Those Bewildering Energy Markets
Wisconsin Governor Jim Doyle has a new proposal for punishing those “greedy, gouging oil companies” for their “unfair profits.” His proposal is to rob from the “rich” – the oil companies – and give to the “poor” – the state government of Wisconsin. However, as I will show in this essay, the irony of the situation is that the poor in this case are already making bigger profits in Wisconsin than are the rich.
Based on Governor Doyle’s recent comments, I have to include him among those with a very naive view of how the energy markets work. His understanding appears to be like that of the proponents of Prop 87, about which I wrote several essays. They apparently think oil companies conduct business like this: Calculate all of your expenses – salaries, utilities, raw materials, capital – and then add on a markup. Historically, this “markup” has been 5-7% – not that great. But, the perception seems to be that if oil companies think they can get away with it, they jack the profit up to 9% – in which case they are now accused of gouging consumers. Setting prices based on costs and markup may be how Microsoft sells software (except with a much higher markup) but it isn’t how oil and gas are sold. And I know that there are many – perhaps even a majority – who think this is how oil companies operate. However, the primary purpose of this blog is to shed light on energy issues, so that is what I will attempt to do in this case.
I should first point out that this is not the first time that Governor Doyle took on Big Oil. In fact, on the Jim Doyle for Governor website it says:
Under Governor Doyle’s leadership, Wisconsin became the first state in the nation to subpoena executives from the big oil companies to come and explain how they could justify sky high gas prices and billions of dollars in profits in the wake of Hurricane Katrina. The Governor called on Congress and President Bush to force the big oil companies to give a refund to American consumers.
So, how did that turn out Governor Doyle? Oh right, none of the executives actually showed up. Those CEOs had just finished explaining to a befuddled U.S. Senate at a joint hearing of the Commerce Committee and the Energy and Natural Resources Committee just how energy markets work. I guess Governor Doyle missed the broadcast, because he subpoenaed these same CEOs to explain to him in person what’s going on. And since these CEOs have multi-billion dollar businesses to run, they can’t just fly away on a moment’s notice to satisfy a governor’s whim. So, they didn’t show up in person.
Governor Doyle’s Proposal
Now Governor Doyle is striking back. Again reminiscent of the aims of Prop 87, the governor has proposed enacting additional taxes on oil companies and to put those funds toward highway and other transportation projects. His proposal would assess a 2.5 percent tax – directly on the oil companies – for gasoline coming into the state of Wisconsin. He projects that this would raise $272 million dollars over two years and he would provide jail time if gas prices rise as a result.
I almost hate to point out that Wisconsin has one of the highest gas taxes in the country and that it is indexed to inflation to automatically increase [a commenter from Wisconsin indicates that the indexing has been repealed]. Given the staggering 9% profit on sales that oil companies have enjoyed recently (this is profiteering?) that means that the Wisconsin government is already making more money from gasoline sales than the oil companies are. Has Governor Doyle offered to step up and refund some of that money back to the consumers given that he took more from them than did the oil companies? (I want to make it clear that I don’t oppose higher gas taxes. However, I do oppose hypocrisy and pandering.)
What Drives Oil and Gas Prices?
So, how are oil and gas actually priced? They are commodities, and as such they are priced on the basis of supply and demand (or actually the perception of supply and demand, which is sometimes wrong). They trade in large volumes on commodities exchanges. When supply is crimped, prices go up. The alternative to increasing prices when supply is crimped would be rationing. Allowing the price to go up also rations product, but it does so by price. Those who really need the gas are able to get it, albeit at a higher price.
There have been two primary drivers for higher prices in the past few years. First, the excess oil production capacity has largely dried up in recent years, putting supply and demand in very tight balance. As excess production capacity has eroded, oil prices have risen. That also means that any hiccup that affects global oil production (hurricanes, civil unrest in Nigeria) or even fears of hiccups (war with Iran) can quickly drive the price higher. And the price of oil is a major factor in the price of gasoline.
The other factor driving up product prices is that we have a capacity bottleneck in our refineries. Gasoline demand continues to grow, and while refiners are expanding capacity, it has not been added fast enough to stay ahead of the demand curve. This puts additional upward pressure on finished product prices. If, for instance, the price was articificially lowered across the country, demand would go up and we would literally run out of product. So price keeps supply in balance with demand. Again, the alternatives to this are price controls and rationing.
Effects of Increased Costs
Now, let’s say that the costs for an oil company increase in a specific location. What the oil companies are going to do is look at their economic models, and they are going to ship the gasoline into the area with the best payback. If costs go up in Wisconsin, supply will likely go down as gasoline gets diverted to other areas with better economics (and believe me, they will do it for a penny a gallon). That means that – you guessed it – prices would go up in Wisconsin because the supply will have been restricted.
Experts are Skeptical of the Plan
But the Governor thinks he can control the price. He proposes to make it illegal for oil companies to pass on the costs, and he is going to hire a team of auditors (one of the articles below suggested it could take 40 auditors to police) to make sure the costs aren’t being passed on. This is discussed in the Wisconsin State Journal’s article Doyle’s oil tax plan difficult to enforce:
The state can tax gasoline brought into the state, as Doyle proposed in his budget last week. But it’s unlikely the governor can follow through on his promise to prevent oil companies from passing the tax along to consumers by raising prices at the pump, said economists and others familiar with the industry. Doyle wants to hire a team of auditors to help enforce a proposed law that would fine, and possibly jail, oil companies or executives who passed the tax on to consumers.
But experts were skeptical whether state auditors could prove that rising gas prices reflected the costs of the tax, as opposed to some other factor in a complex global market. The issue comes as some Republican lawmakers question whether the measure could mean consumers pay up to 5 cents more at the pump.
Wisconsin is Price-Gouging Consumers
The article continues, reiterating Doyle’s claims that oil companies made “unfair profits.”
“Government and policy makers have not been very successful in controlling prices to achieve their policy goals. Taxes tend to be borne by both producers and consumers. It’s hard for me to imagine how this would be any different,” Scholz said.
For his part, Doyle said last week the tax was needed to help pay for much needed investments in the state’s roads and to respond to what he said were the unfair profits that oil companies have made at the expense of consumers in recent years.
“Now in transportation we face a real issue about how we fund the infrastructure of the state,” said Doyle, adding he preferred trying to lay at least part of the bill at the feet of the oil companies. “To me, that’s the better choice.”
Again, what about the higher profits that the Wisconsin state government makes from fuel sales? Are those profits unfair? Why or why not? What constitutes a fair profit?
Doyle repeats his charge of unfair profits in Doyle wants tax on oil companies:
“It seems to me that these companies that have had such a big killing – and this is money that has come directly out of the pockets of the people of Wisconsin and the people of the United States – they ought to be doing their share to help with the infrastructure needs,” Doyle said.
Again, the current gas tax has also “come directly out of the pockets of the people of Wisconsin.” Why is it unfair that oil companies earn 9 cents on a dollar while taking huge risks to bring that product to market, yet the Wisconsin government earns 17 cents on a dollar1 for doing nothing but taxing it? I certainly don’t wish to leave the impression that I think gas taxes are too high; in fact I think they are much too low. But his statements seem hypocritical when the Wisconsin government earns almost twice the money from a gallon of gasoline as the companies Doyle is calling greedy and unfair.The Penalties if Prices RiseContinuing on, the article spells out the penalties that would be faced if the tax does result in higher prices:
Oil company officials would face up to six months in jail if they passed the tax on to consumers. The state Department of Revenue would audit the firms to ensure they do not.
“I think, given the severity of the penalties and the enforcement unit we’ll put in place, any oil company would run a very big risk in Wisconsin if they attempted to violate that law,” Doyle said.
So, like the Prop 87 proponents, Doyle thinks he can control the price. I am not sure, as an oil company executive, I would actually risk selling gasoline in Wisconsin if I was going to face jail for a price increase. Sounds like a prescription for a long court battle trying to prove why the price went up.
Finally, let me say that I really don’t care if they do enact the tax. In fact, I think it would be an interesting case study to see one of these taxes pass and watch the impact. I think it will drive prices higher. This will encourage conservation, which I strongly support. So, this essay is not meant to argue that gas taxes are a bad idea. I am just commenting on the stunning naivety of government officials regarding the pricing of global commodities, and I viewed it as an opportunity to address price drivers in the energy markets.
Incidentally, I am not aware that my company sells gasoline in Wisconsin. We may, I don’t know, but I know we don’t have a refinery in that part of the country. So, it will probably be firms like Koch, next door in Minnesota that have to deal with this new tax. Anyway, should be another interesting piece of legislation to keep an eye on.
1. Based on the current spot price for gasoline ($1.84/gal on the NYMEX) and Wisconsin’s $0.31/gal gas tax.
A special thanks to Gary Dikkers for bringing this to my attention.