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.

The Ripple Effect

The fallout from the collapse of oil prices in the last quarter of 2008 is still rippling through the economy. Yesterday's announcement of a $34 billion write-off by ConocoPhillips, the third-largest US oil company, is the latest signpost of this phenomenon. It's not confined to the oil exploration and production segment, either. We've seen the earnings of non-integrated refining companies drop, along with the announcement by Valero, the largest US refiner, that it would idle its 225,000 barrel per day Texas City refinery for several weeks. At the same time, ethanol producers continue to struggle with low margins and financing problems. In short, only a quarter after fuel companies were reporting record earnings, the tables have turned and consumers are in the catbird seat, still paying less than half of last summer's pump prices.

Conoco's losses didn't surprise Wall Street, and they shouldn't have surprised my readers, either. In late December I examined the impact of low year-end prices on the oil and gas reserves carried on the books of the oil companies. The reasonable change in SEC regulations for calculating their value, which goes into effect next January, came a year too late to prevent massive accounting losses in the oil patch. However, I missed the impact on the value of acquisitions, to which ConocoPhillips may have been particularly vulnerable, having been assembled not just from one big merger, but from a long string of deals. The bones of Burlington Resources, Tosco, and Unocal's refining and marketing business are all buried in there, somewhere. Tomorrow we'll see whether ExxonMobil and Chevron report similar losses, though it's notable that Shell, which reports earnings under UK accounting standards, saw only a 28% drop in fourth quarter earnings, compared to 4Q07.

Meanwhile, the refining business has returned to a more normal situation, compared to the boom years of a few years ago and the dire straits of last month, when spot gasoline was selling for less than light sweet crude oil. The recent bounce in gasoline prices has put refiners back in the black. Since December, the calculated futures market "crack" spread, a simple estimate of the margin on making gasoline, has improved from a average loss for the month of $1.40/bbl to a profit of around $5.75/bbl, while the "3-2-1 crack", which includes the benefit of higher diesel fuel prices, has improved from about $5/bbl to roughly $10/bbl. Although this is a healthy margin, it won't result in banner profits, when US refineries are running at an average utilization of 82%. That's a lot of idle capacity, whether in the form of entire plant shutdowns, as at Texas City, or of reduced run rates at most plants. It's a reflection of just how far US gasoline demand has fallen that until this week, gasoline inventories continued to build, in spite of such low output.

Ethanol producers aren't faring much better. The operating margin, or "crush spread", that I calculate from today's Chicago Board of Trade corn and ethanol quotes is only $0.25/gal. That's a far cry from crush spreads over $1.00/gal that were routine in 2006 and 2007, and that helped fuel an ethanol plant construction boom that has now gone bust, at least temporarily. A growing number of ethanol producers have filed for Chapter 11 protection, and the largest of these, VeraSun Energy, has been forced by market conditions to idle 12 of its 16 "biorefineries." If it emerges from bankruptcy at all, VeraSun, which had been one of the most aggressive consolidators of the industry, will be much smaller. These are hardly the signs of a thriving biofuels industry, upon which a core strategy of US energy policy rests.

Any temptation to find morbid satisfaction in the diminished fortunes of the transportation fuels industry should be tempered by a clear understanding that its dips carry consequences that reverberate for years, because of the planning and construction lags inherent in its big projects. The oil platforms deferred or canceled this year will squeeze output in the mid-2010's, while the gas wells not drilled in 2009 and 2010 will tighten supplies much sooner. And even on the presumably greener side of the industry, an ethanol sector rocked by corporate bankruptcies and distilleries abandoned before they ever started up will be poorly positioned to deliver on the highly-ambitious renewable fuels targets set by the Congress in late 2007, and mooted for further expansion during last year's presidential campaign. The days of profits some regarded as unearned windfalls have clearly ended; however, if the fuels industry doesn't make "normal" profits this year and next, we will all pay for it down the road.

Delayed Reactions

The analysis in the current edition of the Department of Energy's "This Week in Petroleum" highlights an unexpected finding from the department's Short Term Energy Outlook: a forecast of a pronounced uptick in US oil production for next year, by 8% compared to this year. The commentary emphasizes that this reflects more than just a rebound from production that was temporarily shut in by this year's hurricanes. What struck me, however, was how neatly the graph accompanying the analysis illustrated the delayed impact of changes in market conditions on our oil output. As the incoming US administration contemplates its policy stance towards the domestic oil and gas industry, it's worth thinking about how they might benefit from these lagged effects during the next four years, but pay for them in a possible second term, particularly if US energy policy turns more negative to oil next year.

When I studied macroeconomics in graduate school 25 years ago, it was generally understood that changes in fiscal policy--tax cuts and spending increases--involved a time-lag of about two years before they produced the desired results, while the effects of monetary policy--changes in interest rates and the money supply--lagged by about one year. (We haven't heard much about such lags during the current crisis, and even if they have shortened, they prevent any stimulus from yielding the instantaneous result the media seem to expect.) Energy has its own inherent time-lags. For large oil projects, such as offshore production, the delay from "green light" to first production is typically 5-7 years. That compounds the volatility of the oil markets, because by the time new supplies come on the market, the conditions that prompted them may have changed dramatically, as we are now witnessing.




The above chart is a modified version of the one in the EIA's weekly report. I've deleted the Alaskan and Lower-48 production volumes in the original graph and substituted the annual average WTI price, while retaining the annual year-on-year percent change in production. With that price overlay, the effects of the oil price collapse of the late-1990s, precipitated by the Asian Financial Crisis, are evident in both a short-term drop in US oil output and an echo roughly six years later. Although much of the drop in 2005 was attributable to Hurricanes Katrina and Rita, the decline in 2004 reflects a dearth of new production, due to projects that were delayed or cancelled when oil company revenues collapsed in 1998 and 1999. But that relationship also works in both directions. It is hardly coincidental that we should anticipate an oil production rise in 2009, five years after prices began their steady upward march in 2004. That trend might continue for a few years, when projects initiated when oil was $60, $80 or $100 come onstream. However, if we expect oil prices next year to be no higher than they are now, despite the rapid escalation in production costs over the last few years, then we might reasonably expect a dip in production, over and above normal decline rates, beginning around 2013 or 2014.

There's certainly a lot more to US oil production than a simple cause-and-effect relationship with oil prices. Government policies play an important role, as well, and it's reassuring to hear the House Majority Leader, Representative Hoyer (D-MD) indicate that the Congress would not seek to reinstate the recently-expired federal offshore drilling moratorium. Nevertheless, it's worth keeping in mind that oil supplies are ultimately price-elastic, just as oil demand has proved to be. If the lagged response to flagging oil prices coincides with policy decisions that reinforce their effect--for example, if the new administration follows through on President-designate Obama's campaign promise to impose a windfall profits tax on the largest US oil companies--we could be facing a substantial future drop in output that could negate much of our efforts to wean the US off of imported oil. We need to keep in mind that every million barrels per day of domestic oil production is the equivalent of roughly 20 billion gallons per year of ethanol, and is worth $20 billion to our trade deficit, even at today's diminished prices.

The Shifting Senate

Although overshadowed by the presidential contest, there was much speculation going into last Tuesday's election about whether Democrats could capture a filibuster-proof majority of 60 seats in the US Senate. This would have had profound implications, not only for the ability of an incoming Democratic president to push his agenda through Congress, but for Congress to pass a number of measures that the leadership likely considers unfinished business. That includes major legislation on energy and climate change. Although three contests remain unresolved at this point, leaving this possibility tantalizingly open, a review of the voting on a couple of key bills suggests that even if they all went the Democrats' way, that outcome might be less useful than it appears, because several of the Republicans who retired or have been turfed out were moderates who voted with the majority on the measures in question.

Today's topic might seem overly focused on "inside-the-Beltway" concerns, but I think it could have serious consequences outside Washington, DC. Consider two key pieces of energy-related legislation that came before the Congress this year. The Boxer-Warner-Lieberman Bill, S.3036, would have enacted an increasingly-restrictive cap on greenhouse gas emissions, enforced through a national emissions-trading system ratcheting up energy prices and the prices of energy-intensive goods, in order to reduce US emissions of CO2 and other GHGs. After extensive debate, the bill failed on a "cloture vote", which would have brought it to the floor of the Senate for an up-or-down vote, which it might well have passed. The vote was 48-36, but should probably be counted as 54-36, due to some key absences. That would still have fallen short of the 60 votes required to end debate. Adding the six Senate seats the Democrats have already picked up in this election might lead one to see cap-and-trade as a shoe-in in the next Congress. That math doesn't quite work, however. Of those Senators who voted against cloture, only two lost their seats, while four of the six seats that changed hands were already in the "aye" column. Even if the unresolved races in Alaska, Georgia and Minnesota all send Democrats to Washington, they would still come up one vote short, unless another Senator who voted no or did note vote could be brought around.

The prospect of a windfall profits tax on oil companies looks equally shaky at this point, for similar reasons. Consider the voting on the "Consumer First Energy Bill of 2008", S.3044, which in addition to a 25% tax on "windfall" profits of the major integrated oil companies--over and above the taxes they already pay--would have allowed OPEC to be sued for anti-trust violations in US courts and imposed restrictions on energy commodity speculation. This bill also failed its cloture vote, by 51-43. When we adjust for the seats that have already changed hands, that improves to 55-39. Yet if Senators Stevens (R-AK) and Chambliss (R-GA) fall, it would only extend to 57-36, still short of the magic 60 votes.

So even if the new Senate tallies 58 Democrats and only 40 Republicans, not counting the two Independents who have historically voted with the Democratic caucus, enacting major energy legislation will likely require serious consideration of the views of the minority. While that will disappoint partisans and those desiring the strictest possible climate change legislation, the practical necessity of a bi-partisan approach to energy could pay dividends over the long haul, by preventing the majority from passing measures that could be overturned the next time the balance of power in the Congress shifts. Like the Cold War, solving our energy and climate problems is not the work of one Congress or one Administration, but will require a cumulative effort spanning decades. That should align with the necessity of avoiding further shocks to the economy, as well.

Next Tuesday I will be speaking on the climate change implications of the election at a breakfast panel in Manhattan hosted by my sponsor, IHS Herold. The topic of the session is "Investment Insights in Alternative Energy." If you are interested in attending, please email Bianca Smothers.

Throw Out The Kitchen Sink

As I was watching a bit of the Senate debate on the latest energy legislation on C-SPAN, I couldn't help noticing how dysfunctional this process has become. This bill was assembled like Frankenstein's monster, out of mismatched provisions selected more for their potential to satisfy key constituencies than for the likelihood they might bring down gasoline prices or reduce this country's dependence on foreign oil. What if the Congress broke with all precedent by separating these provisions into individual bills and proceeded to a straight up-or-down vote on each one? While that might deprive some members of the opportunity to use another member's support or opposition to the aggregated bill as political weapon, that should hardly be a primary consideration when addressing the ongoing energy crisis.

Although the current bill, the America-First Energy Act of 2008 (S.3044) contains an interesting proposal on commodity trading margin limits that might reduce some of the speculation that many believe is contributing to high oil prices, it also includes a windfall profits tax on oil, at the rate of 25% on "the excess of the adjusted taxable income of the applicable taxpayer for the taxable year over the reasonably inflated average profit for such taxable year." The latter curious notion is defined as, "an amount equal to the average of the adjusted taxable income of such taxpayer for taxable years beginning during the 2002-2006 taxable year period (determined without regard to the taxable year with the highest adjusted taxable income in such period) plus 10 percent of such average" but reduced by excess of "qualified investments of such applicable taxpayer for such taxable year" over an average from 2002-2006. Those "qualified investments" refer to wind, solar, biomass and a variety of other renewable energy technologies. This entire provision would only apply to any "major integrated oil company." In other words, any profits of ExxonMobil, Chevron, ConocoPhillips, or the US divisions of Shell and BP not reinvested in alternative energy would be subject to a 25% surtax, after paying income taxes at the full corporate rate.

Now, whether or not you believe that the profits of oil companies should be taxed at more than the effective 40% rate to which they are already subject, or that these companies should invest more in renewable energy, it should be painfully obvious that even if such a bill received a majority of votes in the Senate and House, it would promptly be vetoed by the President. Whatever other valuable provisions this bill may contain have been made hostage to a measure that would further handicap US oil companies that already operate at a disadvantage in the intense global competition for new resources now underway. The inclusion of this Poison Pill for partisan political purposes exemplifies the unseriousness of our present approach to energy policy.

The real solutions to our energy problems must be genuinely bi-partisan and endure from one administration to the next, much as our Cold War strategies did. This bill in its current form violates that principle. If its provisions are as sensible and beneficial for the American public as its sponsors apparently believe, then they should be willing to disentangle them and offer them up for separate votes, on their merits. That may not be the way things are usually done, but then perhaps this is the kind of change that voters consistently say they are seeking in this election cycle.

Note: My personal portfolio includes shares of one or more of the companies mentioned above.

Painful Lessons

Friday's record closing price for oil of $138 and change put paid to any hopes that last week's average retail gasoline price of $3.98/gallon would turn out to be the high-water mark for this summer, as the price around Memorial Day has been in some previous years. As stressful as the reality of $4 gasoline is on the economy and on individuals, though, there are good reasons not to panic. Hoarding by consumers or attempts by government to moderate prices could make the situation even worse, as we experienced in the previous energy crisis. Although we rarely think of it in such terms, reliable supply generally trumps low prices.

After a long stretch in which the price of gasoline consistently lagged the rate of consumer price inflation, it is now leading the CPI higher along with food-price inflation, which also includes a significant energy-related component. In June 2006 the average retail price of gasoline was $2.85/gal. If it had only increased as fast as overall CPI inflation--ignoring its impact on same--we would now be paying $3.04/gal. That's about what the price would be if gasoline had inflated steadily with the CPI since 1981, when it averaged $1.38/gal. We're just beginning to see the adjustments consumers must make to accommodate this sudden shift in gasoline's share of household expenses, in the absence of ready cash from home-equity loans. If these conditions persist, we will eventually learn what they mean for the value of real estate in outer suburbs that benefited from the rise of long-distance commuting.

Whatever the contribution of speculation to high oil prices--the number one cocktail-party-and-dinner question I am asked, these days--or the role of the weakening dollar, we mustn't forget that oil wouldn't be an attractive investment for commodity speculators and dollar-hedgers without the ongoing collision between global constraints on expanding its output and the rapid growth of demand from the economies of Asia and the Middle East. It would be counterproductive at this point for our government to implement policies that resulted in further increases in demand or reduced supply. Gas tax relief at the pump or a windfall profits tax on oil companies might mollify consumers and voters, but they would ultimately make markets even tighter. So would any quick reversal of the apparent trend by consumers to keep less fuel in their gas tanks.

It might seem odd to look for good news in this situation, but compared to the late 1970s, things could be worse. Gasoline inventories are still at reasonable levels in terms of the number of days of supply they represent. As a result, the only gas lines we've seen were the result of consumers capitalizing on a lag in price increases at stations serving the New Jersey Turnpike. As painful as rationing supply by price has become in this case, it works better than price controls or odd-even refueling restrictions. That's worth remembering in this election year.

Big Oil and Renewable Energy

After watching nearly three hours of yesterday's Congressional hearing on gas prices, I'm torn between my desire to emphasize the few positive aspects of the meeting or the serious contradictions it revealed. Let's start with the latter and try to end on a more uplifting note. The most obvious disconnect relates to the implicit and probably erroneous assumption by the chairman and many members of the House Select Committee on Energy Independence and Global Warming that lower fuel prices are actually consistent with either of the principal aims of the committee's charter. But while high gasoline prices provided the subtext, most of the discussion-- including Chairman Markey's Puritan-style shaming of ExxonMobil for its lack of investment in alternative energy--revolved around the tension between the need to continue providing conventional energy, while renewable energy ramps up. That was exemplified by Rep. Walden's important question, "How do we do both?"

In his remarks, Rep. Markey (D-MA) issued a challenge to oil companies to invest 10% of their profits in renewable energy, with the veiled threat that if they didn't, then losing $18 billion per year in tax benefits might not be the worst outcome they face. Absent from this exhortation, however, was any recognition that some forms of renewable energy are not as beneficial as others, either in terms of reducing greenhouse gas emissions or in making a substantially positive net contribution to the country's energy balance. The committee seemed to be saying that biofuels are the obvious answer, and that any oil company not investing large sums in them is cheating consumers. While that might provide useful soundbites for some House Members' reelection campaigns this fall, this line of argument has largely been superseded by events.

Although the net impact of renewable energy remains modest, compared to the energy we derive from fossil fuels, the recent dramatic growth of biofuels has positioned them as a key element of current and future liquid fuel volumes, which no industry supply and demand forecast can afford to ignore. With one exception, the companies whose executives testified yesterday are already significant participants in this sector, with investments in biofuel production, next-generation biofuel R&D, and, as a result of fuel specifications and renewable fuel mandates, as some of the largest blenders of biofuels in the world. It remains to be seen, however, whether any of these companies will ultimately come out on top in the renewable energy marketplace, which is dominated by a host of new entrants. This is a classic case of the Innovator's Dilemma, with the major oil companies' renewable energy businesses having to compete for financial and human resources and management attention with the giant upstream and refining segments that are still the engines of oil company economic value, and will be for years to come.

When asked their highest priorities for addressing today's high energy prices and our reliance on imported oil--a situation that Chevron's Vice Chairman, Peter Robertson, characterized as "unsustainable"--all of the execs cited the urgent need for gaining access to oil and gas resources that the Congress and various states have placed off limits. (Disclosure: I own Chevron stock.) The execs stopped just short of saying that, if the Congress is serious about bringing down energy prices, it could have the largest impact by opening up the 85% of the outer continental shelf waters that are presently off-limits for drilling, rather than hammering on oil companies to invest in renewables. That is certainly born out by the size of the potential offshore opportunity, which could easily add another 1-2 million barrels per day to slipping US oil production, and by the enormous differences in physical and financial scale between conventional and renewable energy projects. ExxonMobil isn't wrong to suggest it can make more impact by sticking to its knitting in this regard, though I continue to believe they will eventually regret not taking a position in renewables now--a defensible strategic choice that has been a PR disaster for them.

The financial realities of this were explained in greater detail by Mr. Robertson in a blogger teleconference (podcast and transcript available shortly) following the hearing, arranged by API, in which he cited 40 global oil and gas projects in which Chevron is engaged globally, each greater than a billion dollars, Chevron's share, and each expected to provide substantial, profitable production. At the current scale of renewables, there are still relatively few billion-dollar projects of the kind that companies of this size must pursue, in order to have a measurable impact on their results and on shareholder value. It is still uncertain whether the billions that companies such as Shell, Chevron, ConocoPhillips and BP are investing in renewables will yield results on that scale.

I also noticed a surprising omission in yesterday's proceedings. While both the committee and the witnesses mentioned the enormous potential of Canada's oil sands for reducing US dependence on unstable overseas suppliers, the prospect that imports of oil sands syncrude might be blocked by US environmental regulations was only referenced obliquely by Mr. Simon of ExxonMobil. As I noted recently, this issue could have severe supply repercussions in the Midwest, where much of the Canadian oil we import is consumed, as well as for the overall US oil import mix. I'd call that a key missed opportunity on the part of the companies.

So with the committee telling the oil companies to help consumers by investing in renewables, and the oil execs asking Congress to help consumers by lifting restrictions on off-limits oil and gas resources, what was constructive? Well, there was a very encouraging discussion about energy efficiency and its vital contribution to reducing emissions and saving money. This is surely common ground on which the industry and government could cooperate more. The companies also heard some sage advice from Rep. Candice Miller (R-MI) that, regardless of the economic justification of their profits and prices, they face significant consumer and regulatory backlash if they aren't seen to "do the right thing with these profits." I think they ignore that at their peril and ours, because the likely regulatory response would harm the industry and be counterproductive for the entire country. Perhaps most revealingly, though, and in sharp contrast to a similar hearing involving the CEOs of these companies several years ago--and to an entirely out-of-context clip from yesterday's event that aired on last night's NBC Evening News--there was little disagreement about the fundamental drivers of high oil prices, and the degree to which the US is integrated into global energy markets. In that respect, at least, our national conversation about energy has progressed in useful ways since 2005.

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.

The Usual Suspects

"Major Strasser has been shot. Round up the usual suspects."
- Captain Louis Renault (Claude Rains), "Casablanca"

Gasoline prices have been rising steadily since the middle of February, and so, with perfect predictability, the Congress is again discussing measures to deter "gouging" and tax the "windfall profits" of the oil industry. Rather than reciting my well-worn arguments about how counter-productive that would be, in addressing the serious, long-term energy problems we face, I would like to consider whether they--or we--should really wish the price of gasoline were much lower. Many of the same Senators and Representatives desiring to punish oil companies for periodically charging consumers so much for gasoline support legislation that would raise US gasoline prices permanently, as part of an overdue effort to bring our greenhouse gas emissions to heel.

It's understandable that consumers are complaining, since for many years we've enjoyed lower fuel prices than most of the developed world, because the US doesn't tax gasoline as heavily as other countries do. But even though gas prices are now setting records in nominal-dollar terms and again approaching the inflation-adjusted high water mark of the early 1980s, they are still relatively affordable in terms of the purchasing power of all but the poorest Americans. That's a pretty abstract concept, however, when you've just paid $50 to fill up your tank. I can only imagine the quantity of mail that Senators and Representatives have been receiving on this subject.

When the new Congress arrived in January, they brought with them a heightened focus on two important issues with a direct bearing on this subject: climate change and energy security. If they are serious about addressing these problems, then the country can't go on consuming increasing quantities of fossil fuels, year after year, creating serious consequences for the environment, our balance of trade and domestic security. And while a great deal of attention is being directed to increasing fuel economy standards and promoting alternative fuels, I would venture to say that most of our leaders also understand the basic relationship between price and demand. Simply put, we cannot get a handle on greenhouse gas emissions and oil imports without halting the year-on-year growth of demand for petroleum products. And that can't happen if those products revert to being as cheap as they have been. For the first time in many years, gasoline demand in California stopped growing last year, suggesting that the target gasoline price level for achieving zero growth nationally lies somewhere between $3.00 and $3.50/gallon.

At the same time, many of those decrying today's high gas prices also support legislation to cap US greenhouse gas emissions and institute a national trading system that would put a monetary value on these emissions for the first time. Imposing this measure on the petroleum industry, whether at the producer or consumer level, would inevitably increase gasoline prices. If prices for tradable emissions credits in the European markets where this has been instituted are any indication, the increase could range from $0.10-0.30/gallon.

Rather than pursuing populist assaults on Big Oil--some of the large profits of which are the result of the constraints imposed on the domestic refining industry for the last 30 years--the Congress and the President should join in telling the public that the days of cheap gasoline are over. We need to hear how serious the problems of climate change and energy security are, and that we are responsible for the energy we consume and the vehicles we choose. That would be much harder than issuing subpoenas to the oil company CEOs and threatening them with huge fines and jail time, but it is a necessary precondition of building a national consensus on energy and the environment. If we expect our leaders to level with us about the progress of the war, should we ask any less of them on energy?

Timing Is Everything

Two news items about oil caught my attention this week, and both of them illustrate the pitfalls of poor timing. If the windfall profits tax bill introduced by Senator Casey and seven of his freshman Democratic colleagues had been proposed at the front end of the current industry cycle, it would have at least been chasing a genuine price-spike windfall, rather than the profits from increasingly expensive new projects. And had the report that Iraq's oil reserves may be double their officially-reported 115 billion barrels--with the increment mostly in the Sunni western part of the country--come out a year or two ago, it might have helped Iraq's feuding factions find common ground. Instead, these two items merely contribute to a bleak picture of the future facing the major oil companies.

Because Iraq is still immersed in sectarian and terrorist violence, with no end in sight, it's going to be a long time before any of the country's newly-discovered oil gets to market. For that matter, any increase in production above pre-war levels would require a dramatic realignment of OPEC quotas, or Iraq's departure from the cartel. But if the new oil is anything like the old oil, distributed in a small number of large deposits with straightforward geology and low development and production costs, then Iraq's long-term future potential isn't 4-6 million barrels per day, as many have thought: it's another Saudi Arabia capable of similar volumes to what the Kingdom puts out. That needs to be factored into considerations of Peak Oil timing and the future oil price with which alternative energy projects must compete. It also serves as a reminder of just how much of the world's future energy supplies belongs to state oil companies in the Middle East.

As to a windfall profits tax on oil companies, this is never a good a idea, but at no time worse than when the industry is facing a serious profit squeeze--caught between rising global construction costs and more assertive national oil companies, both upstream and downstream. Our energy companies need to develop enormous quantities of new oil to replace reserves they are consuming, while investing in new refinery capacity to keep product supplies growing; all of that is going to cost hundreds of billions of dollars. Siphoning off a large slice of that money to fund new poverty programs is a good way to derail those projects and keep the prices we pay for petroleum products high indefinitely.

Taxing oil companies makes for great populist sound-bites, but it is directly contrary to any realistic notion of enhancing our energy security, when the state oil companies are getting bigger and more powerful.