Energy Prices, Offshore Drilling, and an "Excess" Profits Tax-Becker

Increases in energy prices sharply accelerated during the past year, as the price of oil more than doubled, and gasoline prices in United States rose by 25 percent. Responding to these price increases, Senator McCain and President Bush have called for an end to the 27-year old federal moratorium on offshore drilling for oil and gas in US waters, while Senator Obama supports a continuation of the ban. McCain has also indicated that he is reconsidering his opposition to drilling in the Artic region of Alaska. In another response to the energy price boom, Obama has proposed an excess profits tax on oil companies, while McCain has come out against such a tax. What does economic analysis contribute to an evaluation of these proposals? Supporters of a continuation of the moratorium worry that offshore drilling and oil leakages will kill many fish, and damage beaches and other coastal areas. These are potential risks, but whether to continue the moratorium involves a balancing of the advantages of drilling against environmental and other risks. These risks have not been affected by the rise in energy prices, but the benefits from drilling clearly have increased. Additional oil (and gas) from offshore drilling would lower US spending on imported oil, and thereby reduce the transfer of wealth from Americans to other oil and gas producers. Larger domestic energy supplies would also improve energy security in the event of a disruption in the supplies of oil and gas from major producers located in places like the Middle East and Nigeria that have had terrorist attacks on oil production facilities. Even if offshore drilling started tomorrow, it would take several years before actual production began since construction of platforms in deep water and installation of equipment take time. The value of ending the moratorium now would depend not on energy prices and risks of disruption this year or the next, but on the situation beginning in several years and extending over the following decade. Some oil specialists are predicting a rise in the price of oil to $200 a barrel during the next few years. I have argued previously why such a large price increase is unlikely (see my post on May 11); indeed, oil may very well retreat from its present level of over $130 a barrel. Still, as long as world GDP continues to grow over the next decade at a sizable pace-which is likely- the price of oil will remain far above what it was in the 1990's. This means that the financial and other benefits from offshore drilling are likely to greatly exceed the benefits at the time the moratorium was imposed, for oil was then much cheaper even in inflation-adjusted terms. The increasing share of imports in the oil consumed by the United States, and the rise in oil prices, explain why the value of imported oil rose more than five fold since the 1980s. This is why cost-benefit calculations of whether to end the moratorium and allow offshore drilling have shifted in the direction of allowing drilling. Although the risks of offshore drilling are much harder to quantify than the benefits, I believe the shift in the benefit-cost ratio has been large enough so that the time has come to allow drilling. Norway and Great Britain, to take two examples, have allowed drilling in the North Sea for many years without suffering major environmental damage. To be sure, in the end oil companies are the ones who have to decide whether the gains from drilling are worth the risks, including lawsuits if there are damaging oil spills, but these companies seem eager to start drilling offshore. The proposed excess profits tax on the earnings of oil companies would discourage the search for additional oil, and hence would have the opposite effects on this search from a relaxation of the moratorium on offshore drilling. An excess profits tax that is expected to persist for many years discourages further exploration for oil simply because much of the profits on new oil production would be taxed away. In 1980, President Jimmy Carter introduced a windfall tax on oil companies to prevent them from profiting a lot from the high price of oil due to the Iran-Iraq war. An evaluation by the Congressional Research Service, a think tank that provides reports to Congress, concluded that the tax significantly reduced domestic oil production and raised oil imports. Disillusionment with the tax led to its abandonment in 1987. Yet the lessons from this fiasco have been forgotten, for since the post-Katrina rise in gasoline prices in 2005, members of Congress have made regular attempts to introduce legislation with a sizable excess profits tax on oil companies. Even those Americans who worry a lot about global warming and other global pollution form the use of oil should be reluctant to discourage oil production offshore or elsewhere by American oil companies. Lower production by American companies would cause a rise in the world price of oil. Moreover, increased production by other countries would tend to offset reduced production by the United States, so that the effect on global warming and global pollution is likely to be modest. However, the increase in wealth transferred from the United States to the Middle East, Russia, Venezuela, and other oil-producing countries could be substantial.

Comments

[Anittah Patrick]

I wonder if the moratorium in conjunction with rising oil prices has encouraged an attempt to research more efficient energy extraction techniques out of oil or, more interestingly, alternative energy sources. Is allowing such drilling simply delaying the inevitable need to find new energy sources, or, conversely, is the fact that the moratorium exists a way for folks to drag their feet on looking for new resources?

Sure, we know we'll run out of oil someday, but if we know we have a few buckets tucked away in the sofa cushions ...

[A student of Economics]

The US consumers 25% of the world's oil but has 3% of its oil reserves. We reached peak oil production in the US back in 1970.

Thus, the notion that draining America's reserves more quickly is the solution to our problems is clearly inadequate. With oil prices set on world oil markets, draining our reserves faster will not appreciably affect world oil prices.

Fortunately, we do have a much more powerful alternative: reduce our demand. Many of the costs of burning oil are not born by those who purchase the oil. Pollution, congestion, national security risks, climate change, etc. are all negative externalities. Textbook economic theory shows that we should tax oil to address these problems.

If we tax oil much more heavily, the market will lead consumers to consume less oil and entrepreneurs to develop alternative energy. They will do this in literally thousands of ways, many unimaginable to Becker, Posner or me. In turn, the revenues can be used to reduce payroll taxes, thereby increasing incentives for work and reducing inequality (payroll taxes are regressive).

The attention to more offshore drilling is largely a distraction. "Drain America Faster" is no energy policy.

Becker and Posner should be calling loudly and frequently for replacing much of our payroll taxes with oil or carbon taxes.

Tax pollution, not work, and let the market take it from there.

[rogue]

Perhaps there should also be a mechanism to distinguish oil use for indistrial and public use vs. individual private use. Industrial use that benefits a lot of people has a more attractive cost-benefit ratio than private use i.e. for private vehicles, homes, etc. More tax should be levied for the latter's use.

[Alternative]

While I appreciate Becker’s comments on the disincentives caused by an increase tax, subsidizing profitable companies is poor public policy unless we are receiving fair value for those subsidies. Why do oil companies deserve preferential tax treatment, subsidized distribution costs, and the ability to ignore many of the environmental externalities? If prices rise without the subsidies, do be it. Let the taxpayers keep the money and they can decide how to spend it.

[David Heigham]

Joe Stiglitz, who is usually to be found these days talking politically umwelcome realities in a loud voice, has been recommending an excess profits tax on oil companies. He should kick himself. That is just as stupid as the governments that have reacted to food scarcity and consequent high prices by levying various forms of tax on farmers excess profits. In either case tax will cut future supply; not an obviously sensible reaction to increasing scarcity.

As for off-shore, Alaskan etc. drilling, surely the oil companies can now accept substantially higher costs of keeping their operation clean? New drilling permissions should be accompanied by tougher environmental regualation.

[noname]

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[Chuck]

To what extent is Barack Obama taking the advise of your colleauges that are advising him?

[Chuck]

To what extent is Barack Obama taking the advise of your colleauges that are advising him?

[Chuck]

To what extent is Barack Obama taking the advise of your colleauges that are advising him?

[jack]

A student of Econ, FWIW I'm giving you an A for the day! "Alternative too!"

"While I appreciate Becker’s comments on the disincentives caused by an increase tax, subsidizing profitable companies is poor public policy unless we are receiving fair value for those subsidies. Why do oil companies deserve preferential tax treatment, subsidized distribution costs, and the ability to ignore many of the environmental externalities? If prices rise without the subsidies, do be it. Let the taxpayers keep the money and they can decide how to spend it."

rogue sez "Industrial use that benefits a lot of people has a more attractive cost-benefit ratio than private use i.e. for private vehicles, homes, etc."

........... I'd need to see more evidence on this one. For example there seems low energy industrial uses, say a truck getting 5 mpg (or about $1/mile) to move 40,000 pound payload. Were there an increased tax it would amount to little even on heavy, low value freight. So no biggie. For Alcoa (aluminum is virtually energy turned into a solid) the tax would be an added burden. But! very little aluminum disappears once it's created and we've hardly begun to recycle aluminum. Higher energy prices would spur more recycling. Beneficial I'd think. Nope..... if we're going on a diet, I see no reason to exempt industrial uses; perhaps next time I fly over the sun belt states I'll see lot of those flat, black, factory, office building and mall roofs recoated in reflective white?

David: I think we're favoring excess profits taxes because the profits are excessive due to something being awry in "the market". I think the American spirit cheers for those who make a profit by driving down costs, ala Intel, Dell or by inventing a Google or Windows and there has been no suggesting of levying an excess profits tax on them. I'll predict that we'll soon see in depth price-fixing investigations and perhaps, after this admin is gone, a reawakening of our long slumbering Anti-trust Division and some not so surprising answers.

...As an Alaskan I shouldn't complain and even say "Thanks!" to all those anteing up, as the small slice our state gets from oil royalties has created a $5 billion surplus this year, with the Gov proposing to send us all $1200 to ease our own energy cost burden, however I do NOT see why oil that was profitable at $18 in 2000 should command an extra $100 or more, though $40 - $50 might be reasonable under the concept of getting replacement cost/value for existing reserves, and our (world) economy might be able to withstand $70 but at $130 we have not even begun to experience the dramatically negative changes such gouging will create.

[David Heigham]

jack

US energy markets, and quite a few elsewhere, have smelt like some fresh and up to date anti-trust action was overdue since before prices shot up. However the anti-trust agents will have to realise that nowadays de-facto agreement on the price margins to be charged takes such ostensibly innocent forms as, e.g., conferences arguing about the rational set of assumptions to run in models.

But the reason why prices shot up is that both supply and demand for oil are pretty inflexible in the short term. A bit more demand and/or shortfall in supply than the market forsaw will always mean much higher prices for the producers - for now.

What is wrong about excess profits tax is not that a one off tax would do much damage. What does the damage is oil producers and distributors cutting investment plans because they fear that next time they make high profits they will be hit by another (and another, and another) "one-off" tax. That results in lower supply for all the forseeable future. And given the frequency with which people ask for such taxes, the fear would be rational.

[Jeffrey]

This is an interesting view, and it looks at the issue from a different angle than I had previously thought about.

This underscores our country's lack of a coherent energy policy. Energy spending, taxes, and environmental issues as political tools rather than a cohesive whole which could be applied to effectively manage the whole situation, not just small hot-button topics.

[Jefe]

The windfall tax is a bad idea. However, I the inability to calculate the risks of offshore drilling make it incorrect to allow such exploration. As pointed out, it will be years before any benefit is had, and due to our (most likely) quite low share of global oil, those benefits probably won't do much to oil prices anyway.

In addition, this is all in the assumption that lower oil prices are actually desirable. Not everything that makes sense economically also makes sense socially and politically. Not only would decreasing consumption lower prices, it would probably also make us a healthier society.

[Jack]

David, I'd agree that anti-trust action would be complex as a part of the game is that of having a futures market for them to hang their hats on and that there's little we can do about the OPEC cartel's role. But, Congress is looking into the workings of the market and finding a number of "curious" practices. It is good, after all, for a market to price goods accurately and provide a measure of stability, rather than be a means for speculators and manipulators to make a bundle while pushing prices well beyond what is reasonable.

I'd disagree with "But the reason why prices shot up is that both supply and demand for oil are pretty inflexible in the short term."

.... well, let me reword my disagreement. There is no shortfall of supply that justifies prices shooting up at the rate they have over the past couple of years. On the other hand, given, a partially rigged market, the combo of somewhat tight supply and Bush's "tough talk" against Iran that could shut down that nation too, along with the closure of the Strait, could combine to create a "can't lose" psychology among "traders" and an upward slope that mangers of mutual funds and sovereign funds can't resist. The game may be much like the Hunt Bros attempt to corner the silver market back in the 70's.

But while silver soared and fell with few being involved an oil bubble going to $200 will wreak havoc both for individuals and the economies of the world.

As for your fears that exacting an excess profits tax from the producers who have had exorbitant profits unrelated to their efficiency in finding and producing oil will make them timid, I doubt it. Instead they'll continue to go out looking for finds large and small with the knowledge that should one come in like Prudhoe Bay for them, no one will be chasing that company down for an excess profits tax.

A complex mess to be sure!

[Rodney]

I'm puzzled by your statement that "lower US spending on imported oil" would "reduce the transfer of wealth from Americans to other oil and gas producers." Importing oil obviously involves a transfer of one form of wealth from Americans to others, but isn't there a corresponding transfer of wealth from others to Americans in another form, namely, the oil itself? And assuming the transactions are voluntary, doesn't it follow that there is a net increase in wealth, shared by both parties, not a decrease in American wealth, as your statement seems to imply? Or am I reading you wrong?

[Andy]

It’s $8.9 for a US gallon in the UK so can your whole country stop crying please…

[Don P]

To change consumption behavior - the only workable solution, tax on gasoline is necessary but must be a zero sum game for the average Joe...

Based on the fact that average family drives about 20000 miles a year in a 20 mpg(actual mileage) car = 1000 gallons -

$2000 April 15 Federal income Tax rebate for each family
Start April 16 with $2.18.4 per gallon Federal Gasoline tax.

Get the money up front and may use the money to buy a higher mpg vehicle.
Walk to work - make $2000
Drive a Prius 20000 miles a year - make $1000
Drive a Hummer 5000 miles a year - make $1000
Drive a Hummer 20000 miles a year - lose $2000.

The Federal gas tax has been stuck at 18.4 cents per gallon since mid 1990's when gas was under a dollar - so this is really a return to previous rates and doesn't bring us to World parity in price at the pump.

The tax is really progressive in that:
The rich have more cars boats planes and other gasoline toys

The rebate will selectively benefit the less wealthy who tend to have older smaller cars and often can't get a new car unless they had $2000 for a down payment.

Everyone thinks they get better gas mileage and drive less than they do - so will pre-calculate this proposition favorably.

Again - conservatives will like the idea of use tax as opposed to income tax.
Law and order types will like the fact that those who don't file will not get any benefit.
Anti -illegal immigrant conservatives may be smart enough to notice that it will put significant pressure on undocumented denizens - though I suspect the effect will be very small based on their limited driving.

Business can have the rebate (but not more than $2000) only against actual gas receipts - otherwise sham claims.
Business will also benefit as Diesel would not be taxed and more should be available as gasoline use decreases and more crude in made into diesel and likewise into jet fuel.

Phase in may be necessary to sell this but it will diminish the possibility of using the rebate to buy new technology.
The car companies need to and could benefit and the idea of trying to tax oil company profits will become moot.

The State and the Nation could use less wear and less congestion on the highway system.

This brave step would increase respect for the ability to sacrifice the Americans have shown in the past with rationing and sacrifice in the wars and ability to come together for the common good as during the depression

[neilehat]

Rodney, Really! The Trade balance has nothing to do with "wealth" National or otherwise? Fascinating...
I wouldn't put much stock in the Liberty Fund; not even withstanding it's "Mission Statement". Or it's "Concise Encyclopedia". As for Smithism (both real and imagined) may I present for your reading pleasure and illumination, Henry Carey's, "The Harmony of Interests, Agricultural, Manufacturing and Commercial".

[Jack]

Rodney: Exactly! Just like a couple of farm kids who've inherited a nice spread they can party long into the night spending a lot more than they get from the sale of their crops. All they have to do is either borrow against the farm, its machinery or sell off the back 40 every once in a while so their "current account" balances nicely.

Good gawd! Where do you guys come from? Do you have a "theory" as to why our dollar has lost so much value vis a vis virtually every currency not pegged to the dollar??

[A student of Economics]

Direct Link:
Nice post.

One small tweak:

I would just drop the businesses from getting the rebate altogether. They costs of the tax all go, eventually, to humans (customers, employees, owners) so you only need to rebate to human tax payers. The math would be to divide the total gas consumption in the country by the total number of human taxpayers and that's your rebate amount.

[Jack]

Rodney: Interesting. Despite the "incoherence" of my farm analogy it appears that you got precisely the message I intended.

And yes, if you gathered that the concern is not only the trade deficits of the past and present but the increase in the size of the future deficits, that would be accurate as well.

It's economically cute and even a bit of a fad these days to claim that we live better for running deficits while those "fools" over there get only increasingly worthless script for their efforts, and that "after all most of them come back eventually to buy, remaining, factories, toll roads, buildings, and the "back 40" so the current account "sort of" balances with the rest being reflected in a dollar worth only 1/900th oz of gold or more importantly 1/144th bbl of oil.

It's not my conclusion or opinion that this act is not sustainable but that of the outgoing Gspan who deemed it "unsustainable" and pointed out that the assets purchased with surplus dollars from our deficit spending would themselves be a conduit returning yet more dollars to the foreign owners in the future. ie. it it THEY building a "retirement fund" with we, their serfs providing the funds; most likely by ramping up the selling of the back 40.

And of course the "reverse mortgage" is designed so that one can live well for a time while spending their lifelong savings; a viable choice for an aging person but surely not one for a nation.

(Though it has been clever of the baby boom generation to consume over $12 trillion more US government services than they paid for and leave that debt as well to the young and not yet born. Sort of a "reverse mortgage" on that we never had, eh?)

IF we were borrowing to invest in a brighter future as was the case in America's developmental years when our GDP growth out-paced other nations and gave us our far higher standard of living I'd be all for mortgaging the back forty, but truth is they are graduating more engineers, investing higher percentages of their earnings into R&D and saving at much higher rates. I'd say it's time, not for us to work harder as there's not much left in that well, but to work a LOT smarter. Do you disagree?

As for the grocer? Yes I "run a deficit" there and to be sure, despite rising costs, still provides food for our table more cheaply than I could grow it at home, but typically I run a surplus in my other endeavors so that my current account really does balance; a good thing too, as responsible bankers rarely offer loans for current consumption......... unless they can attach a valuable asset.

BTW it's been a while since I formally studied Econ and I wonder if they're teaching the kids that it's a sustainable model to borrow money from "ever increasing" home prices, sell each other fine cuisine and lattes, importing most of our oil, and ignore a trade deficit that's 7% of GDP along with the soaring federal deficit? Is the fall of the dollar from parity with the Euro to 100/150 just a "ho-hum" in the "class room" these days?

[neilehat]

Rodney, Take a close look at the dates (what dates? there is only one) on that budget (1991), where are the reports on say 1973 to 1990 and 1992 to the present? A one year analysis does not a trend make. That's statistics. Simple accounting states that if the debit column is greater than the credit column, a deficit and loss has occured. Unless of course you're Arthur Anderson, Enron, WorldCom, Bear & Stearns, U.S.A., etc. Full faith and credit, not anymore.

If you can't make the connection between "mission statement" and actions I can't help you.

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