Original URL: http://www.theregister.co.uk/2008/08/13/oil_windfall_taxes/

Windfall taxing big oil: how to make the gas crisis worse

Election crowd pleasing = higher pump prices?

By Tim Worstall

Posted in Financial News, 13th August 2008 11:02 GMT

There's something about the oil business that turns even intelligent people into frothmouthed loons: they're raping the planet, shafting Joe Sixpack or, from the other side, insisting that the drill in every back yard is the very definition of America. I realise that in the middle of an election that the small still voice of reason isn't going to get much airplay but let's give it the old school try anyway.

The first and absolutely most vital thing we have to remember about the oil business is that it is big. Really big. That's solar system type big where this bowling ball is the Sun and that guy four blocks away with the peanut represents the earth to scale sort of thing. Yes, it's true that Exxon's recent quarterly profits were, at near $12 billion, big. It's also worth noting that turnover was $138 billion, giving them a margin on sales of 9 per cent: which isn't really, anything much to write home about. Shareholder's equity (i.e., the capital employed within the business) is north of $120 billion: the reason the profits number is a huge one is because the business itself is a huge one.

So what 'windfall' is this?

We also need to remember that these are the numbers at the very top of the cycle. Oil has gone from being worth less than spit to a figure that has achieved the almost impossible, reducing the amount Americans drive, in around a decade. Even with this top of the cycle aspect the oil business as a whole is only the 60th most profitable sector in the US. So where does all this fury that there must be windfall taxes come from? Is it simply that people don't realise how much money is used to make those profits? That big numbers confuse people? Or are we just tied up in the usual election year nonsenses?

The second thing we need to know about the oil business is that it already pays a great deal in taxes. While these numbers can be argued with (for there are foreign taxes in there too), Exxon paid $32 billion or so in taxes in the quarter it made the $12 billion. Indeed, you can put it another way. Exxon alone pays more in income taxes (or at least will, this year) than the bottom 50 per cent of all taxpayers in the US.

Just so that I'm not accused of being entirely in Exxon's pay, British Gas (which pumps the gas out from under the North Sea) has the highest tax rate of all companies in the FTSE 100 (think London's version of the Dow, ish) at 57 per cent, and it pays 75 per cent profits tax on its actual gas extraction.

So there's at least one thing to ponder: given that they already pay hefty taxes, why is there this screaming that they should pay more?

More taxes, higher prices

We could and should go further of course. People are seeing that the prices they pay for energy are going up and that will of course trigger some disgruntlement. But why they should then call for higher taxes on the producers boggles the mind. Given that the companies (I deliberately leave out the effects of the governments and companies which make up OPEC) are operating in a competitive market these prices aren't being caused by either collusion or gouging: they're being caused by supply and demand. More people want to use $30, $50, $90 oil than there is oil to go around at that price so markets do their magic thing, prices adjust and supply meets demand.

So, to lower those prices we'd rather like there to be either an increase in supply or a reduction in demand, yes? An increase in supply is going to come from someone, anyone, actually going out and finding more of the blessed stuff, or, if you want to be all technical about it, how to pump up more from the reservoirs than we already do (we never actually do get everything out of an oil or gas patch, although we've been getting better. We used to get maybe 10 per cent, now the best run fields get maybe 40 per cent). But both of these things cost money to do. So, umm, taking more tax out of the profits of those who look for more is going to help in what way? These cries for higher taxes seem to be missing the most basic point about how markets allocate capital.

Simply put (and the real theory has a number of caveats) there's a general idea of a natural rate of profits. This is risk adjusted though, so that people in riskier ventures do make more money until they don't. If people are making more than this (so called "excess profits") then all those other greedy capitalists out there will see this, after a time, at least. So they'll invest more of their own money in that sector, making that extra cash. This will, again in time, increase the supply of whatever it was making that extra, and thus bring prices down and profits back to that natural level. Writing here for a technical site the most obvious example would be the PC business: there are so many players now that it's not really where you want to be to make those big profits - while it most certainly was way back when in the days of only a few box makers.

So theory (and that theory has been around a long time, Adam Smith remarked upon it when he published in 1776) tells us that excess profits attract the competition that wipes them out... and do so by lowering the prices of those things which were in short supply. Which is, I think, exactly what we all want to happen, no? Let's make gas cheap again! So confiscating those extra profits will mean that first, no one making them has the money left to look for more and, secondly, no one is going to dive into the industry if they think that they won't be allowed to keep the profits they might make.

So, umm, a windfall tax on profits means that, umm, gas prices will stay higher in the future than they would have been without the tax. Which, if I've understood this thing properly, isn't in fact what the general public is baying out for. (Please note that I am indeed leaving out the Green arguments about fossil fuels: I don't think they've got much to do with these cries for higher profit taxes anyway.)

Now the letters page of The Guardian might not be all that well known over the Pond, just think of it as a home for all those ideas too stupid to make it into The Nation or Prospect. Like this one. Yes, it is (to the practised English eye at least) the usual bunch of nutters calling for that, as I argue above, entirely silly idea of a windfall tax on the energy companies. I'm not surprised to see it there, I'm not surprised at the level of intellectual effort that has been avoided by their not getting to grips with the realities of markets.

However, I am in fact rather surprised by this from Obama:

"Repeating his call for a windfall profits tax on companies like Exxon-Mobil, which he singled out in his speech on Monday, Mr. Obama said he would use part of the tax to provide consumers with an 'emergency energy rebate' of $1,000 per family."

I know the man is more intelligent than I am (I'm not going to be offered a Chicago Chair, not in this lifetime) so why is he offering something so blindingly stupid? Yes, I know, politics is all about pandering to the prejudices of the populace, but really, this is going much too far. As I said here earlier, both parts of the plan are silly and I had hoped that he had been misquoted:

"But rebates on utility bills? That's nonsense: what we've now got is a large and complex (and expensive don't forget) system whereby we discourage people from using energy by taxing it and then encourage them to use energy by subsidising them to do so. Quite insane."

Apparently not: something of a pity of course. As a foreigner who gets elected in the US is nothing to do with me but I have to admit that I wasn't exactly against an Obama victory.

Having said that these plans, whether they are being proposed by British twits or an American Presidential candidate, are silly, I'm left with only one important question: who are the fools here?

Is it that those politicians, with their groups of extremely expensive and presumably highly intelligent advisors, are not intelligent enough to see that their plans are entirely counter-productive? Or is it that they know they are, but think that we the voters are too stupid to understand it ourselves? ®

Tim Worstall knows more about rare metals than most might think wise, and writes for himself at timworstall.com, and for The Business, among others. He is a Fellow of the Adam Smith Institute.