Proposition 87

After a summer in which the threat of windfall profits taxes on the oil industry seemed to grow in direct proportion to the commodity price, that tide has receded--for now--leaving behind only a California ballot initiative that would impose a "severance tax" on oil produced in the state. Proposition 87 provides an excellent example of some of my recent comments on energy policy. After wading through the text of the actual proposition, I concluded that it is essentially a $4 billion plan to cut oil use via the slow path of efficiency incentives and alternative energy investment in infrastructure and R&D. Voters should be asking many questions about this proposition, including whether this is the most effective means of reducing their consumption, how such a program should be financed and administered, and who will ultimately benefit from it.

Having spent the better part of thirty years living in California, I still miss the excitement of its hotly-contested state ballot initiatives. This is the purest form of high-level democracy in our country. Some see it as a great boon and others as support for the Framers' choice of a democratic republic for our national government. In any case, past California propositions have changed the face of the state and sparked broader movements across the nation. The oil industry seems justifiably worried that this one could fall into the latter category.

There are two basic issues here that voters ought to consider. The first is whether Prop 87's stated goal of reducing California's oil consumption by a quarter is achievable by means of its support for more efficient cars, renewable fuel infrastructure, and energy R&D. Since that consumption currently stands at 1.9 million barrels per day, second highest in the US--though first in gasoline and jet fuel usage--a little skepticism seems in order. $4 billion would buy a lot of R&D, but not very much alternative energy capacity. For example, spending it all on building ethanol plants would yield the approximate fuel equivalent of one new oil refinery. If a $4 billion investment could really cut $10 billion from California's annual petroleum bill, that would be remarkable leverage, indeed. Without tackling consumer behavior, this path will take decades to reach its goals. The environmental consequences and national security ramifications of the status quo trends suggest we can't wait that long.

The second question relates to the impact on the state's oil industry, which has generated economic growth, jobs, and taxes of all kinds for more than a century. I wonder if the authors of this initiative understand that of the 630,000 barrels of daily production they cite, the majority is heavy oil--64% of it per the state's 2005 annual report--and much lower in quality and value than the benchmark West Texas Intermediate crude oil traded on the New York Mercantile Exchange. For example, the Midway-Sunset grade of San Joaquin Valley Heavy oil, a key marker crude in California, was selling for $8.72/barrel less than WTI in July, ranging between a $5 and $10/barrel discount over the last five years. What we're really talking about is adding a couple of dollars per barrel in cost to some of the most expensive, least valuable crude oil produced in the US. Now, you might say that oil companies have no better alternatives, but if world oil prices continue to fall, that may not be true in the long run. It's a good bet that the severance tax will accelerate the long decline of California's production and the shrinking of the whole industry.

For that matter, the severance tax language in the proposition is so skimpy and vague that it appears to have been more of an afterthought than an original intent. You can imagine the drafters devoting all their time and energy to carving up the $4 billion for alternative energy and efficiency, and then realizing they had to find someone who would pay for it all--preferably not the voters who must pass it. It is telling that even the state's own legislative analyst office has been unable to parse the exact specification or intent of how the severance tax is to be applied, whether on the entire barrel or by increments up to each price bracket. (I.e., like a sales tax or an income tax.)

The initiative's highly-publicized protection against producers passing the cost of the tax on to the public is even more vague and naive. In fact, the description of this provision in the proposition literature is longer than the relevant portion of the legal text, which is short enough to quote here in its entirety:

42004 (c) The assessment imposed by this part shall not be passed on to consumers through higher prices for oil, gasoline, or diesel fuel. At the request of the authority, the board shall investigate whether a producer, first purchaser, or subsequent purchaser has attempted to gouge consumers by using the assessment as a pretext to materially raise the price of oil, gasoline, or diesel fuel.

Contrary to the above, though, Prop 87 would not revoke the law of supply and demand. Simply put, increasing the cost of California's heavy oil will make it less attractive to produce and less attractive to refiners, who will import more foreign crude oil and/or petroleum products refined offshore. From an energy security standpoint, this initiative goes in exactly the wrong direction, reducing supply today in exchange for the prospect of reduced future consumption, while focusing on a point in the value chain with minimal leverage on reducing current demand. The selection of a severance tax as the funding mechanism for alternative energy incentives appears either arbitrary or cynical, eschewing the more obvious and effective route of a gasoline tax that would at least have a direct effect on demand.

On balance, while Proposition 87 would help alternative energy--and alternative energy investors--the outcome for the majority of California's energy consumers is ambiguous. Because its funding mechanism penalizes current domestic energy production, I can't join with the prominent figures who have endorsed Proposition 87. It might save some oil over the long haul, but it would do so at the cost of speeding the decline of a vital American oil resource in the San Joaquin Valley, while increasing our near-term reliance on foreign oil suppliers. That's a consequence that California's consumers and taxpayers would rue for years to come. Rather than being told that they can have alternative energy but pass the tab to someone else, voters should have been given the opportunity to indicate whether they're willing to pay more at the pump to fund it.