How Taxpayers Could Benefit From High Oil Prices

end polluter welfare act
In last week’s post — If We Only Had a Stable Energy Policy — I mentioned three specific examples of legislation under consideration that create uncertainties within U.S. energy policy. These uncertainties increase the financial risks for those trying to develop energy projects — both for conventional fossil-based projects and for renewable energy projects.

One piece of energy legislation that was recently introduced is called the End Polluter Welfare Act. It was introduced by Senator Bernie Sanders, an Independent from Vermont, along with Minnesota Democratic Congressman Keith Ellison.

In my opinion our energy legislation should promote a stable regulatory environment for energy producers, and that a major goal of energy policy should be to reduce our dependence on oil from unstable regions of the world. When politicians change the rules of the game every 2 to 4 years, they create an unstable regulatory environment, and in turn energy developers adopt a more conservative approach to projects. The result is that our dependence on oil imports is higher than it needs to be.

In addition, the fact that a U.S. Senator and a member of the House of Representatives characterize our domestic oil companies as “polluters on welfare” is a symptom of our dysfunctional energy policies. Domestic energy is critical to U.S. energy security, and yet one of our major political parties has declared open war on the energy companies that produce most of that energy. That is at best pandering, and is not a prescription for a successful energy policy.

Instead of going through Senator Sanders’ entire bill, I want to focus on one item from the bill, explain why I believe Senator Sanders is wrong, and propose a better way of doing it.

Section 4 of the proposed bill is Royalties Under Mineral Leasing Act. Subsection B — Leases on Land on Which Oil or Natural Gas is Discovered — reads: “Section 14 of the Mineral Leasing Act (30 U.S.C. 223) is amended by striking 12 1/2 and inserting 18 3/4.” The same amendment is proposed for federal land on which natural gas or oil are known or believed to exist: Increase the royalty from 12.5% to 18.75%.

The premise is straightforward; oil companies are making record profits and hence they should pay more for the oil they are extracting from public lands. This is an understandable sentiment, but as written the bill is short-sighted. It is based on a fundamental misunderstanding of how the oil industry works. It is the same sort of tactic that Hugo Chavez has utilized in Venezuela, and this has in turn caused oil production there to decline by 25% over the past decade. Chavez kept arbitrarily raising royalty rates, and in turn producers invested less and less back into new production. (He also siphoned off profits for social programs; great for his popularity in the short term, but then oil production plummeted because insufficient funds were reinvested into finding and producing oil).

Senator Sanders’ proposal will certainly have populist appeal, but it will almost certainly cause oil companies to reduce their investments in developing new oil and gas. Yet there is a better way that would capture higher royalty rates when prices are high without causing reduced investments in exploration and development.

Many people believe that with oil at $100 a barrel, there is plenty of incentive for oil companies to produce oil even if their drilling incentives are removed and their royalties are raised. The problem is that oil companies don’t make decisions based on the oil price today; they make decisions based on where they project prices to be. And most of them are projecting prices to be lower than they are today. Projects take years to complete, and if oil companies are forecasting $70 oil, a higher royalty, and no drilling incentives — then the likely outcome of the bill will be less domestic drilling. (Of course given the title of the bill, maybe that is the intention). But it does absolutely nothing to address our energy security; in fact it risks reducing our energy security.

On the other hand, I do think that as oil prices escalate, it is fair to increase the royalties on the oil companies. But it needs to be done in such a way that if prices fall, oil companies aren’t stuck with high royalties because of the negative impact on investments in new production. That’s the problem with Sanders’ proposal; it is only a provision for times of high oil prices. If oil prices decline, the provision is a prescription for a rapid decline in domestic drilling. In other words, it isn’t sensible long-term energy policy.

So I would structure an escalating scale of royalties for future contracts. This is one of the things I discussed in my book; how to structure contracts such that citizens will increasingly benefit from oil taken from public lands as oil prices increase. The present royalty — 12.5% — dates to a time in which oil prices were $10 or $20 a barrel. So I would structure future leases to charge 12.5% until oil prices reach some threshold (e.g., $25/bbl) and then ramp up as oil prices increase. It might be reasonable to have a royalty of 18 3/4% when oil prices are at $100/bbl and 25% for oil prices of $150/bbl.

Such a scheme would likely not discourage oil companies from exploring for and producing oil. Oil companies are not planning for $150 oil, and if oil does rise to that level they will profit handsomely from the increase in price. Under the system we have today, they can receive large, unexpected windfalls when prices spike; windfalls that are often brought on by the actions of OPEC or by geopolitical uncertainties. Because of the damaging nature of high oil prices to the U.S. economy, I believe it is reasonable that the damage be mitigated somewhat with a sliding royalty scale. In order to do that, I think it would be wise to earmark the royalty windfall for programs that can directly decrease our oil consumption.

One option would be to put the increased royalties into a separate fund and offer rebates for cars that get high fuel economy. For example, we could provide rebates of up to $2,000 for cars that achieve 50 miles per gallon. This would help consumers afford to improve their fuel economy even if they are struggling with high gasoline prices. With a program like that, the fuel economy of the fleet would probably rise even faster than fuel economy standards require.

Or we could nationally enact a scheme like Alaska’s Permanent Fund, which returns a dividend from the state’s oil revenues back to Alaska’s residents. As oil prices rise to $100 or $150, 5% of the sales price (for example) could be put into a special fund and returned to citizens as a dividend. This kind of program would likely be much more popular with the general public, but unlike a rebate program it does nothing to address the rising consumption that has helped push oil prices to high levels.

Regardless of the specifics of how such a program is implemented, a sliding royalty scale should minimize the risks that politicians will decide to change the rules as oil prices change. Those changes would already be built into the system, and as a result oil companies could build that into their financial models. This system would decrease their risks in the case of lower prices, but would not be a major impediment to new investments in the event of rising oil prices because oil companies are not forecasting $100 0r $150/bbl oil. In the event that high oil prices do occur, that will also mean a sharp rise in oil company profits to help offset the increased royalties.

This is in my view a more comprehensive and long-term energy policy; it addresses both supply side, demand side, and contains provisions to account for changes in oil prices.