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Thesis & Antithesis

A critical perspective on energy, international politics & current affairs

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greekdefaultwatch@gmail.com Natural gas consultant by day, blogger on the Greek economy by night. Trained as an economist and political scientist. I believe in common sense and in data, and my aim is to offer insight written in language that is clear and convincing.

05 November 2005

Windfall tax on oil

To bridge the discrepancy between high oil prices and the inability of governments to reduce them, populist politicians have turned to the idea of a windfall tax on “excess” profits in the oil industry as a way to placate voters and reassure them that government is not sitting idly by as the price on the pump goes up. Pete Domenici, a Republican senator, said: “oil companies have failed to tell us and show us what they are doing with these profits that justify them” (1).

Windfall taxes are generally a bad idea. As the Financial Times put it, “What company would invest in oil exploration knowing that if prices collapsed, it would have to bear the cost, but if prices soared, government would grab back the profits?” (2). But there is a legitimate question that can be raised about the utility of windfall taxes.

The Financial Times explains it this way: “The trickier question is whether governments should tighten the tax regime on national oil reserves in the light of sustained high prices. In principle, governments should seek to capture the economic rent from oil reserves, over and above the risk-adjusted cost of capital. The higher the oil price, the higher the share of rent in corporate profit, so the higher the tax rate should be” (2).

I would give it a different slant: the oil business is cyclical and it has been so forever. The oddity is that oil companies have an incentive to keep it cyclical: sustained high prices compensate for past low prices; and when prices rise, companies have enough cash to invest in new projects that increase supply and help bring down the price. But the longer the tight market lasts, the more money they earn.

In other words, companies have an incentive to withhold investment until prices rise very high—the reason is that they can earn more in a tight market than in a glut. Now, most companies value projects with a $20/barrel price in mind; if the average price during the value of the project exceeds the projected price, they earn over and above what they had in mind. This is what the Financial Times means when it talks of rents.

Put this in the context of windfall taxes, and the case is this: windfall taxes would reduce this perverse incentive and force companies to make more timely investment since they would know (with certainty or not) that their “excess” profits could be taken away from them. The question to ask now is whether this syllogism is sound.

My sense is that it is not. For one, it assumes that companies act in unison, which they do not. Even if all companies have an incentive to maintain a tight market (which they do not necessarily because in the long run this could force consumers away from oil), individual companies have an inclination to free ride and capture these rents.

But the more important reason against this syllogism is OPEC: most of the new projects to balance the oil market have to come in places beyond the reach of the major international oil companies that are targeted for the windfall tax. To follow the logic offered above would be to misread the nature of the oil market and to follow cheap populist instincts in pretending (or avoiding) to solve a much more complex problem.

References:
(1) “An oily slope,” The Economist, 5 Nov 05
(2) “No case for a windfall tax on the oil industry,” Financial Times, 31 Oct 05

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