Taxing the Winners

Perusing the papers, national and local, it's clear no one likes oil companies very much. This makes me nostalgic, because it's precisely the environment in which I joined the industry nearly 27 years ago. Oil prices were high then, too, and just as much for reasons beyond the control of either US oil companies or US politicians as they are now. The only bright side in 1979 was that the public hated Ma Bell even more than they did us. The biggest consolation in the current situation is that--so far--we have avoided many of the mistakes we made during the last energy crisis, such as enacting windfall profit taxes, controlling oil and gasoline prices, and rationing fuel on odd and even days. But that could change, soon.

With so many people blaming oil companies for high gasoline prices, the natural constituency inclined to resist popular-but-counterproductive policies is small. It won't deliver many votes in November, so we can't discount the possibility of something foolish being enacted. Right now my top candidate for a plausible-but-dumb response to the current situation is a new windfall profits tax. Before taking a step like that, it's important to consider just what it would mean.

The top 15 US oil companies earned $93 billion in profits last year on sales of just under $1 trillion. This diverse group includes Supermajors such as ExxonMobil and Chevron, independent refiners such as Valero and Sunoco, and large independent producers such as Apache and Occidental Petroleum. It excludes a couple of large, foreign-owned companies with bigger US operations than some of the outfits included here. In any case, $93 billion is serious money, and there's a legitimate argument that these companies are benefiting from factors at least partially beyond their control, no matter how well their management may have positioned them to capitalize on these conditions once they appeared.

What would $93 billion mean to consumers? Well, if it were allocated across all the gasoline, jet fuel and diesel sold in this country, it would account for 41 cents per gallon. That sounds like a big deal, but of course we're not going to tax away 100% of these profits, only the amount we deem "excessive." Ah, but how do we determine what constitutes excessive?

One proposal suggests confiscating all earnings above the equivalent of $45/barrel oil. That would be impractical, because several of these companies don't produce any oil, though they still make substantial profits selling petroleum products. It also ignores the reality that all oil is not created equal. One company may produce oil that is generally similar in quality to the benchmark West Texas Intermediate grade, while another produces oil that is much higher in sulfur and much heavier, on average. This sells at a sizeable discount to WTI, sometimes as much as $14/barrel less. Judging them on the same scale would be unfair to both. The best thing, politically, about pegging a tax to oil prices is that it wouldn't frighten other industries with even higher profit-margins, such as computer software or banking.

When US Senators refer to "obscene profits", I have to believe they are sophisticated enough to base their assessment on more than just the absolute dollars involved, given the mammoth scale of the oil industry. So let's assume they mean excessive relative to their sales. If a 10% margin is excessive, then perhaps 5% might be acceptable. This is about what Exxon earned in 2002, before oil prices went wild. What would happen if we taxed the top 15 companies to cap their earnings at 5% of revenue?

First, you'd only be taxing 12 of the 15 companies. Even in their best years, independent refiners don't achieve above 5% earnings on their revenues. Secondly, you'd be hitting US independent producers much harder than larger international companies like Marathon, which scored barely above 5% in 2005. The average margin of the six large independent producers on this list was a whopping 35%. I suspect, though, that they'd be safe. Punishing US producers who have remained dedicated to finding oil and gas in the country, when their larger brethren were increasingly seeking opportunities offshore, would be economic and political suicide, even in an election year.

After you eliminate the independent producers and the independent refiners, you're left with just four US companies to tax: ExxonMobil, Chevron, ConocoPhillips and Marathon, again ignoring Shell and BP, most of whose profits would be exempt as attributable to their non-US operations. After allowing these four companies a 5% profit on sales, we are left with about $29 billion. Spread out over US petroleum product volumes, this gets us 13 cents per gallon. Not insignificant, but about equal to the swing we see in the oil market from one week's good or bad news out of the Middle East.

Now, I will grant you that $29 billion, if it were retained at the federal level, would cover the entire budget of the Department of Energy, or allow us to more than double it. But if the same funds were raised via a 13 cent per gallon increase in the federal gasoline tax, that would at least help to moderate demand. Unfortunately, a windfall profit tax looks temptingly like a free lunch, or at least one paid for by an incredibly unpopular host.

So where is the downside? Why not skim a little of this cream, just this once? Well, one of the first consequences of such a measure would be a drop in the stock market valuation of the companies in question, and probably a cut in their dividends. That would hurt a whole range of investors. I know I'm not the only person with oil company stock in my 401-K, either directly or via a mutual fund. The bigger issue, though, is the competitive hurdle this would create for the US in a totally globalized industry.

American oil companies, even the biggest, must compete vigorously for global exploration, production and market opportunities against a growing group of rivals, including established European firms and up-and-coming Russian and Asian firms. The price of entry for large energy projects starts at $1 billion and goes up to the tens of billions. Forcing the US majors to borrow, when their competitors can fund mega-projects from free cash flow--or using free state cash--would put them at a real disadvantage. I can't be certain how much that would cost American consumers at the pump, but it would reduce oil investment in the US and damage our standing in a sector in which American companies remain best of class.

Ultimately, we must make up our minds about these companies, and we really only have a few choices. From my perspective, since we would never contemplate bailing them out in tough times, we ought to let them keep the benefit of good times, provided they reinvest it. The alternative is tantamount to converting them into public utilities, subjecting their annual budgets and profit margins to governmental scrutiny and oversight. Personally, I have more confidence I'm paying a fair price for gasoline at $3 than for electricity at 17 cents/kW-hr--or milk at $7/gallon.