Strengthening Constitutional Self-Government

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Lots of Gas in Washington

A few Republicans have joined the bandwagon for the economically illterate idea of imposing a "windfall profits tax" on the oil and gas industry. But lo and behold, guess who makes the largest windfall off gasoline sales? The government. According to this study from the Tax Foundation, between the years 1977 and 2004, the government has collected $1.34 trillion in gasoline taxes, while the combined profits of the oil companies was $640 billion.

Meanwhile, even as gasoline prices are starting (predictably) to decline, natural gas prices look to stay very high through the winter. The Argonne National Laboratory issued a report entitled Environmental Policy and Regulatory Constraints on Natural Gas Production that identifies more than 30 different laws and regulatory regimes that have put off limits at least 100 trillion cu. ft of natural gas in the United States—a 20 year supply at current rates of use. Instead, we’re soon going to have to start importing natural gas from you-know-where. (Hat tip to Holman Jenkins’ column in today’s Wall Street Journal—not available to non-subscribers—"Something to Think About While Shivering in the Dark.")

Discussions - 6 Comments

Mr. Hayward:

I have been confused about this issue. Hoping you can explain it to me. Everything I have read indicates that profits went up, and by a lot. I can understand prices going up in relation to costs, that makes sense, it would result in the same amount of profit being made, but it does not really make sense that profits ought to dramatically increase. Increased profits would indicate they charged more than the increase in costs, and in fact charged a lot more than they were accustomed to making (in terms of profits) in the past.

Can you offer some economically justifiable reason why profits increased so much? Did profits increase because of increased risk: prices fluctuated so much that companies had to make more in order to cover themselves if gas spiked? Just curious if you know the rationale, I have not read anything attempting to justify it yet.

If I had to guess, I would say that oil and gas companies have aligned with the EPA, etc. in order to prevent building of independent (non-established company) refineries in order to prevent entry into the market. Obviously, this cannot not be allowed. If we have to have an EPA, it ought not to be captured and used as a means to limit competition.

A sensible question. Partly this is a bit of an accounting phenomenon. Oil companies always have huge profit increases when prices spike because they have a lot of oil in inventory they bought or contracted for months and even years before at much lower prices. ExxonMobil, for example, may be paying for some oil today at a price they contracted for two years ago, at, say, $35 a barrell. In this case they will make out like bandits. But if the price of oil stays permanently high, what happens to quarterly profit a year from now when their contract price rolls over to current market prices? Thus one should keep in mind the principle of "replacement cost," i.e., what is it going to cost to replace in your inventory the barrell of oil you bought for $40 a yeart ago but will not cost you $60 to replace? Their profit will shrink over the long haul. In fact, ExxonMobil stock is down $10 a share in the last six weeks, which should tell you something. Within two or three years it is certain that oil company profits will return to a more normal range, even if market prices for oil stay high.

The other reason for huge profit spikes is that the average cost of the oil ExxonMobil and others produce themselves is probably about $15-20 a barrel, or maybe a little less. When the market price rises like is has the last year, then they will make a huge profit on their own production. However, bear in mind again that there isn’t a lot of $20 per barrel oil easily found, and although the higher price will make more oil fields economically viable, the profit margin on those new fields will be in the normal range over time because their production costs will be high. And if the market prices falls back below $30 a barrel (which many economists predict over the next five years) the oil companies will be stranded with a lot of high cost wells they will have to cap. It has happened before: look at Texas and Oklahoma in 1985.

The refinery question is a little more complicated. We actually had too many refineries back in the 1970s and 1980s. Believe it or not the government actually had refinery subsidies! Reagan got rid of those--as well he should have--and the refining industry was able to retool and expand output of existing refineries to meet demand just fine. But now we have reached the limit of that. I am sure you are right that existing refiners like a constricted market, just as theylove having the EPA mandate 70 different blends of boutique gasoline (that aren’t needed any more) for which they can charge premium prices. This is a perfect "bootleggers and Baptists" coalition between refiners and environmentalists, if you are familiar with the public choice literature on this great analogy. (Bootleggers supported teetotaling Baptist politicians in the South, because they were great for bootleggers’ profits. In this case, the environmentalists are the Baptists, and the refiners are the bootleggers.)

Thanks for the answer. I thought the high profits could be justified by the risk of being stuck in a losing contract, but was unsure how far out they contract.

Has anyone mentioned this reason for high profits? I do not think high oil company profits will become a politicla issue because gas prices are dropping. If they were still $3 a gallon it would be an issue, but not now.

Does anyone ever consider building more refineries? I have heard nothing about this, I just keep on hearing people say we need more. This talk happens every spring and summer but nothing is ever built. I am pretty certain Bush could get the EPA to relax regulations, and although some people would complain about environmental impact it will be a very small minority, because most people want cheaper gas. The fact that Bush won’t pressure the EPA for such changes makes me suspicious.

Ah, excuse me Steve, but the first mechanism you cite as an explanation for high gasoline prices would have the effect of dumping lots of cheap oil on the consumer market (old $35 per barrel oil). Shouldn’t that have the effect of lowering the price (you know, supply and demand)? Of course we are assuming the lack of price-fixing, which I have to wonder about.

Dain:

Your comment has confused me. I am unsure whether you are referring to raising prices as a way of compensating for risk, or the lack of refineries?

If you mean lack of refineries then building more of them would lower gas prices. Oil could be $5 a barrel, but cars cannot use crude oil, it has to be refined. Obviously if you have a limit on the amount of refineries the price of gas is somewhat independent from the price of crude oil (in terms of it being cheap, obviously it will respond to crude oil price increases). Because of the artificial limitation on refineries (due to misuse of the EPA) there is a point when gas cannot get any cheaper because supply has maximized. Furthermore, lack of competition allows the few players who operate the refineries to be less competitive and efficient in their production. There is no incentive for them to be, and plenty of incentive for them to justify their costs by avoiding cost cutting measures.

Clarify what you mean and I will try to explain what I think is going on.

The first mechanism Steve mentioned was selling $35 oil at $70 prices, which accounts for this massive profit. Well, to realize that profit you have to sell it, correct? So...that means it had to be refined, which doesn’t cost more because a few refineries are shut down, right? Essentially, we have oil companies charging top-dollar during a national crisis. That’s what people are saying, and it looks to me like they are correct. The oil companies certainly didn’t pass those savings on to the consumer. I’m just trying to understand how Steve’s logic exonerates the oil companies.

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