Thursday, February 14, 2008

Adversaries or Allies?

The final version of the Energy Bill that passed last December omitted several provisions that were near and dear to the hearts of its original sponsors and their supporters. One of those measures, the repeal of specific tax benefits for oil and gas companies, has just been reintroduced in the House of Representatives, sponsored by Congressman Rangel (D-NY.) Unfortunately this bill, which would also extend the renewable energy production tax credit (PTC) that is due to expire at the end of the year, repeats the error of pitting a key component of our current energy supplies against a growing segment of future supply. That is hardly a recipe for achieving energy independence, or in any way enhancing our energy security. I believe the impetus behind this urge to rob Peter to pay Paul stems from a misunderstanding of basic oil industry economics, distorted by the enormous profits that the big firms are earning in the current high-price environment.

Let's begin by acknowledging that the PTC should be renewed, and not just for another year or two. We can argue about whether it should eventually be phased out, as renewable energy becomes more competitive with conventional energy, but our all-or-nothing approach to this subsidy plays havoc with the pace of development of wind power and other alternatives. But that does not mean that the funding for the PTC should come at the expense of critically-needed supplies of oil and gas. With the US already reliant on imports for two-thirds of our crude oil needs and a growing share of our natural gas consumption, that is folly.

No one can argue that oil companies are suffering today, though it is also clear that US-based companies face enormous obstacles to remain globally competitive, when the vast majority of the world's oil reserves are controlled by national oil companies. Viewing the pending tax bill as counterproductive doesn't require justifying the industry's record profits or arguing that they are over-taxed already. Rather, it requires the simple recognition that today's huge profits are not being generated by projects currently under construction or in the planning stages, but by projects that were completed in the past, when oil prices and construction costs were much lower. Projects that were approved in the 1980s and 1990s with the expectation of earning a few dollars per barrel of profit are now generating margins in the tens of dollars per barrel. However, many of those mature producing projects also experienced years such as the late 1990s, when those returns were nonexistent or negative.

Other than helping to determine the total size of a company's capital and exploratory budget, the current profits on existing projects have nothing to do with decisions about which new projects to develop and which to put on hold. Those decisions are made based on calculations of expected net present value, after paying all relevant royalties and taxes, foreign and domestic. That's why the provision of HR.5351 that would limit the ability of companies to deduct foreign production taxes from their US income is so insidious. At a time when foreign governments are increasing royalties and taxes on new production, and with project costs having spiked dramatically in the last five years, anything that makes the incremental economics of new oil projects less attractive will result in lower future supplies, and still higher prices.

Every year, oil producers must replace the amount by which their annual output has declined, as a result of the depletion of mature reservoirs. A recent study by CERA put that rate at around 4.5%, though many believe it is higher. At a 4.5% decline rate, the US must replace the equivalent of over 200,000 barrels per day, just to stay even. That's equivalent to the net energy contribution of 14 billion gallons per year of ethanol, or the average output of 42,000 MW of wind power capacity. At that scale, anything that promotes renewables at the expense of the new oil projects needed to maintain output seems unlikely to result in a net energy gain for the country. In reality, we need both, if we're going to make a dent in our oil imports, as everyone seems to desire.

I know this is a tough sell, after a year in which ExxonMobil made $40.6 billion--after paying $30 billion in tax--and my old company, Chevron, reported $18.7 billion in after-tax income. But the real issue is not how much of those profits their shareholders (including me) should get to keep, but how to ensure that any additional tax burden is not added in a way that makes new production less attractive. Ultimately, we need the contribution of the new forms of energy that HR.5351 is seeking to promote via the extension of the PTC and other subsidies, but we still need the steady stream of oil and gas production that its funding mechanism would put at risk, if we want to get to a greener energy future without increasing our dependence on OPEC in the process.

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