Analysis Requested by Senate Democrats Highlights the Risks of Their Energy Proposals

This essay highlights the reason I loathe politics. Here I present a case in which politicians present a partial story and withhold key findings in order to push a specific agenda. But their trump card is that if things don’t go as planned they can assign blame elsewhere. The media is complicit because they have simply lapped up the claims uncritically without having a look at the original source material.

Before I get into that, I want to make one thing crystal clear. I want to see oil consumption in the U.S. drop significantly. But to the extent that we require oil, I would like to see that oil produced domestically. I have offered very specific proposals on how to achieve these goals here and here. So those who suggest that I am simply defending oil companies are way off the mark. These people are intellectually lazy (for example), and fail to see the distinction between a blanket defense of oil companies and arguments against politically driven agendas that will have ultimately undesirable consequences for U.S. energy policy. What I want to avoid is policies in place that discourage domestic production, do nothing to address overall consumption, and result in higher imports. These are the risks I see in the current Democratic proposals being floated, and as I show here once you get past their spin their own analysis warns of that risk.

Lies and No-Brainers

In order to combat the idea that they are going to raise your gas prices, Senate Democrats asked the Congressional Research Service to look into the elimination of specific tax deductions for oil companies. The results, unsurprisingly, are being used very selectively:

Senate Dems say ending Big Oil tax breaks will not affect fuel prices

The staff of the Joint Economic Committee, chaired by Sen. Bob Casey (D-Pa.), conducted the analysis.

“By taking this action, by eliminating the tax breaks, we can actually have substantial deficit reduction over the next 10 years, $21 billion in deficit reduction, if we do this,” Casey said during a conference call with reporters Friday morning.

“This report makes it very clear that any actions taken as a result of the reduction of subsidies to big oil companies is not going to in any way affect our investment decisions,” he added.

Let’s just say that Senator Casey is being very creative with the truth here. That is not what the report said at all. In fact, it said just the opposite, as I show below.

“I think Republicans are just trying to justify their opposition to ending these subsidies, they’re giving the same excuse,” said Sen. Charles Schumer (N.Y.), chairman of the Democratic Policy Committee and a member of the Finance panel. “The verdict is in on the argument that getting rid of these subsidies would raise prices at the pump.”

“Getting rid of these outrageous subsidies is a no-brainer,” Schumer added.

Yes, as Senator Schumer indicates, for someone with no brain — someone unable to dig a little deeper and think critically — it does seem quite obvious that their proposals should be adopted. But because I am not very trusting of politicians given their inclination to spin, I went to the actual CRS memorandum. So let’s cut through the spin and see what it actually said by examining bits that Senator Schumer and his colleagues are conveniently omitting from their grandstanding press releases.

Cliff Notes

If you don’t want to wade through this entire essay, here are the Cliff Notes of what this memo actually said:

1.     Taxes already make up the 2nd largest component of gasoline prices, well ahead of profit margins for oil companies.

2.     In the short-term, passing these proposals is unlikely to impact gasoline prices, but it certainly won’t lower them.

3.     In the longer term, the report warns of “lowering the return of marginal projects, and reducing over-all domestic exploration and development activity by U.S. firms” – especially if oil prices fall below $100.

4.     So if Democrats get their wish and bring oil prices down, we will see the most significant negative effects on the U.S. oil industry.

5.     The proposals selectively hit small producers the hardest, yet they are responsible for over half of the oil produced in the U.S.

6.     Natural gas projects will be the most severely impacted.

7.     If these proposals do reduce domestic production, that “does not necessarily imply that less oil would be available in the U.S. market.” Why? Because we can simply import more oil, continuing our policies going back to Nixon of increasing dependence on foreign oil. The impact on tax revenues and domestic jobs in this case? Those would naturally be exported.

8.     Of major significance to the politicians, if the consequences are negative, they can dodge blame by pointing out that the oil markets are complex, and you simply can’t blame them if these proposals ultimately result in higher imports and loss of U.S. jobs.

Dissecting the Memo in Detail

Below are excerpts from the memo, with commentary by me.

Who Bears the Burden? Not the Fat Cats in the Smoke-Filled Rooms

The economic theory of taxation takes the point of view that corporations do not have an independent capability to pay taxes, only people can pay taxes. The implication of this viewpoint is that corporate income tax payments will ultimately be shifted to shareholders, owners of the factors of production, or consumers. Using this framework, the question of whether the tax provisions identified in your request will affect gasoline prices is one of whether the nature of the tax provision is such that forward shifting of the burden of the tax to consumers is likely, or whether the tax burden will fall on the shareholders in the form of reduced profit.

So up front, the question is whether this is going to come out of the pocket of Joe the gasoline consumer, or Joe the guy who owns shares of ExxonMobil through his retirement plan. (A 2007 study showed that the ownership of “Big Oil” is 43% mutual funds and asset management companies, 27% institutional investors like pension funds, and 14% IRA and other retirement accounts).

Government Gougers

The price of gasoline is composed of four components. The largest component of the price is crude oil, 67%, followed by federal, state, and local excise and sales taxes on gasoline sales, 13%, refining expenses, 11%, and distribution and marketing expenses, 9%.

Important to note here is that governments already make up the second largest component of gasoline prices — well ahead of gasoline profit margins for oil companies. So if the oil companies are greedy gougers, what does that make the government? I guess it is fortunate for the governments that they don’t have to issue quarterly ‘earning statements’ on what they ‘earn’ from higher gasoline prices, because we would see them already earning more on gasoline than the oil companies, and yet demanding more.

The Impact of Removing Section 199

Because Section 199 provides an incentive for domestic production compared to foreign production, some have claimed that the result of repeal would be greater dependence on foreign sourced oil and natural gas. In the short-run it is unlikely that this would occur due to the nature of oil and natural gas production. Once a well is in the producing phase, production tends to be maximized, within the limits of sound oil field management techniques. With current oil prices at, or near, $100 per barrel in the United States, it is unlikely that firms will slow production, or close wells as the result of the loss of the Section 199 deduction.

So in the short-run, it is unlikely to shift dependence to foreign oil. What about the longer term? The reason they give for their “short-run” answer is that the investment decisions on producing wells were made long ago, and that at current oil prices the change won’t be large enough to impact production. So then what happens for future investment decisions? Oil companies of course don’t base their investment decisions on a long-term oil price of $100 per barrel. They are basing them on expectations of maybe $60-$70 per barrel. So then the question becomes, in the long-term, will the proposed changes impact domestic production and increase dependence on foreign oil and gas? The report leaves that question hanging, but I think the answer is pretty obvious. Marginal investment decisions will be pushed toward the “No” category.

Intangible Drilling Costs – No Impact on CURRENT Production or Prices

Repeal of the immediate expensing of intangible drilling costs provision and replacement with a form of cost amortization more consistent with depreciation methods common in other industries likely will have no effect on current U.S. oil production, and hence no effect on current gasoline prices.

The focus on “current gasoline prices” is interesting, because it lets them dodge the question about future prices and supplies. I would submit that if you raised ExxonMobil’s tax rate to 90% tomorrow, it wouldn’t affect current gasoline prices. But it wouldn’t be long before you would start to see a big impact. So whether a proposal impacts current gasoline prices is rather irrelevant. There are very few proposals that could impact upon today’s gasoline prices, outside of the government suddenly suspending sales tax on fuel (something I would definitely not support). What matters is the future, and a critical reading of this memo clearly hints at the possibility that future oil supplies will be impacted. For example…

The Future? That’s a Different Story (but we will worry about that when it gets here)

Wood MacKenzie, a consultancy, determined that the sum effect of eliminating the Section 199 deduction and the repeal of the expensing of intangible drilling expenses would have an effect on the rate of return to exploration, lowering the return of marginal projects, and reducing over-all domestic exploration and development activity by U.S. firms.

Now there is an interesting bit that you don’t see in the Democrats’ press releases. While the CRS notes that these conclusions are sensitive to oil and gas prices — and that high gas prices would mean that companies would invest anyway — once more this displays a real level of ignorance of how the oil and gas industry executes projects. If oil prices race to $200 a barrel, oil companies can’t run out and turn on the taps. Projects take many years to complete, and therefore oil companies use projections of future prices. Taxes that impact these projections will mean that some projects are not done, which will lower domestic supplies. End of story.

However, it is also true that if the oil company projections are too low, the projects that they did decide to drill would be far more profitable. That brings to mind some alternative ways of taxation that wouldn’t limit their current investment decisions, but could mean more government revenue when those investment decisions pay out. Of course that is actually sort of the system that is in place now. When their projections are low, oil companies make more money, and the government gets more in the form of income taxes. But if we collectively felt that the government isn’t getting their fair share, that could be structured differently without negatively impacting current investment decisions.

Punishing Cleaner Burning Natural Gas

Natural gas projects are more likely than oil projects to be affected by the tax changes because they are experiencing low market prices due to the volume of non-conventional gas production that has entered the market in the past several years.

So the memo suggests that because of high oil prices, current oil projects may be unaffected, but it’s a different story for current (and future) natural gas projects. This is what the politicians don’t seem to get when they start making their deficit reduction projections. They simply see that if they take $21 billion from the oil companies over the next decade, they will have $21 billion for deficit reduction. In fact, another outcome may be that they take $21 billion from domestic oil companies and it merely ends up in the hands of foreign oil companies. In that case the politicians lose that revenue because they don’t understand how their decisions impact the industry. In fact, the memo alludes to that, which I will get into below.

Increasing Taxes Will Spur Domestic Production?

The oil industry has benefited from the ability to deduct very broadly defined foreign income tax payments from their U.S. tax liability since the 1950s. If the definition of what constituted an actual income tax payment were tightened and foreign governments did not reduce their charges correspondingly, the industries’ domestic, as well as total income tax burden would likely increase. However, this provision again is a tax on profit, and in line with the economic theory of taxation, should have no effect on the firms output or pricing decisions, and therefore no effect on the price of gasoline. The incidence of the tax would appear to be on shareholders.

In that case, Joe the Pensioner.

The change in the dual capacity tax payer rules might make overseas investment that leads to foreign profits less attractive to the companies than investment in the United States. This could lead the firms to enhance domestic capital spending leading to increased domestic production and reduced oil dependency.

That is an interesting angle that I hadn’t thought about. But it is also an incentive for firms to simply relocate overseas, such that they aren’t subject to dual-taxation.

Percentage Depletion Allowance? Will Only Impact Smaller Producers

The percentage depletion allowance was repealed for the major oil companies by the Tax Reduction Act of 1975 (Pub.L. No. 94-12). Percentage depletion remains generally in effect only for the independent oil companies. As a result the percentage depletion allowance should no longer be a factor in investment, output and pricing decisions by the five major oil companies

So, this isn’t even a tax break for big oil, yet one they are still considering repealing. People may not realize it, but small producers already produce the majority of the oil in the U.S. While the EIA apparently no longer publishes it, up to 2006 they published the U.S. Crude Oil, Natural Gas, and Natural Gas Liquids Reserves Annual Report. In that report was an appendix called Operator Level Data, which a reader graciously sent me. I have hosted that appendix here. What that document shows was that as of 2006, the largest oil producer in the U.S. was BP, the 10 largest producers made up less than 50% of U.S. oil production (Table A4) — and that percentage had been in decline for several years.

So the proposal here would not impact big oil at all, but would impact the smaller producers that supply the majority of the country’s oil.

It is “Likely” that the following would yield “Only” a “Small” impact on gas prices and domestic production, “Unless” oil prices fall

Costs associated with the use of tertiary injectants are currently treated as deductible expenses. Expensing of these costs encourages their use and enhances oil production levels. For smaller, independent exploration and development firms the cost incentive could be important. However, the five major oil companies, to which repeal would apply, earned over $32 billion in net income in the first quarter of 2011. Repeal of the deduction for the industry is estimated by the Obama administration to yield only $6 million in revenue in 2012. Only a part of the $6 million revenue estimate would be paid by the five major oil companies. As a result, it is likely that repeal of the deduction, with a change to capitalization, or amortization, of these costs, would have only a small effect on oil production or pricing, especially in a market where oil returns over $100 per barrel. In periods of low oil prices the repeal of the deduction could have a larger effect. The effect on domestic gasoline prices is likely to be small.

Once again, here is an issue that is going to hit small producers that hardest, will generate a tiny amount of revenue next year, but risks reducing oil production in the longer term. Further, they admit there is likely to be some impact on gasoline prices, especially if oil prices fall, because that would make some marginal production uneconomical. The last line projecting a likely small impact on domestic gasoline prices is only in the very short term, and only if oil prices remain above $100 per barrel.

The magnitude of the revenue effects of these tax changes might be important in evaluating their effects on the oil industry. The five provisions, taken together, are expected to raise approximately $1.2 billion in 2012. For the calendar year 2010, the revenues of the five largest oil companies were approximately $1.5 trillion with additional revenues accruing to the non-majors. The net incomes, after tax, of these five companies totaled over $76 billion with additional earnings accruing to the non-majors. The total expected tax revenues are only 5% of the earnings of the five largest firms in the industry and a smaller percentage of the total industry.

But those are global earnings. They are looking at earnings that have absolutely nothing to do with the U.S., and coming up with a relatively small percentage. If you look at only U.S. earnings, it is going to be a lot larger percentage than 5%, and it is silly to think that won’t impact on investment, production, and ultimately pricing here. But the most astonishing part of the report attempts to address that concern:

If We Are Wrong, We Can Just Import More Oil and Shift Blame Elsewhere

Even if the changes in taxes did impact domestic, or overseas exploration and development activity, that does not necessarily imply that less oil would be available in the U.S. market. More might be imported, with little or no effect on gasoline prices.

Let that sink in for a moment. Yes, these policies might impact U.S. producers in a negative way. But no big deal, because we can just import more oil — sending even more money to the Middle East. Oh, and those jobs that are associated with that domestic oil production that was lost? The tax revenue associated with that lost production? Funny you asked. Those would be exported, along with the revenue the governments were counting on from enacting these changes.

The concluding paragraph is also remarkable:

Political unrest, expectations effects on financial markets, macroeconomic growth trends, the value of the dollar and a host other factors have contributed to fluctuations in the price of oil and gasoline. Any effect due to changes in the tax treatment of the oil industry would be hard to separate from the changes due to other factors, given the size of the relative magnitudes.

Translation: Even if these policy changes do negatively impact the domestic oil industry, reduce domestic supplies, increase our imports, and result in loss of jobs — have no fear. This is a complex issue, and you can easily dodge the blame by pointing at all of these other factors. So the Democratic proposals are really a win-win for them. Stir up more anger at the oil companies, and get your political opponents to oppose the legislation — so you can then paint them as friends of the evil oil industry. Or, pass the legislation, and you can avoid blame if things don’t work out as you think (and their own memo that I have dissected here clearly paints the risks that they won’t). The losers will be the American people as they watch jobs and money flow out of the country.


Here I have summarized Senator Schumer’s “no-brainer”, and the reason why Chuck should be kept as far away from energy policy decisions as possible. Decisions like this are one reason our dependence on foreign oil has increased from one presidential administration after another since the 1970’s.

With all of the political double-speak and grandstanding around issues like this, is it any wonder why we don’t have a consistent, coherent energy policy in this country?