Why Not Just Steal the Oil Companies’ Money?

Any answer I would give to that question would be, to put it charitably, non-technical. But my friend Bob Cunningham, who has worked in and around the energy industry for a number of years, sent us a more scholarly explanation, which I’m reproducing in full:

There was a great article in slate.com last week by Jacob Weisburg on how oil price increases can drive otherwise normal, intelligent people completely insane, not least the politicians who do or should know better — they become stunningly stupid in the face of seemingly intractable economic issues. Unfortunately, another well-known Slate contributor, Michael Kinsley, did nothing to improve this situation with his article providing a justification for an “excess profits” tax on oil companies. http://www.slate.com/id/2140695/

As one would expect from him, Kinsley’s argument is subtle and sophisticated — but not sophisticated enough to be right. Kinsley argues that the run-up in global crude oil prices amounts to unearned income for the owners of oil already in the ground in the U.S…..nature produced it, and, generally speaking, production or extraction costs have not materially increased and yet the price is dramatically higher. Here is the essential rationale for an “excess profits” tax:

Nature produced the oil and charges nothing for it….Ordinarily, we shouldn’t want the government to decide when profits become ‘excess.’ But the case of huge profits from the run-up in oil prices is different…it is unusually clear that these profits have nothing to do with productivity. Diverting them to the U.S. Treasury would have no effect on the incentive to extract more oil from American ground.

It is, therefore, a “free lunch” to tax away these “excess profits.”

There is a name for this argument. It could be called “naive George-ism” after Henry George, the 19th century auto-didact who advocated taxing only land values, because nature made the land, it cannot be created or destroyed, so any “profits” on land are unearned and confiscating them cannot affect the economy as a whole.

For oil or any other extractive, non-renewable resource, however, the difference between the “earned” profit and the market price is not “excess profits.” In fact, in energy economics it is not considered a “profit” at all, but a cost! A cost is not just what you write a check for–.it is primarily what you have to give up to get something else you want. What you give up when you produce a barrel of oil TODAY is the opportunity to produce and enjoy its value TOMORROW. Today’s price of a barrel of crude oil must include, then, in addition to direct extraction costs, the opportunity cost of having one less barrel tomorrow — when the oil will be worth MORE because there will be….one less barrel left in the ground.

This is referred to as “user cost” and has been well understood in oil economics for 75 years. It is just as real as the checks written for the labor, utilities and materials required to “extract” the resource. And it must be recovered in price — or else the oil should be left in the ground.

And, critically, note that it doesn’t matter WHO owns the resource — if Chuck Schumer or the U.S. government itself owned ALL the oil they would still face the necessity of recovering the same “user cost” as ExxonMobil or a rancher with 10 stripper wells!! Indeed, when the government leases oil rights, royalty schemes are devised precisely so an estimate of the “user cost” can be recovered and the resource extracted so as to optimize society’s wealth.

What happens if you tax away as “excess profits” the resource owner’s user cost? Kinsley claims there would be “no effect on the incentive to extract more oil” and so presumably social wealth is not diminished. But is this true? And is it the entire story?

It might be true for already discovered resources; theoretically, the resource owner might be as well off producing as not, since under Kinsley’s scheme he does receive “fair” profits plus direct costs. But there is also the possibility that if the new tax regime were thought not to be permanent…and is it realistic that such a draconian scheme would be?…capital could “go on strike,” as it were, and owners could simply leave the oil in the ground and refuse to produce…and the large integrated companies, especially, could simply buy their crude — for cash at the full global market price — from foreign producers!

On the other hand, if the tax regime WERE thought to be permanent, the incentive of resource owners would be to “drain America first” by pumping out as much as possible as fast as possible, since they themselves would not be able to recover the opportunity cost of the oil’s value in the future. This is clearly suboptimal, and, indeed, unsustainable — because it would in essence be acting as though today’s consumption would NOT induce increased future scarcity; in other words, that the “user cost” is zero.

Either way the incentives to resource owners of such an “excess profits” tax regime are perverse. The justification of this “excess profits” scheme, in addition to getting wrong a fundamental feature of non-renewable resources, is insidious as well. It amounts to de facto expropriation: since the oil companies have already “sunk” the discovery costs and found the oil, and the value can be taxed away with impunity, the resource owners are placed in the same position as if they had not owned the resource in the first place.

Moreover, it would essentially be inviting the oil companies to exit the business of exploration and development of NEW oil resources anywhere the U.S. government could tax them. An “excess profits” tax implicitly assumes that we have already found all the oil in the U.S. that we will ever either need or can find — somewhat of a self-fulfilling prophecy since the incentive for exploration and discovery, if not production from existing resources, would certainly be substantially diminished.

An “excess profits” tax regime as advocated by Kinsley is an assault on the very concept of private property in natural resources, would entail massive government control of this sector of the economy, and would not be without damaging consequences. But here’s the question I have: I wonder if Kinsley wants to apply the logic of neo-George-ism to any real estate he may own….after all, what did he do to earn any capital gains in the land values? Any run-up in the value of his property is “excess,” isn’t it?

Responses

Books to read from Power Line