liability. However, if the Senate is going to impose that liability even if the inventory isn't sold, then the incentive to hang onto those barrels vanishes. The result of this across the whole industry might create a quantum drop in inventory.

An even more convoluted version of this scenario would entail drawing down inventories drastically at the end of December, then stocking up in early January at prevailing market prices. That would create a massive new high-cost LIFO layer, effectively trading unavoidable high taxes today for lower taxes later.

I fully understand the pressures under which our elected representatives are operating in this area. But sometimes leadership means recognizing and explaining the counter-productivity of a popular measure. The oil companies won't win any "most admired" contests these days, but it is in everyone's interest that they be allowed to function in a manner consistent with providing reliable supplies of energy, even if that means that they occasionally earn extraordinary profits when prices are high. Clawing back these profits by selectively fiddling with established accounting methods is a deeply bad idea.

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