"Windfall Profits" Tax on Oil Companies

"An angry public wants quick relief from high prices" at the pump, says Business Week. That's hardly a surprise. Over the past year, the Energy Department reports, a gallon of regular gasoline has gone from $1.86 to $2.96.

But even at less than bottled water, $3 gasoline hurts consumers and the economy as a whole. The question, however, is what to do?

The worst approach is one now being considered by the Senate: slap a windfall profits tax, or WPT, on oil companies.

The United States has tried this before, between 1980 and 1987, and the results were hugely counterproductive, according to a 1990 Congressional Research Service report.

"The WPT reduced domestic oil production between 3 and 6 percent, and increased oil imports from between 8 and 16 percent," says the report. "This made the U.S. more dependent upon imported oil."

It's not hard to understand why. Energy companies are in a very risky business. They (and the investors and lenders who back them) commit hundreds of billions of dollars annually to searching for oil and gas, and to building or expanding refineries, ports and pipelines. These projects take many years to complete and the payoff down the road is highly uncertain.

It's tough enough to make investment decisions in anticipation of market conditions that can change overnight, but why spend vast sums to develop energy if -- as a reward -- government hits you with a special tax? So, with a WPT, oil companies cut back.

As for the WPT's professed rationale, profits have indeed risen lately, but, according to Business Week data, second-quarter earnings of oil and natural-gas companies were 7.7 percent of sales, compared with 7.9 percent for all U.S. industries.

The price of oil -- like the price of any commodity -- bounces around as a result of changes in supply and demand. In the early 1980s, a barrel of oil was more than $80 in today's currency. By the 1990s, oil was less than one-third the current price and gasoline was just over a buck a gallon. When oil fell to $9.39 a barrel six years ago, was Sen. Byron Dorgan, D-N.D., author of the current WPT, proposing a windfall losses rebate?

Nope. You take your own risks, and you're entitled to your own gains -- or losses.

Consider farmers, abundant among Dorgan's constituents. The December 2005 futures contract for a bushel of corn has varied, over its brief lifetime, from $2.05 to $2.89. Should a farmer who scores a big gain because of the movement of corn prices on the open market pay a WPT? Faced with such a penalty, why plant new acreage?

The same open market determines oil prices. Demand from emerging nations has boomed. ExxonMobil's Energy Outlook now forecasts that, between 2004 and 2030, energy use by China will rise 100 percent; India, 164 percent, and Latin America, 85 percent.

With such potential, energy companies can be expected to invest more in finding and producing oil, and price increases should modulate -- level off or even fall -- as supply increases. In fact, this year, exploration spending was anticipated to hit $180 billion.

But what if supply is constricted for political reasons? That's the problem going forward. Environmentalists have put vast areas off-limits to exploration and have made building refineries, liquefied natural-gas facilities and nuclear plants (to name a few sources of supply) extremely difficult.

Now, there are new threats to supply: 1) the proposed WPT; and 2) price controls on gasoline and home heating fuel, already imposed in Hawaii and under consideration in Illinois, Massachusetts and elsewhere. This is a combustible combination. The 1980 WPT was an attempt to offset the decontrol of oil prices. The 2005 WPT may accompany recontrol of oil prices.

The good news is that, for now, markets are working. Crude oil and gasoline prices have dropped in the past two weeks as rigs, refineries and pipelines come back on line in the wake of Hurricane Katrina and as drivers balk at $3 gas. My guess is that we'll see $2.50 soon.

Beyond that, the ball is in the politicians' court. They've got two choices: Create a recipe for energy disaster with a windfall profits tax and price controls, or take steps to encourage more supply. It's the latter course that will calm the public's anger.

James K. Glassman is the host of TechCentralStation.com.