Once again a windfall profits tax is being discussed in some circles as a response to high oil prices and high gasoline prices. Such consideration is a display of misunderstanding the dynamics of supply / demand and the reality of the oil market and the oil companies. Several points normally ignored or unknown by the major media need to be brought to light.
The next few pages will review (1) what determines oil prices, (2) Are there “windfall profits”, and (3) Who benefits from oil company profits?
1) Can oil companies actually determine the price of oil?
The International Energy Agency has stated that global oil production in August was 84.9 million bls/day. The major integrated oil companies, often collectively referred to as “Big Oil”, produce a combined 13.6 million bls/day. This is only 16% of global supply. The following figures are 2004 volumes in millions of barrels per day, compiled from several independent sources.
Major Integrated Company Government Companies
BP 2.463 Russian
ExxonMobil 2.178 Petroleo
RoyalDutch 2.178 Petroleos
ChevronTexaco 1.715 Sonagal
Total (French) 1.695
ENI (Italian) 1.033
Statoil (Norway) .726 OPEC
Repsol (Spain) .569
*While some of these companies are ostensibly public, government control is the reality.
The above numbers show the major integrated oil companies with a 16% market share, a sampling of the larger non-OPEC national oil companies with a 21% market share, the OPEC countries with a 38.8% market share, and the remaining 24.2% market share scattered among thousands of smaller producers, privately held, public and government entities. Obviously collusion among such a diverse and disparate group is a fantasy.
Oil prices are high because of demand acceleration from industrialization of the Asia/Pacific area, and a sharply curtailed lack of excess capacity in global production. Demand growth from 1994 through 2002 was 12.9%, and then accelerated sharply. If the IEA estimate for 2005 proves correct, current consumption of oil will have increased another 10.2% in just the past three years. In comparison, oil production volumes grew only 10.9% from 1994 through 2002, as “just in time inventory” and supply complacency became accepted behavior. The demand acceleration then caused supply volumes to increase more rapidly trying to catch up, resulting in a rapid decline of spare productive capacity, and much higher prices.
2) Aren’t the oil companies reaping “windfall profits”?
The absolute dollar amount is large because the capital base is large. If party A earns $1 on a $10 dollar investment, that is a superior profit to party B earning $1,000 on a million dollar investment. The dollar amount is not the proper yardstick for profitability, but rather the actual return on total capital. The following table is a sampling of many diverse industry groups for their return on capital invested over the past five years.
** 2001 2002 2003 2004 2005 E Average
Major Integrated Oil Companies 13.9% 9.0% 13.3% 17.9% 19.0% 14.6%
Home Appliance Industry 12.8% 21.4% 18.3% 15.5% 16.0% 16.8%
Medical Supplies Industry 16.4% 17.9% 17.6% 17.5% 17.5% 17.4%
Natural Gas Diversified 9.6% 2.0% 6.1% 8.1% 7.5% 6.7%
Information Services 8.4% 11.1% 11.9% 12.2% 12.5% 11.2%
Restaurant Industry 12.4% 11.4% 11.3% 13.0% 13.0% 12.2%
Specialty Chemical Industry 7.6% 9.4% 9.6% 10.5% 10.5% 9.5%
Metal Fabricating Industry 8.1% 8.6% 8.2% 11.6% 13.0% 9.9%
Telecommunication Services 4.3% 7.7% 8.3% 6.9% 7.0% 6.8%
Auto Parts 6.6% 9.5% 8.6% 9.0% 8.0% 8.3%
Toiletries Cosmetics Industry 21.5% 19.9% 22.5% 22.5% 23.0% 21.9%
Retail Building Supply 13.8% 15.5% 16.4% 17.4% 15.5% 15.7%
Home Building Industry 11.2% 12.3% 12.9% 14.0% 16.0% 13.3%
Household Products Industry 20.3% 20.6% 20.1% 21.2% 22.0% 20.8%
Electrical Equipment Industry 19.3% 18.6% 17.5% 18.5% 18.5% 18.5%
Computer & Peripherals 12.5% 8.9% 11.4% 13.0% 14.0% 12.0%
Office Equipment & Supplies 11.7% 11.4% 12.0% 12.3% 12.5% 12.0%
Basic Chemicals 5.2% 6.9% 7.6% 11.2% 18.5% 9.9%
Drug Industry 23.5% 21.1% 19.9% 20.5% 20.0% 21.0%
Food Processing Industry 10.7% 12.0% 13.3% 12.6% 14.0% 12.5%
Beverage (Alcoholic) 16.7% 19.0% 18.1% 18.5% 15.0% 17.5%
Soft Drink Industry 16.5% 17.4% 16.5% 16.6% 17.0% 16.8%
Educational Services 12.9% 14.3% 14.6% 18.1% 19.0% 15.8%
Apparel Industry 10.0% 12.5% 11.2% 11.5% 11.5% 11.3%
Shoe Industry 14.7% 14.3% 14.6% 15.2% 16.0% 15.0%
Publishing Industry 11.9% 10.1% 10.1% 10.5% 11.0% 10.7%
Petroleum Producing 11.0% 7.2% 11.8% 13.4% 12.5% 11.2%
Oilfield Services/Equipment 7.7% 4.6% 5.1% 5.8% 5.0% 5.6%
Computer Software & Services 16.0% 15.5% 14.5% 14.0% 13.5% 14.7%
** The five-year return on capital is taken from “The Value Line Investment Survey” as of the September 23, 2005 issue.
As is readily apparent to anyone, there is no such thing as “windfall profits” in the energy business. The major integrated companies have favorable returns on capital, but certainly not out of line with many other industries. The petroleum producing companies (independent producers) are among average returns on capital, and diversified natural gas and oil services actually lower than many other industries. The concept of a “windfall profit” is a fantasy.
3) Isn’t “Big Oil” making a lot of money at the expense of the “little guy”?
In a word, NO!!!. The companies commonly referred to as “Big Oil” are all publicly owned by the “little guys”. There is no Scrooge McDuck sitting in a vault counting his money. There are bank trust departments, mutual funds, IRAs, pension plans, financial annuities owned by all the “little guys” collectively known as institutional shareholders. The middle class worker paying the pump price is the guy that also holds an ownership position in the oil companies through his retirement plan, IRA, insurance annuity or mutual fund. The “little guy” through his retirement and pension plans receives the dividends and stock appreciation of the oil companies.
Of course that is after the industry invests heavily trying to provide enough oil, natural gas, and refined products to keep up with demand. The table below shows the estimated per share earnings, and reinvested capital expenditures for several of the oil companies. The estimates are all taken from “The Value Line Investment Survey”.
2005 Earnings 2005 Capital
Major Integrated Companies per Share per Share
BP $6.25 $4.00
ChevronTexaco $5.95 $4.45
ConocoPhillips $8.30 $6.55
ExxonMobil $4.90 $2.05
Royal Dutch $6.60 $4.30
Reinvestment of capital to fund the search for more oil and gas to provide consumers is estimated to take 67% of major integrated oil companies’ net income in 2005.
The independent producing segment of the industry is even more aggressive in capital investment in the search to provide more oil and gas to consumers. The estimate for 2005 is 129% of earnings will be reinvested for the continued search for more oil and natural gas. Reinvestment in excess of net income shows that cash flow including depletion is sourcing more drilling activity. This belies the assertion that depletion is merely a tax preference item. In actuality, it helps fund greater production of oil and gas.
It is clearly and easily observable with a minimum of effort that oil companies do not set the price of oil, do not reap “windfall profits”, and actually reinvest the vast majority of the money they earn in trying to provide the consumer with greater volumes of oil and natural gas. In fact the latest examples globally of government meddling in the energy markets have been disastrous. Russia, once thought of as a counter measure to OPEC has now experienced much lower than anticipated volume growth and forecasts after the “re-nationalization” of the oil business. Venezuela has turned about from an aggressive growth profile that threatened OPEC discipline to a struggling producer unable to even achieve their production quota. The United States does not need to make a mistaken policy based upon political fantasy that would discourage supply, and quite possibly lead to product shortages.
If you want to make oil, natural gas, and refined products such as gasoline more available and at a lower price, you can help to increase the supplies and bring down costs. Let your elected representatives know that you are in favor of opening up federal lands for exploration and production of oil and gas therefore providing greater quantities. Support relaxation of lengthy permitting processes and reduce bureaucratic delays in permitting of refineries. Allow refineries to be built throughout the consuming areas, not concentrated in a narrow swath of the Gulf Coast. This would reduce transportation costs, weather disruptions, and increase the supplies, resulting in lower prices.
By Gregory J. Winneke, CFA, CMM September 29, 2005
In considering a price cap for oil and gas (windfall profits tax), a review of how price signals work in a market is highly instructive.
If you offer ten cents a month to workers to clean capital hill toilets, how many workers would sign up? If you offer these same workers $1 million a month to work on a study of Hawaiian beaches on location, how many workers would sign up? That is what price signals do to supply. A higher “incentive” (i.e. price) encourages supply.
This supply response is already underway in the energy markets. The number of drilling rigs in the United States searching for oil and gas has increased dramatically as the price, “incentive” increased. In fact, there are now problems with not enough rigs available on a timely basis as every oil and gas producer with money available wants to try and find more oil and gas to produce.
This shows up too in the projected earnings and capital reinvestment forecasts in studying the industry. The table below shows the estimated per share earnings, and re-invested capital expenditures for several of the oil companies. The estimates are all taken from “The Value Line Investment Survey,” Issue 3, September 16, 2005.
2005 Earnings 2005 Capital
Major Integrated Companies per Share Reinvested per Share
BP $6.25 $4.00
ChevronTexaco $5.95 $4.45
ConocoPhillips $8.30 $6.55
ExxonMobil $4.90 $2.05
Royal Dutch $6.60 $4.30
Re-investment of capital to fund the search for more oil and gas to provide consumers is estimated to take 67% of major integrated oil companies net income in 2005. Capital investment by independent producers (predominantly U.S. production) is even greater. Again from “The Value Line Investment Survey,” Issue 3, September 16, 2005 and Issue 12, August 19, 2005.
The estimate for 2005 is that 129% of earnings will be re-invested for the continued search for more oil and natural gas. Re-investment in excess of net income shows that cash flow including depletion is sourcing more drilling activity. This belies the assertion that depletion is merely a tax preference item. In actuality, it helps fund greater production of oil and gas.
Since the increase in earnings is being reinvested and showing up as a higher number of drilling rigs searching for oil and gas, how is supply doing? Looking at U.S. natural gas production from the Department of Energy in conjunction with the increased rig count, this is what we find.
The obvious question is why we can’t get more natural gas production from the higher drilling, and thus increase supply, lowering price. It has to do with geologic maturity of the domestic natural gas basins, and new areas for exploration.
Think of it this way. You are into your fourth hour of filibuster and ask a staffer to get you some water which you very much need. A couple minutes later, she returns to tell you that the usual “onshore traditional basins” vending machine is very nearly sold out and there were several dozen other staffers milling around trying to get their coins in the machine, i.e. she couldn’t get you any water. You respond by suggesting trying another vending machine in a different location. A few minutes later, the staffer returns to inform you that while she believes the vending machine on the second floor “offshore Florida” has plenty of water, the elevators and stairs to the second floor have all been sealed off. Getting ever thirstier, you suggest the other side of the building on the same floor, perhaps that vending machine will have some bottled water. After a lengthy time, the staffer returns and tells you that yes, there is bottled water at the “Federal lands vending machine”, she even saw it, but she still has no bottled water for you. It seems someone has put a turnstile in the way that will cost more than the change originally budgeted for bottled water. In addition, there is an individual that won’t allow her to step up to the turn stile without a written 30-page essay of why she wants the water.
Finally, in exasperation and nearly hoarse needing some water during your filibuster, you hand your staffer significant additional change and suggest going to the vending machine in the basement “deep gas” or next door “outer continental shelf,” but please bring back some water.
Unfortunately, she returns to explain that while there was bottled water at either of those two vending machines and although they were more expensive, she did have the necessary change, but there was a new problem. It seems a gruff, masked figure stepped out of the shadows and took the change, telling the staffer that he had a better use for it than buying bottled water.
Congress must decide its proper role. One choice is a free market response to remove impediments to oil and gas supply so that the increased funds and increased drilling can in time bring new supplies of oil and gas and lower prices and lower inflation and assist economic growth. The other choice is to “mug the staffer” (windfall profit tax) so that there is no bottled water(oil and gas).
Help solve the problem or magnify the problem?? Your call!
As we are in an election year with higher than historic fuel prices, there will be many “solutions” to high oil prices advanced by politicians, think tanks, and pundits. One of the all time favorites is conservation as a solution. Of course conservation is necessary, economically rational, and should be promoted as a part of the solution. It does not in itself offer a solution. Proponents always state that the U.S. is energy wasteful compared with Europe, and also report that we successfully improved our energy efficiency in the last oil shock of the late 1970’s. A thorough analysis though leaves questions on both these believed “truisms.”
1) Conservation through energy efficiency, with the example of Europe.
The American public will be criticized for our large homes, driving habits, and “wastefulness” -compared with Europe’s mass transit, and more ecology-friendly lifestyle.
However, there is much less here than meets the superficial eye. A comparison of U.S. oil consumption and oil consumption by the 25-member countries of the European Union (E.U.) are instructive. On the surface, 453 million residents of E.U. countries consume only 14.8 million bls/d of oil compared with 295 million Americans consuming 22 million bls/d of oil. We certainly do seem wasteful, but on a full comparison, what do we really find?
The E.U. Gross Domestic Product (GDP) according to the World Factbook is a virtual tie with the U.S. GDP, at $11.650 trillion for the E.U. and $11.750 trillion for the U.S. On a per capita basis though, the U.S. citizen enjoys $40,100 of GDP to only $26,900 for an E.U. resident. As energy consumption is fundamental to an economy, it is unlikely our populace would favor reducing oil consumption by throttling back the economy. A “beggar the poor” policy of reduced economic activity is both unworkable and unconscionable.
What about transportation though? A different story, as we all “know” of Europe’s trains, better vehicle mileage, and conservation-inducing gasoline taxes. Again, there is more to the comparison, such as the fact that even without including Alaska, the continental U.S. land mass is more than twice the land mass of all the 25 E.U. countries combined. According to the “World Factbook,” the U.S. even without Alaska is 8.15 million sq. kilometers while the total land mass of the E.U. countries is only 3.9 million sq. kilometers. Yes, the E.U. has better mass transit and better fuel mileage, but how expensive, inconvenient, or unwanted would a mass transit system stretched to the U.S. size be? Can a mass transit system that works in small countries even be “super-sized” to U.S. standards? London to Birmingham just isn’t meaningful to compare New York to Los Angeles. If a mass transit system raises questions, what about vehicle efficiency? Let us look at actual gasoline demand and other fuels and products, adjusting for economic and land mass differences.
If we break out oil demand into product categories, and per capita (adjust for population) we find the E.U. within 20% of U.S. demand through the middle distillates and fuel oil, but much lower per capita consumption in light distillates, and other products. Other products are generally lubes, tars, waxes, petrochemical feedstock, i.e. industrial usage, reflecting again our healthier economic position. Light distillates for gasoline though offer a conservation opportunity. Adjusting for consumption differences in gasoline, diesel, and space heating, with consideration given to economic growth, GDP per capita and the land mass difference, a number of ratios become surprisingly similar. Actual total oil consumption is 39.8% greater for the U.S., just as our energy growth coefficient (EGC) is also 38% greater and after adjusting for land mass and per capita GDP, the per capita oil consumption is 34.6% greater. So with those ratios lining up and matching with the economic differences, (I am assuming the U.S. doesn’t mind consuming more oil for higher growth and greater wealth) that leaves only transportation for improved oil conservation. In transportation then even after adjusting for the land mass difference there is evidence we are 30%-35% less efficient. As noted above, a U.S. super-sized mass transit may not be realistic, so I will focus on vehicle fuels. If we look at per capita adjusted gasoline demand, this would calculate to not quite 2 million bls/d of oil consumption to reduce from our roughly 9.5 million bls/d of light distillate consumption.
In conclusion, while on the surface it would appear to offer massive reduction, after a more thorough analysis, to meet E.U. “efficiency” standards without harming our economy, suggests only about 2 million bls/d of oil consumption can be reduced through mileage standards, and mass transit where applicable, roughly a 20% reduction in gasoline consumption. There still remain several questions.
2) Of course supporters of conservation will vehemently disagree with the assessment that our economy can’t become more efficient in production without damaging itself. They will point to the success of the response to the energy shocks of the 1970’s, where the U.S. energy growth coefficient (EGC) did decline meaningfully while we transitioned to a more service oriented economy.
Herein though is what former Fed Chairman Alan Greenspan would call a conundrum. While it is true that our economic growth has increased while our EGC fell, that is only part of the story. A question must be answered: Did we truly reduce our industrial & manufacturing energy consumption per unit of GDP, or merely out-source our heavy industry to lower cost developing nations? Did we really conserve oil, or just shift the energy cost to a different part of the globe where it could be offset by cheaper labor costs?
If we take the refined product history of U.S. consumption from 1965 through 2005, there are interesting comparisons. Between 1965 and 1980, light distillate demand grew 2.2% CAGR (Compound annual growth rate), but from 1980 to 2005 grew at only a 1.18% CAGR, a decline in growth rate of 46%, as would be expected. This is the period of muscle cars fading out as the popularity of Japanese vehicles with lower fuel use became popular.
However, the decline in growth rate of middle distillates on the same two period comparison was 52.75%, the decline in growth rate of other (industrial usage) declined by 67.4%, and fuel oil usage actually declined meaningfully in absolute terms. Clearly industrial oil consumption slowed more than gasoline consumption. While many will claim this is American ingenuity in energy saving technology, a review U.S. government data raises questions.
A comparison with the Federal Reserve Total Index of Industrial Production, seasonally adjusted shows a correlation with the decline in oil consumption. The U.S. industrial production index grew at a 3.65% CAGR between 1965 and 1980, but decelerated to only 2.48% CAGR between 1980 and 2005. I don’t believe anyone would argue that U.S. consumption of manufactured goods slowed dramatically while our population grew during that time frame. The U.S. simply obtained its goods from external rather than internal production. This is shown in records of the Foreign Trade Division of the U.S. Census Bureau.
In the 1960 through 1970 period, the U.S. actually ran a balance of trade surplus in goods, and not until 1984 did it cross $100 billion deficit balance of trade in goods. Since then the balance of trade deficit in goods has accelerated sharply to $1,473 Billion in 2005.
It is at least worthy of review, that the U.S. move to a service economy, our supposed aggressive improvement in energy efficiency, and our exploding balance of trade deficit are actually an interrelated result of merely off-shoring our manufacturing base. Of course, this merely shifts oil demand to a different part of the globe, not representing conservation but just movement to where cheaper labor could offset higher energy costs to mute the inflationary impact.
Indeed, a review of total oil consumption globally shows merely a transitional pause in the early 1980’s (as industry moved from the west to the developing countries and substituted labor for energy) and then resumed the upward growth in demand. This substitution of labor for energy was possible in the oil shocks of the 1970’s-1980’s as there was adequate availability of substitutable labor and spare capacity in oil production via withheld volumes from the market. The current situation, however, sees China and India rapidly industrializing, lessening the pool of available “labor at any price,” and increasing the cost structure of the energy substitute in the factors of production. More worrisome is the lack of spare capacity in oil production as we no longer have withheld volumes.
This time, we are in a true supply/demand balance situation, not artificially caused through withheld volumes. The world also is more uniformly developed and with less ability to substitute raw labor for energy.
Accordingly, faith in conservation as a solution is misguided. It is a necessary but insufficient part of the response to rising energy costs.
”A Locrian who proposed any new law stood forth in the assembly of the people with a cord round his neck, and if the law was rejected, the innovator was instantly strangled.” — Edward Gibbon, ”The History of the Decline and Fall of the Roman Empire”
If Congress had the rule of the Locrians, a people in ancient Greece, it would have been fatal to Sen. Byron Dorgan, the North Dakota Democrat. He recently got 34 colleagues, none of them Republicans, to vote for his measure to punish oil companies for earning profits that, relative to revenue, were unimpressive.
Dorgan’s measure also would have inflicted collateral damage on everyone who buys petroleum products, and it would have injured millions of Americans — many of them currently inciting Congress to smite the oil companies — who do not know that they own oil stocks. Herewith an after-action analysis of a battle that has been fought before and will be again.
”None of us know much about what is happening with respect to pricing,” said Dorgan, disclaiming a competence rarely ascribed to senators. But, quickly recovering from uncharacteristic humility, Dorgan joined Senate colleagues in exhibitionistic indignation about the fact that the five largest oil companies, led by ExxonMobil’s $9.9 billion, had combined third-quarter profits of $32.8 billion.
ExxonMobil, which has more than $50 billion of past profits invested in energy development, made 9.8 cents per dollar of sales, much less than the 21.2 cents made by a company selling another fluid that lubricates American life — Coca-Cola. Nevertheless, another Midwestern populist, Sen. Charles Grassley, the increasingly eccentric Iowa Republican who chairs the Finance Committee, admonished the oil companies to contribute 10 percent of their third-quarter profits to augment existing federal subsidies that help some Americans pay their heating bills. Many of those Americans live in the chilly Northeast and vote for liberals who, in Congress, write this narrative: By blocking much drilling in Alaska and offshore, Congress does nothing to lower the price of oil. Then Congress spends taxpayer dollars to soften the impact of the price, thereby encouraging consumption that raises the price. Then Grassley asks oil executives to join the moral grandstanding by squandering their shareholders’ wealth — diverting it to protect oil consumers from some consequences of their representatives’ irrationality.
The Senate, having flirted with this loopy idea of oil companies tithing themselves, then contemplated a worse idea — Dorgan’s ”windfall profits” tax. A ”windfall profit” is a technical term denoting a profit made by someone else. Americans do not say there was anything windfall-like about this year’s $2.5 trillion increase in the value of their houses.
This year the six largest oil companies will disperse 34 percent of their cash flow — $31 billion — in dividends to shareholders. But such flows can be shrunk by ”windfall profit” taxes. That is explained, with a clarity sufficient even for the dimmest 35 senators, in a study — ”The Economic Impact of a Windfall Profits Tax for Savers and Shareholders” — by Robert J. Shapiro, former undersecretary of commerce in the Clinton administration, and Nam D. Pham, an economist.
Although the real rationale for a windfall profits tax is to allow legislators to strike a histrionic pose, Dorgan’s tax, say Shapiro and Pham, would have produced gross revenue — depending on where the price of oil is in the range between $45 and $60 a barrel — of $18.5 billion to $104.9 billion over five years. But because the windfall profits tax payments would have reduced corporate income tax payments, the government’s net, say Shapiro and Pham, would have been only $8.6 billion to $48.7 billion.
They calculate that 41 percent of oil company stocks are owned by pension plans and individuals’ retirement accounts. Hence much of the tax’s burden would have fallen on current and future retirees, reducing both the market value of, and dividends paid by, those stocks. The cost to all the oil companies’ shareholders, in forgone stock appreciation and dividends, would have ranged — depending on oil prices and inflation — from $21.3 billion to $121.8 billion per year. Shapiro and Pham also conclude that the windfall profits tax would have discouraged domestic oil production and increased U.S. dependence on imports from the Persian Gulf. And from Venezuela, thereby funding the left-wing fascism of Hugo Chavez.
Because the average price of a gallon of gasoline has swiftly plunged from the post-Katrina high of $3.07 to $2.15 (compared with $185.60 for a gallon of Starbucks espresso), the recurring populist fever that always follows oil price spikes has broken. It will be back. Too bad the Locrians’ rule will not be.