Oil's Pogo Problem

Yesterday I participated in another in a series of blogger conference calls hosted by the American Petroleum Institute (API.) This one covered a study commissioned by API and conducted by Dr. Robert J. Shapiro, a former Undersecretary of Commerce for Economic Affairs, examining the ownership of US oil and gas companies. The study's findings dispel the notion that the oil industry is owned by a few insiders, rather than by a broad cross-section of the public via our mutual funds, pension funds, and direct equity investment. In fact, the owners of these companies look a lot like those in other industries. While that might not surprise many of my readers, it highlights a significant disconnect in some pending energy legislation. Anyone familiar with the late Walt Kelly's cartoon possum, referred to in this posting's title, knows where this is headed.

The study looked at the ownership of oil & gas company shares, among management, individuals, and various institutional investors. Although these owners don't make the day-to-day decisions that guide these companies, they are entitled to all of the firm's earnings, whether paid out as dividends or reinvested. Out of every dollar of oil company pre-tax profit, roughly 35 cents cents goes to Uncle Sam and another 7 or 8 cents to the appropriate state tax authority. Of the remainder, Dr. Shapiro's study suggests that approximately 57 cents ends up in someone's IRA, 401-K, life insurance policy, or pension fund, leaving under a penny for "corporate insiders." That seems very much at odds with public perceptions about oil companies.

In the podcast interview that accompanied API's press release on the study, John Felmy, API's chief economist, made an astute observation. Referring to recent legislation increasing taxes on the industry, he said, "They seem to be predicated on the notion that people believe that no one owns the oil companies, and somehow if you take money from an oil company, no one gets hurt." The data paint a very different picture; the people who own those large profits we want our representatives to tax away are mainly the same ones who elected them: us. When I asked him about this, Dr. Shapiro was careful to make a distinction between the composition of the electorate and of the owners of financial assets. The latter group is skewed toward the upper half of income, compared to the whole population, though the electorate probably is to some extent, as well. However you slice it, though, raising taxes on oil companies means taxing the nest eggs of America's middle class.

In that light, the only practical difference between raising federal revenue by taxing the oil & gas industry, in preference to some other broad or narrow target of corporate income taxes, lies in reducing the amount available to invest in producing more energy, rather than materially shifting the pockets from which the funds will ultimately come. Surely that is counterproductive to the cause of reducing our reliance on imported energy, even if some of those profits would otherwise be spent on share repurchases or mergers. When we argue that we want to tax oil companies, because we have more confidence in the government to invest in alternative energy, we are really saying we want to tax our own savings and those of our parents, friends and neighbors to fund energy R&D. When you look at it that way, that's just not a very enlightened policy, compared to a tax on energy consumption or carbon, either of which would do far more to reduce demand, improve efficiency, and reduce greenhouse gas emissions.

Resting Bull?

Over the weekend I was struck by the apparent paradox of a stock market correction inspired by concerns about debt somehow affecting the market values of oil companies, which have some of the cleanest balance sheets around. Today's Wall Street Journal may be close to the mark, in assessing the prospects for future earnings growth of these shares, but ultimately the fortunes of these firms are tied to the supply & demand balance for the commodity, and that still looks quite robust. Is this just a case of market jitters in one sector affecting all, or does the market see something that's not readily apparent in the energy sector?

Considering that nothing occurred last week to ease the tight oil market fundamentals noted by the International Energy Agency (IEA) two weeks ago, the dramatic drop in oil equities on Thursday and Friday--starting from levels close to the all-time highs that many of these stocks set the previous week--seemed unlikely to be connected to growing worries about the quality of the nation's home mortgage debt. Leverage doesn't factor into the value of these companies, which have been retiring debt and repurchasing shares by the billions. But there's clearly more at work here than a flight from equities and into T-bills.

In an article tellingly titled "Energy, Once Hot, Now Not", the Wall Street Journal boils down energy equity analysis to two simple drivers of future earnings: volumes and margins. Observing that the major oil companies seem incapable of generating significant year-over-year production growth at this point, the whole issue reduces to the future of margins. The article notes that production costs have been going up, though that's hardly a new story, having been equally true when these stocks were making new highs. Almost as an afterthought, the Journal mentions demand. Last week's correction makes more sense, if it's viewed in the context of changing expectations for demand, which has been a key driver of the whole energy complex for the last few years.

Perhaps this is the scenario that put investors off last week: Continued weakness in the US housing market and spiking adjustable rate mortgages put pressure on middle class consumers, who respond by economizing on fuel and consuming fewer goods with a big energy component. That undermines US refining margins and crude oil prices, which in turn puts the earnings of US oil & gas companies in jeopardy, making their recent share values unsustainable. So they drop.

Now, does that scenario ignore the strong economic growth outside the US, and especially in China? At a minimum, it may overestimate the spillover effect, considering that China's continued expansion may now be more tied to exports to a resurgent Europe than to making further inroads here. And could struggling US consumers have to keep their old cars longer, even if they are gas guzzlers? That would make oil demand more inelastic, after months of $3 gasoline have squeezed a lot of discretionary driving out of the system. Gauging future demand is a tricky proposition, particularly when you factor in the impact of new energy legislation and efforts to address climate change.

On balance then, deciding whether last week's correction in oil equities was justified requires working through a fairly complicated assessment. Are the US debt problems that spooked the market big enough to slow the growth of global oil demand and allow the production increases cited by the IEA to overwhelm OPEC's market discipline, and thus to end the bull market in oil prices that has been in place since 2003? Betting against demand hasn't worked out very well, so far, but every trend eventually turns.