Overproducing US Oil?

Tuesday morning I dialed into an API media teleconference concerning the administration's latest proposals on energy taxation and access. During the call API's President, Jack Gerard, mentioned the recent Congressional testimony of a Treasury Dept. official who suggested that current policies were promoting "overproduction of US oil and gas." That remark struck me as so absurd that I later asked for the reference, so that I could confirm what had actually been said. In fact, the written testimony of Alan Krueger, Assistant Secretary for Economic Policy and Chief Economist of the US Treasury, before the Subcommittee on Energy, Natural Resources and Infrastructure of the Senate Finance Committee included that statement and others in a similar vein. According to Dr. Krueger, the US oil & gas industry has benefited from a set of tax policies and incentives that have steered too much of the nation's capital investment towards energy and away from other sectors. In his view, removing those incentives would increase federal revenue by some $30 billion per year and create a "level playing field" for other forms of energy, while resulting in only insignificant reductions in US oil & gas output, with a negligible impact on our energy security. While his opinions might be shared by plenty of Americans, they reflect an excessive adherence to theory, ignoring the geopolitical circumstances in which global energy markets operate. And on a more basic level, his numbers don't even add up.

It's hard to know where to begin in analyzing Dr. Krueger's remarks. Perhaps the best starting point is the limited zone of agreement between his views and mine. From his comments about greenhouse gas emissions, I assume we share a deep concern about climate change and the contribution of fossil fuels to this problem. Reducing our emissions will require us to consume progressively less of these fuels in the years ahead, and improved energy efficiency and alternative energy production are important strategies for achieving that result. However, Dr. Krueger seems to believe that constraining domestic oil & gas production is another appropriate strategy for addressing climate change. I hope that view is merely his own and not widely shared in the administration, because it represents a horribly inefficient way to reduce emissions, at a shockingly high cost to the US economy. As I've noted many times, most of the emissions from oil and gas come from their consumption, not their production, and merely offshoring the upstream emissions associated with the oil and gas we consume would do nothing at all for global climate change, while reducing US economic output, employment, and energy security and increasing our trade deficit. In this regard the needs of energy security and climate change are perfectly aligned on the necessity of reducing our use of imported oil. Domestic oil and gas are not the enemy; they are part of the solution, and no reasonably informed person would suggest we produce too much oil.

Then there's the notion of a "level playing field," which in this case is fatally flawed for at least two reasons that should be obvious from the most cursory inspection of the issue. First, the global oil market does not conform to anyone's notion of a level playing field. The chief economist of my old firm used to preface many of his comments on oil prices by reminding his audience that the entire oil market was based on turning conventional economics on its head. If the oil market matched economic theory, the lowest cost producers would be going flat out all the time, and only enough high-cost oil from places like the US, UK, etc. would turn up to balance supply & demand. On that basis, I imagine OPEC would be producing 70 or 80% of the world's oil, and the US wouldn't be importing 57% of our crude oil needs, but perhaps 90%, because many US producers would slide right off the edge of that level playing field. Of course that wouldn't be a problem, because in that pure world no OPEC member would ever think of cutting output to raise prices, or of using oil as a geopolitical lever.

The other obvious fact undermining Dr. Krueger's hope for a level playing field arises from his administration's own policies--and those of the last several administrations--with regard to renewable energy. We have tilted the playing field quite far from the level in favor of corn ethanol and electricity from wind and a variety of other renewable sources. Putting all of these incentives into common, more familiar units might help to illustrate just how un-level we have made the field. Consider ethanol, which receives a Volumetric Excise Tax Credit, a.k.a. "blenders' credit" of $0.45 per gallon. That's $18.90 per volumetric barrel, though when we adjust for ethanol's much lower energy content compared to petroleum products, it works out to an effective rate of $32 per barrel of oil-equivalent energy (BOE). Wind power and other renewable electricity sources are eligible for a federal Production Tax Credit of $0.021/kWh generated. Assuming that they back out mainly power generated from natural gas, that works out to an effective subsidy of $2.33 per million BTUs (63% of the current spot natural gas price) or $13.40/BOE. Now let's compare those figures to that $30 billion the government could collect by closing tax loopholes that benefit oil and gas.

If you have a gut feeling that the subsidy per BOE of oil and gas would be much lower than for renewables, give yourself a gold star. The reason the incentives in question are lower is that the denominator is so large. When you add 2008 US domestic production of crude oil, natural gas, and natural gas liquids on an oil-equivalent basis, it works out to a shade over 6 billion barrels. As a result, that $30 billion worth of incentives equates to just $5 per barrel, or 12 cents per gallon, which is not only less than the incentives for renewable energy--the production of some of which appears to be no better for the environment than oil--but also less than the federal excise tax on gasoline. And while Dr. Krueger expressed concern that US lease terms for offshore oil production in the Gulf of Mexico were more generous than those of other producing countries, he does not appear to have factored in the effective 40% federal income tax rate on the earnings of the companies producing oil & gas from those fields.

Now, I can't say that taking $5 per bbl away from the domestic oil & gas industry would cripple it. At this point, the industry is pretty healthy, though not nearly as healthy as it was a year or two ago. But even in a world of $70 per barrel oil, and with US natural gas currently trading at a much lower equivalent price of $21/bbl, that $5 looks like a significant deterrent to investing in more production here--production that would contribute essentially net-zero to global greenhouse gas emissions but that would back out foreign oil and gas imports on a direct, barrel-for-barrel basis. With a lifetime of experience in that industry, I don't need an economic model to know that Dr. Krueger's estimate of losing only "one-half of one percent" of domestic oil & gas output defies common sense and looks suspiciously like a manifestation of "garbage in, garbage out".

There is legitimate debate over the best way to address the externalities associated with our use of oil and gas and the emissions they create, and I come down squarely on the side of recognizing the emissions externality via the mechanism of cap & trade--though not in the grossly-distorted
form inherent in Waxman-Markey. That's an entirely different kettle of fish than making US hydrocarbon production less competitive with the imported oil and gas with which it must contend, in a global market that is anything but level, thanks to OPEC and the consequences of resource nationalism. A quick review of Dr. Krueger's impressive bio suggests that his main expertise lies in the economics of education and labor. It is clearly not in energy. We live in a world in which the geopolitics of energy are so challenging, and in which the EU subsidizes airliners, while China apparently subsidizes tire makers, and any number of countries--now including ours--subsidize carmakers. In that context, a modest level of incentives for the production of domestic energy from a variety of sources, including oil and gas, doesn't look so extraordinary. If anything, it's sensible and prudent.