Wednesday, November 09, 2005

Windfall Profits

The current popular idea to charge oil companies with a "windfall profits" tax is nonsense. Oil companies do not set the price of oil and finished products, the commodity markets do. Imagine if I had a barrel of oil and I placed it on EBay for bid. Now imagine several buyers bid the price of that barrel of oil up. That is what happens in the commodity markets. Now imagine things have been going along pretty much the same for several years and suddenly two people that have been regular bidders for your product suddenly start to need much more of it. They are buying more and more barrels of oil and are willing to outbid other people for it. The price rises higher. That is what is happening in the international oil markets with China and India as they ramp their economies up. Now, imagine something happens in the news. Say a hurricane is headed directly at a major oil producing region and could potentially disrupt supply. Some buyers might become concerned and decide to speculate. They will buy up oil they don't need in order to sell it later when they think the price will be higher. The impact of that is to drive prices up very quickly. Prices could possibly begin to go up before the storm even arrives as the speculators enter the market.

Now imagine the people in your town are now mad at you because you are making so much money on EBay selling your oil. They now show up on your lawn one night with torches and demand some of your money (windfall profits tax). What do you do? Chances are, you might leave town. That is going to suck for the town because they were getting some money from you in taxes, now they are going to get nothing. And to top it off, they are *still* going to pay the same amount for their oil.

And the same thing goes for finished products too. You can go to a broker right now and buy 100,000 gallons of gasoline on the commodity market and take delivery of it if you have someplace to store it. The price you pay is going to depend on how many others are also bidding on that gasoline and how much they are willing to pay. It is an auction that goes on every day. The oil company doesn't set the price of gasoline. The people bidding for it on the commodities exchanges do. They can bid the price up very quickly if they get "spooked" by bad news. If a forecast comes in that cold weather is expected, heating oil contracts will start to rise before the temperature starts to fall as speculators enter the market. The price rises very quickly.

Another thing that one must understand is the domestic consumption is only around 10% of a global oil company's business. Of all the profit that the oil companies are reporting, 90% of it is money from other countries that they are pulling in to the US. If we hammer them with a windfall profits tax, they might just move out of the country. There are plenty of countries that would love to have a major US oil company move there. If it is cheaper for the company to operate someplace else, they will. And to top it off, people in the US will still be paying just as much for their oil and gas. I say leave the situation alone. Increased profits will likely result in increased production which will result in lower prices but it takes time for the increased investment to work through to the gas pump. It can take a decade to get a refinery from drawing board to full production. It can take many years to open a new oil field or build a new pipeline.

It is also in the interest of the oil company to keep prices low. Every time the price of gasoline rises, it makes alternative energy sources more competitive and results in a decrease in the amount demanded. If people switch to more fuel efficient cars and homes, it can result in a fundamental change in demand itself with consumption dropping so that even if prices dropped back to where they were, profits would be lower than they were because consumers have become more efficient in their use of energy. So overall, it is in the best interest for the oil company to sell as much oil as it can at the lowest price that it can. It just so happens that the two go hand in hand. For every additional barrel they place up for sale, the price drops a little because there is more supply. It is easier to get. People don't need to bid the price up so high.

Windfall Profits Tax feels good and appeals in an emotional sense, but it is short-sighted and could end up costing the country a lot more money than it saves. It is a bad idea.


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