Honey, I Shrunk the Oil Industry

I finally finished watching the archived video from last week's Senate Finance Committee hearing with the heads of the five largest major oil companies in the US, including the two that are based in the EU. The few nuggets of real information and insight that were exchanged were nearly drowned out by political posturing, but my hat is off to Chairman Baucus (D-MT) for his willingness to engage in a genuine give and take with his guests. I attribute much of the frustration that was on display to the conflict between the facts and their context: Although the companies are mostly right on the principles and consequences involved in the proposal to strip them of their tax incentives, it's nearly impossible for anyone outside the industry to get past the large profits these companies are making and the out-of-control federal deficit that the Congress must endeavor to rein in. Perhaps I can offer a bit of perspective for both sides of the argument.

First, neither this Congress nor the administration is proposing windfall profits taxes--government's traditional threat when oil profits soar--nor are there serious calls for nationalization of the industry. Having watched other countries make a hash of such moves, it appears we've learned a thing or two in the last three decades. The measures currently under consideration are much less extreme than that, and I imagine they sounded reasonable and fair to a lot of Americans who are in sticker shock every time they drive by a gas station. However, that doesn't make them good policy--energy or tax.

At the same time, despite Senator Hatch's pie chart showing the relative size of the US oil industry compared to the global industry, including OPEC, few of those grilling the CEOs seemed to grasp the scale involved--a major factor in the absolute magnitude of the profits in question--including the size of companies with which these firms must compete for opportunities around the world. For comparison I couldn't turn up an estimate of Saudi Aramco's first quarter earnings through a Google search, so I had to devise one myself. Based on an average OPEC basket price of $101/bbl and a conservative production cost of $20/bbl, Aramco's average volume of oil exports in January and February, as reported in the database of the Joint Organizations Data Initiative, implies quarterly earnings of around $50 billion--more than the total of the five companies represented at the hearing--and that's assuming that every barrel Aramco refines and sells within the Kingdom is at a breakeven. When it comes to oil profits, big is relative. Even the much smaller Petrobras, 64% owned by the Brazilian government, posted $6.7 B in first quarter earnings, beating US #2 Chevron, in which I own shares.

Several of the Senators complained that the math didn't seem to work, in terms of understanding how the withdrawal of a couple of billion a year in tax incentives could have a serious impact on the five companies and shift investment away from the US, a much more serious concern than the effect on earnings. Having participated in the project portfolio process of a major oil company in the past, I believe I know what the Senators were missing.

It seems counter-intuitive, but corporate-level accounting profits reported after the fact have virtually nothing to do with project selection decisions, other than influencing how much money is available to invest. The choice of which new projects to pursue and which to leave on the shelf hinges on detailed comparisons of expected future after-tax earnings and cash flow for each project. Tax rates, deductions and credits play an important role in those calculations. For some projects the go/no-go decision rests on a knife edge of risked net present value, and in that environment a lost tax deduction (Section 199) or tax credit could make US projects look consistently less attractive than their foreign counterparts. (Ironically, these companies' renewable energy investments in the US would also suffer the same disadvantage.) Put enough US energy projects in that position, and the result is inevitable: fewer wells drilled here, less future US production as current production declines, and eventually a smaller domestic oil industry with fewer capabilities.

Despite a few half-hearted attempts to channel the ghost of William Jennings Bryan, I doubt that any of the Senators participating in the hearing really wants such an outcome. It wouldn't help the millions of Americans who are alarmed by high gas prices, and it's hardly consistent with the President's goals of reducing oil imports by one-third and improving US energy security. Unfortunately, because of the way the question has been framed, in terms of a narrow set of tax breaks the industry enjoys, there are no good answers. Those can only be found by expanding the conversation to encompass a truly constructive US energy policy promoting both conventional and renewable energy, along with meaningful deficit reduction.