Crude Oil's relentless march towards the near term spike target of $150 is now threatening to send the Global Economy into a recession. Big Oil companies (Exxon-Mobil (NYSE:XOM), Chevron (NYSE:CVX), Royal Dutch Shell (NYSE:RDS.A), BP (NYSE:BP) and ConocoPhillips (NYSE:COP)) are in the thick of the controversy as the rising price of oil has seen their profits sky-rocket. Congress smells an opportunity to cut the Federal Deficit and score election year brownie points, and is pondering legislation to impose windfall taxes on Big Oil companies. As expected these bills did not garner enough support to even get to a vote in the Senate and break the Republican filibuster.
Many conservatives and pro-business commentators are aghast at the thought of taxing excess profits. Big Oil companies have increased their public relations campaign against any windfall taxes. Their supporters point out the following:
1. The profit margins of Big Oil companies are not very high compared to other large corporations. Karl Rove recently published an opinion piece in the Wall Street Journal where he dismissed the claims of excess profits by focusing on the fatter profit margins in the technology industry (between 14.5% and 27.5%) versus those in Big Oil (8.3%)
2. Big Oil companies control just 10% of the world's crude supply. They buy the rest of the crude in the open market and pay market prices.
3. Taxing Big Oil profits will deter them from making future investments in developing new fields which will further exacerbate the supply squeeze.
4. And finally the fundamental principle that in a capitalist society, the government has no business to determine how much profit is too much.
In this article I will explore the broader context in which the oil industry operates with a focus on our Government's energy policies.
Energy Security and International Politics
Energy security is one of the cornerstones of any major nation's military and foreign policy. In the early part of the 20th century the discovery of easy to extract oil within the US, and the adoption of the internal combustion engine, meant that oil became a cornerstone of US energy security. Oil is easy to extract, convenient to store and transport, has a high energy density, and allows vehicles to go hundreds of miles before a fill-up. Americans love their automobiles, and for a long time, the fate of US economy was closely associated with the fate of Detroit's automobile industry.
As the American economy expanded, the gap between demand and domestic production started widening and secure access to foreign sources of oil became a corner stone of our foreign policy. The Middle-East with its vast oceans of oil has been a focus of our foreign policy since WW-II.
As early as 1953, the CIA's station in Tehran, headed by the grandson of President Theodore Roosevelt, Kermit, led the effort to oust Iran's Prime Minister Dr. Mosaddeq, when he threatened to nationalize Iran's oil resources. After the 1970s oil shock and the Islamic Revolution in Iran in 1979, Saudi Arabia flooded the world with inexpensive oil in exchange for our military umbrella. Saudi supply kept oil prices depressed affecting countries like Iran and the Former Soviet Union. The financial shock of oil at $20/barrel helped get the FSU, a major energy exporter to her knees; they could not keep up with President Reagan's strategy to spend big on strategic initiatives, leading to the eventual collapse of the FSU.
Today Indian and Chinese oil companies are jockeying for drilling rights all over the world, often bidding up the price of fields. China has been turning a blind eye to Human Rights violations in many parts of Africa, as they rush in to lock in access to oil and other basic materials.
Worldwide more than 80% of oil resources are nationalized; oil continues to shape the economic, foreign and military policy all over the world. Only the truly ingenuous will pretend that oil trades in a free-market and governments have no role to play in it.
Energy Policy: Captive Market for Oil Companies
Our domestic government policy has created a situation, where Big Oil companies have a secure, captive market for their products. Our policies, heavily favors the use of oil based private means of transport versus public mass-transit systems.
We have a nationwide highway system which brings a huge country together. However, passenger trains are neglected; Amtrak continues to be on life-support depending on Congressional bail out every few years. Unlike Europe where trains are the primary means of travel between cities, we prefer to fly even along the densely populated North Eastern sea-board. Our system is a lot more energy intensive compared to other parts of the developed world.
Congress provides a variety of subsidies, both direct and indirect, to keep our oil based transportation system rolling. Whether it is investments in highways (versus rails) or tax subsidies for oil companies, our policy is focused towards an oil based economy.
In the past there was little government support for alternative energy systems which would wean us away from our oil based economy. California took the initiative to legislate the use of electric cars, but without any Federal support and an unsupportive automobile industry, the initiative died a slow death. Subsidies to encourage the use of photo-voltaic solar cells lag those in Western Europe; the solar industry has to battle it out continue subsidies every year or two.
Though the US was a pioneer in the development of nuclear technology, our policies have not encouraged the use of nuclear power and no major plant has been built over the last three decades. This is in contrast with France which gets about 80% of its electric power from nuclear plants.
Thanks to the decades of government driven investments in the oil based infrastructure, changes in energy usage pattern require will take a lot of time to happen. As oil prices rise, Americans living near metropolitan areas can alter their lifestyle to reduce their use of the automobile. However, rural America will continue to have a dependency on the automobile. Rural areas have a low population density which makes mass-transit unfeasible; plus the distances are vast and require a personal vehicle
Our way of life depends on oil, just as human beings need air, water, and food to survive. As long as Big Oil can find and distribute oil, they are guaranteed to make a profit on every gallon sold. Big Oil's role in the economic landscape is more akin to a grocery store distributing staples, than technology companies producing discretionary items.
Big Oil and Exploration Risks
A major task for Big Oil companies is exploration, and development of new oil fields. However, over the past few decades, Big Oil's share of world-wide oil production has rapidly declined and now stands at 10%. Clearly, Big Oil is in not investing enough in discovering new resources.
A bulk of Big Oil's capital expenditure goes into finding new ways to extract oil from existing oil fields. While soaring oil prices lead to big profits for Big Oil, the total expenditure on exploring new oil fields went up to just $10B in 2006 compared to $6B in 2003 even though the replacement rate of oil reserves has been plummeting and has fallen below 100%.
One reason that Big Oil is unable to invest in exploration is the strong presence of nationalized oil companies which now control the exploration rights. However, many times nationalized oil companies from other major importing nations like India and China, bid for drilling right in foreign lands, and Big Oil rarely, if ever comes into the picture. Even within the US, Big Oil companies are drilling on a fraction of the Federal land they have drilling permits for; only 28% for on-shore permits, and an even lower 20% for off-shore permits.
Big Oil companies are now content in acting as processors (refinery) and distributers of oil based products, rather than pioneering explorers who invest a large amount of resources in finding new fields.
Big Oil: Microsoft or Safeway?
Comparing the profit-margins of Big Oil with those of large technology companies like Microsoft (NASDAQ:MSFT) is not fair. After defense, oil industry gets the most assistance from our government. American soldiers put their lives on the line every day in Iraq to ensure our long term Energy Security and help Big Oil. Microsoft loses Billions of dollars due to software piracy but we do not hear any news about our Armed Forces invading another country to prevent software piracy!
Currently Big Oil is operating in the grocery store model where they process and distribute oil, but do not take much risk in the process. Why shouldn't the profit margins of Big Oil be like those of grocery stores (low single digits)?
Big Oil and Alternative Energy
Another area where Big Oil has severely underinvested is the Alternative Energy area. Exxon-Mobil has pledged to spend around $10M/year for the next ten years to spur Research and Development in renewable resources. To put this number in context, Exxon-Mobil spent $31B in stock-buybacks and paid its CEO in excess of $50M last year. Their entire renewable energy budget is five times less than the CEO's annual compensation!
In fact Big Oil is spending more money in ad campaigns which will help build their green credentials, than they spend on efforts to develop renewable energy. The irony of the situation is not lost to a few of Exxon-Mobil's largest shareholders, the members of the Rockefeller family. They recently proposed changes to increase Exxon-Mobil's focus on increasing investments in renewable energy, and lowering emissions, but the resolution failed to pass at the annual shareholder meeting earlier this summer.
As a strong believer in free markets I also agree with those who are aghast at the prospect of the Congress determining profit margins. Though I do find the idea of windfall taxes abhorrent, a deeper look at the structure of the new bill reveals something less ominous.
The proposed Consumer-First Energy Act would create a 25 percent windfall profits tax on companies that don't invest in renewable fuels or electricity production. It also would zero out some $17 billion in tax breaks for the oil industry and use the revenue to help consumers by investing in an Energy Independence and Security Trust Fund.
Big Oil has taken very little initiative to either strengthen our energy security by investing in exploration or pursue alternatives which will reduce our dependency on foreign oil. The bill will force Big Oil to invest in renewable energy resources to reduce our dependency on foreign oil, or lose out on recently granted subsidies and pay a larger percentage in taxes.
It is indeed a sad day when we need Congressional laws to force Big Oil to help alleviate our energy crisis. The US government has spent billions of dollars to help Big Oil function and thrive; our Armed Forces have made immense sacrifices to provide access and security to Big Oil operations; our domestic policies guarantee Big Oil a captive market; government subsidies provide Big Oil with billions in tax breaks. However, even their major shareholders like the Rockefeller's feel that Big Oil needs to do more in return; investing 20% of its CEOs annual pay in renewable energy research is just not enough. By completely ignoring their social and patriotic responsibility, Big Oil has pushed things too far.
Big Oil was asking for it; they are now going to get it.