Earlier this week I had written an article reviewing the proposal to increase the tax Big Oil companies pay on their profits, if they do not invest in alternative and cleaner energy resources. This article dwells further into that issue, especially with regards to the role of Big Oil companies and their ability to balance their shareholder’s interest against our national interest.
Government's Role in the Free Market
Free market advocates (I am one), believe the government should have a minimal role in managing how any market operates. The winners and losers in any market should be determined purely by market forces, with the government not taking any sides. However, in the real-world, there are very few markets which are truly free of the influence of the government.
The world’s financial markets provide a striking example. Even though the restrictions on the movement of capital across the globe are perhaps at the lowest level ever, the sentiment in the financial markets is heavily influenced by the decisions of central bankers. Bonds issues by the United States Treasury continue to be safe-havens of last resort with the 10 year bond yielding around 4% even when inflation threatens to explode. The Federal Reserve continues to play a vital role as a lender of last resort, trying its best to prevent a collapse of the financial system.
All over the world, industries deemed to be vital to national interest are under some form of government control. In the United States companies providing basic utilities like electricity, natural gas, telecommunications, public transportation etc. are regulated by Public Utility Commissions [PUC] of individual states to provide ensure a reliable supply and stability in prices. These industries are deemed to be essential to the basic functioning of a modern economy and protecting them from the extremes free-markets can take is considered essential. Reducing the uncertainty associated with their availability and pricing, allow other segments of the economy to function better, and increase our overall prosperity.
Oil and Government Regulations
Though oil plays a critical role in our national economy, and shaping our foreign policy, the oil industry is not heavily regulated and does not come under the purview of the PUCs. Since we import a bulk of the oil we consume, our energy security is closely tied to maintaining access to the sources of foreign oil. As a result oil companies are the 800 pound gorilla when it comes to our energy policies and thanks to national interest our foreign policy. Our energy policies are designed to help our oil companies in providing us with reliable supply at stable prices. The United States offers a variety of incentives and subsidies to oil companies to achieve their goal.
Oil companies get leases to Federal lands for the purpose of exploration and development of new fields at a minimal cost. A report published in 1999 (.pdf) (when oil was near a long term bottom), by the International Center for Technology Assessment, a non-profit, bipartisan organization with the goal to provide the public with full assessments and analyses of technological impacts on society concluded that:
“…Together, these external costs total $558.7 billion to $1.69 trillion per year, which, when added to the retail price of gasoline, results in a per gallon price of $5.60 to $15.14…”
Some of the subsidies mentioned include:
· The Percentage Depletion Allowance
· The Nonconventional Fuel Production Credit
· Immediate expensing of exploration and development costs
· The Enhanced Oil Recovery Credit.
Since 1999 the Congress and the Bush Administration has added more programs to help oil companies maintain our energy security, while some of the credits have become inapplicable as the price of oil soared in recent years.
The Cost of See-Saw Oil Prices
Though the US Government provides incentives to ensure reliable supply at stable pricing, the price of crude-oil has gone through significant gyration over the past few decades. On an inflation adjusted basis the price of oil has varied from the $20s/gallon in much of the 50s and the 60s, with a spike up in the 1970s which peaked in 1980 with an average price of $98/gallon, followed by the Saudi led glut in the 1980s with oil falling as low as $16/gallon in 1998 and the current super spike with average oil prices not projected to be well above $100/gallon in 2008 (EIA estimates $122/gallon in 2008 and $126/gallon in 2009).
The massive swings in the cost of oil have a huge impact on the economic well-being of our country. Any long-term project with a significant energy component becomes much riskier: Do the planners use oil at $20/gallon or $130/gallon in their planning? A study sponsored (.pdf) by the US Department of Energy (published December 2000) and conducted by the Tennessee based Oak Ridge National Laboratory’s National Transportation Research Center, tried to measure the impact of the gyration in oil prices on the US economy. The study came up to the following conclusions:
“Estimates of the total economic costs to the United States of such oil market upheavals during the last 30 years are in the vicinity of $7 trillion, present value 1998 dollars, about as large as the sum total of payments on the national debt over the same period. Transportation is at the center of the oil dependence issue. More than 25 years after the first world oil crisis in 1973-74, the U.S. transportation system comprises 67% of U.S. petroleum demand (25% of world oil demand) and relies on oil for more than 95% of its energy needs.”
Energy Policy: Expediency Wins
The decline and fall of the former Soviet Union and the military stability provided by the US presence in the Middle East in the 1990s resulted in two decades of low oil prices from the mid 1980s to the early 2000s. During this period the United States dependence on foreign oil increased significantly. The availability of inexpensive foreign oil resulted in pressures from environmentalists to limit exploration and drilling in the United States.
Why Drill in the US When The World Is Awash?
The low price of oil meant that Big Oil companies had very little incentive to explore newer oil fields. For a long time Big Oil used oil price value at $20/barrel to determine the viability of any new project. As shown in the chart below (taken from this link) a result the replacement rate for Big Oil’s has been in a free-fall since the 1990s.
While Big Oil’s proven reserves where falling faster than they were being consumed, the economies of emerging markets in Asia were cranking up. It did not take much to figure out that the energy demand from these economies would increase as more than 2.5 Billion people emerge from a subsistence lifestyle to the consumption focused lifestyle we export to the rest of the world.
It was in this period of lull that the United States missed a great opportunity to wean itself off foreign oil and establish itself as the leader in more sustainable energy technologies which are not completely dependent on discovery of relatively scarce natural resources.
It was not for the lack of trying; California passed an initiative to encourage the use of Electric Vehicles in 1990. However, the initiative failed due to strong opposition, primarily from the US automobile and oil industries, which feared an erosion of the dominance of internal combustion engine in the US’ transport system.
Big Oil’s off-course did not want our reliance on the gasoline to end and tried their best to kill electric vehicles. The big automakers were afraid of the electric vehicle since they have much lower wear and tear and hence last for a longer time, while requiring much lower maintenance during their life-time. The brakes in electric cars use regeneration technology to convert the kinetic energy of the car into electricity which recharges the battery, instead of expending the energy as heat in the brakes. There is no high-temperature engine where gas is exploded in a controlled environment.
The NiMH battery patent lock-up was an egregious example of how the Big Oil and GM colluded to push back the development of electric cars by at least a decade.
Electric-Only Cars, NiMH Batteries and Big Oil
During the 1990s Nickel Metal Hydride batteries were considered the ideal candidate for plug-in electric cars. Their reliability and ability to store a lot amount of energy make them especially valuable for vehicles which do not have a gas-powered engine to supplement the battery power. These batteries powered the first generation of electric cars launched in the US, including the EV1 (NYSE:GM) and RAV4-EV (Toyota).
In 1994, GM acquired controlling rights of the company, Ovonics, which invented and patented NiMH batteries. It sat on the patent for a few years, while the first generation of electric cars met their pre-destined end. In 2001 it sold that stake to Texaco which was then acquired by Chevron. The battery venture was spun off as a 50-50 venture, Cobasys, between Chevron and the original owners, Ovonics-Energy Conversion Devices.
Cobasys has been following a policy which prevents the use of large-format NiMH batteries in transport applications in the US. It sued Panasonic EV Energy (PEVE), a joint venture between Panasonic and Toyota, which supplied large format NiMH batteries used in RAV4-EV for patent violations, which resulted in a sealed settlement.
The terms of the settlement involved a compensatory payment to Cobasys, licensing of some patents, and above all some unspecified restrictions on the size of NiMH batteries which could be sold to the transportation industry. Right after the agreement, PEVE stopped selling large-format NiMH batteries targeted towards the transportation market in the US.
Toyota’s RAV4-EVs are running great, but may have to be moth-balled since there is no legal way for Toyota to provide new batteries to replace the 10 year old NiMH battery packs, if and when they need replacement. RAV4-EVs owners have to contact Cobasys for replacement batteries; Cobasys has refused to deal with anyone in non-OEM quantities. Under the terms of the settlement, Toyota can use small-format NiMH batteries in hybrid vehicles like the Prius which have an Internal Combustion Engine to burn gasoline and supplement the electric power.
To complete the picture: Cobasys, the firm which refuses to sell large-format NiMH batteries to RAV4-EV customers, or license its technology to other manufacturers, is on GM’s list of distressed suppliers in poor financial condition. I wonder why a firm in financial distress is unwilling to generate extra revenues by addressing the needs of an existing market.
Detroit should be thankful that the horse and carriage industry of the 19th century did not have the protection of the US Patent Office to prevent the Internal Combustion Engine from being used in cars.
Opportunity Cost of the EV Failure
The opportunity cost of the failure of electric cars is not only in terms of what we lost in the US (less pollution, reduced dependence on foreign oil) but also the message we sent to the emerging markets. When China and India develop their transportation system, they do not have a working model based on electric vehicles to look at. Distances travelled in those countries are typically much less than the average American commute, and our ideal for electric vehicles.
Further, we lost the chance to be the leader in a technology of the future. America’s prosperity is built upon being innovators; in the future we will have to work much harder to maintain the edge as the rest of the world catches-up. By missing the boat on the next wave of transportation systems, the American economy has lost billions in economic benefits.
Towards a Cogent Energy Policy
It is clear that our energy policy needs a radical overhaul to wean us of foreign oil. Our new policy should be multi-pronged; while in the short term we continue to seek more oil, especially domestic oil, in the medium to long term, we have to focus on weaning our self off oil, and fossil fuels in general. Our nation will pay a high strategic cost for the enormous amount of wealth we are transferring to oil exporting nations, which more often than not, are not amicable to our national interest.
Restrictions on domestic drilling and refinery capacity have to be reviewed to come to terms with reality. Similarly the NIMBYs of Cape Cod, who are afraid of wind-farms spoiling the view from their vacation homes, need a reality check. More significantly, we need to take charge in becoming the leader in developing alternative energy resources.
Big Oil’s Financial Strategy: Wait and Watch
In 2007 Exxon-Mobil spent $31.8B in stock buybacks and another $7.6B in dividends. Big Oil in total increased their share buy-back programs from $10B in 2003 to $60B in 2006. The return of capital though laudable, also indicates that Big Oil companies are unable to find better alternatives for investing capital to drive future growth.
The irony of the situation is mind-boggling: In the past five years, the price of crude oil has gone up 4x, the replacement rate of Big Oil companies has plummeted to below 100%, but Big Oil companies are unable to find better alternatives for investing their capital?
Purely from a financial point of view this seems like a prudent move: if the importance of oil declines and prices fall, not making investments in new fields will turn out to be a wise decision. On the other hand, if oil continues to be important, the rising crude oil prices will ensure huge amount of profits from the existing resources Big Oil has. It is a win-win for the investors in Big Oil. But what about the interest of a nation, which has hitched its wagon behind oil?
Big Oil, National Interest and Renewable Energy
Big Oil’s decision to limit the growth of capital invested in discovering new oil fields puts the United States in a precarious position. Our transportation system, economy, and way of life, depend on oil. While Big Oil fiddles with its wait and watch approach, the global economy is on the cusp of falling into a major recession. Big Oil has wielded tremendous power in shaping our energy policy and now they seem content to watch while our economy unravels, and we ship our wealth to countries amicable to our national interest.
The best way of unshackling ourselves from the vagaries of the international oil market, and gaining technological leadership in the energy market, is to focus on renewable sources which are not dependent on fossil fuels. This is where Big Oil companies can pay a leadership role.
If history is any guide, initiatives to drive the adoption of renewable energy sources, will face a big political challenge by Big Oil. As long as the interests of Big Oil companies’ are completely opposite to those of renewable energy companies, the growth of renewable energy companies will be stinted. However, if the Big Oil companies develop a stake in the progress of alternative energy projects, they are likely to show less opposition.
One is tempted to argue that Big Oil companies have no business dabbling in alternative energy and by returning capital they allow their existing shareholders to determine where to invest. If they feel that alternative energy has as future, let them invest in that sector. Though this sounds good in principle, the dynamics are quite a bit different in real life. The percentage of investors who will sell their Big Oil holdings and then invest them in alternative energy resources is going to be small. Since many alternative energy companies are private, most investors can not invest in them. Since the total market capitalization of alternative energy companies pales in significance with Big Oil, a rush of capital into those companies results in speculative equity valuations, which will deter the buy and hold big-cap buyer who invested in Big Oil.
Any potential capital reallocation of investment from shareholders of Big Oil companies to alternative energy companies cannot be as effective as direct investments by companies which are already major players in the energy industry. With the precarious situation we are in, we do not have the luxury to see whether the capital reallocation will occur in a timely fashion.
Last but not the least, Big Oil has benefited immensely from the patronage of the United States foreign and military policy. At a time when the industry is making mind-boggling profits, it behooves it to help the United States and her residents, and not just the short-term interests of her share-holders.
Government Spending and Big Projects
While no one likes to pay taxes, it is easy to forget that the government has a big role to play in spurring major innovation and increasing the adoption of newer technologies. The Manhattan Project, the Apollo moon-landings were all government funded projects which have transformed the world as we know it. The technological superiority of our armed forces is a result of massive government spending.
Right now ensuring our future energy security is of vital national importance. Due to our extreme dependence on foreign oil, we have put our self in a situation where traditional free market mechanics will be unable to fix the situation quickly enough; the fact that Big Oil is not keen on spending capital to find new oil does not help the situation either. To set things in perspective, the head of the state-owned Russian oil company Gazprom, greeted us on our Independence Day with a restatement of his view that oil is likely to hit $250/barrel and natural gas will trade at $1000 per 1000 cubic meters.
Encouraging Big Oil to Invest in Renewable Energy
The next question which arises is that where we will find the money to fund initiatives to accelerate the adoption of renewable energy. I feel that ensuring that Big Oil companies participate in that project is a key to its success. If Big Oil does not have a skin in the game, they are unlikely to change their ways and will use their financial and political muscle to defend oil’s share in the US energy markets.
This is where the current proposal to force Big Oil companies to invest in alternative energy resources comes into play. The crux of the proposal is that unless Big Oil invests in alternative energy resources, they will have to pay 25% windfall profit on excess profits; the level of excess will be determined by looking at the current oil price versus the oil price in the recent past.
Comparison with the Carter-Reagan Era Bill
The knee-jerk reaction to any windfall profit on oil is to compare with the failed windfall profit tax imposed by President Carter’s administration. A comprehensive analysis of that tax is available from the House Republican whip’s Office. The Carter era tax was passed as a quid-pro-quo for deregulation of the energy markets in an era of high oil prices, to pass on some of the resulting profits back to the people of the United States who are the eventual owner of its national wealth.
Critics of the Carter-era windfall profit bill say that the bill succeeded in reducing domestic oil production since it reduced the incentive for Big Oil to explore domestic oil fields when they could import foreign oil which was exempt from the tax. The critics ignore the fact that domestic oil production had already been declining since reaching a peak in 1970 of 3,517,450,000 barrels. It had dropped to 3,146,365,000 by 1980 when the windfall profit tax was initiated. In fact, Oil production actually rose to 3,274,553,000 barrels in 1985 before starting another downward trend which has continued till today.
Further the critics discount the fact that the 80s and the 90s was the era of cheap Saudi oil flooding the world market reducing the incentive for domestic oil exploration. President Reagan replaced President Carter in 1982, but he did not see any need to repeal the act which continued till extremely low oil prices made the tax meaningless in 1988.
The current bill is dramatically different from the Carter-Reagan era bill both in its structure and goals. Specifically:
1. Oil companies can avoid paying these taxes by investing in renewable energy and refinery expansions.
2. The tax rate on excess profit is 25%, and not as high as 70% as it was on the Carter Era Bill.
3. The money collected from the new tax will go to a fund focused on expanding renewable energy sources and reduce our dependency on foreign oil
4. Any profits gathered by Big Oil from investments in renewable energy will be exempt from the tax
Further, the world energy situation is dramatically different today. Saudi Arabia no longer has the capacity to flood the world with cheap oil, while demand for energy is sky-rocketing as billions in Asia integrate with the world economy. The price of oil has gone up so much that even if companies pay a 25% excess tax, they will still reap huge profits on every barrel they are able to extract.
Boarding the Alternative Energy Train
With the dramatic growth in world energy demand, it is almost a foregone conclusion that fossil fuels cannot continue to be the primary source of the world’s energy needs. However, on June 11, 2008 when sponsors of the bill which would tax windfall profits could not get enough support to bypass a Republican filibuster, another bill which would have extend expiring tax breaks in support of wind, solar and other alternative energy projects, and for the promotion of energy efficiency and conservation also failed to progress. If nothing else, the failure to extend existing credits on alternative energy and conservation points to the immense power wielded by Big Oil (and of course partisan politics), highlighting the need to co-opt the oil industry in our pursuit of alternative energy.
Four decades ago, the area now famous as the Silicon Valley, was full of fruit orchards. Now it is home to the highest median home prices in the nation, which continue to rise even in the current housing downturn. There is nothing which prevents the current centers of the oil industry in becoming the Energy Alley to the world, if Big Oil is willing to take a longer term view.
Right now Google with its RE<C and RechargeIt initiatives has pledged tens of millions of dollars per year to support the development of renewable energy; ExxonMobil has pledged to spend $10M/year over the next decade on alternative energy. Clearly something is wrong with this picture.
Disclosures: The author holds both long and short positions in futures, equities and options in the oil industry. He does not have any positions in alternative energy sector except those in general (non-sector specific) mutual funds.