President Biden and some other members of the Democratic party would like oil companies to bring down gas prices, which they see--correctly--as being a drag on the economy. However, the president’s proposed windfall profits tax will not achieve lower gas prices. An additional tax on U.S. oil companies would ultimately deter investment into the sector.
Lower energy prices are desirable for a stronger economy. Economics teaches us that to reduce prices, we must increase supply. There is also the expectation that if there are higher potential profits, firms will invest a sizable portion to produce more.
However, one fundamental economic principle this administration is forgetting is that if future profits are threatened--which is precisely the point of a windfall profits tax--energy firms would likely respond by reducing the very investments needed to increase supply and put downward pressure on prices.
If the administration wants more oil production, then it should implement policies that encourage energy companies to invest and produce. A cursory glance at what’s occurred in U.S. energy markets in the last decade reveals that output is sensitive to potential profits.
The advent of modern methods for hydraulic fracturing--also known as fracking--made it much easier--and cost-effective--to drill for oil, and its widespread adoption resulted in the U.S. more than doubling its output of crude oil over the last decade. It’s worth noting that the sizable investments it took for the technology to finally become cost-effective after decades of experimentation occurred in the mid 2000s, when oil prices were at record high levels.
The resumption of economic growth after the exigencies of the pandemic, combined with the impact of the Ukraine war on the oil market, has pushed prices near record levels, and domestic crude oil production has recovered to 12 million barrels. However, prices remain high across the globe as countries scramble to replace the oil and gas that had previously come from Russia. More production would definitely be welcome in the market. Hence, the need to signal to oil companies that they can invest and produce.
President Biden objects to what he characterizes as “obscene” profits of oil companies in the last year, which begs a question: Are investors in U.S. oil and gas companies earning outsized returns? In 2021, the U.S. energy sector was second from the last in terms of profitability out of 11 major sectors in the economy, and from 2012—2021, the average annual stock market return of the energy sector was the lowest at about 1% per year, compared to S&P 500 at 15%, and information technology returns at 23% per year. In the last decade the value of Exxon-Mobil fell so much that it was replaced on the Dow Jones Industrial Average.
While oil and gas companies have had a good year, they’re still recovering from a mediocre decade and facing a future that promises to be more hostile to their product. A windfall profits tax would send a clear signal to the industry that they won’t be compensated for taking risks and investing more to boost production when prices increase.
Despite President Biden’s statements against oil companies for not increasing production, it’s not clear that he or some of his fellow Democrats truly want to see more oil and natural gas production. In the current Congress they have proposed legislation that seeks to stop banks from funding new fossil fuel projects (Fossil Free Finance Act), and the administration so far has also leased fewer acres for oil-and-gas drilling than any other administration dating back to World War II. The contradiction becomes even starker when the administration encourages non-U.S. producers to produce more while discouraging U.S. producers. But even here, the U.S. Treasury is simultaneously promoting an end to financing fossil fuel based energy production under an Executive Order.
We even have the president coming right out and saying, “no more drilling” at a campaign event in New York right before the election. These contradictions in policy create significant uncertainty and confusion for oil and gas companies and their investors.
Other parts of the petroleum supply chain also contribute to higher oil prices. For instance, during COVID, refineries also took significant financial losses, and some shut down. U.S. refinery capacity has fallen by about a million barrels a day from before the pandemic. Investment in new refineries could help increase supplies, but the life cycle is long: The average age of U.S. refineries is more than 40 years, and the newest large refineries were originally constructed in the 1970s. Given the regulatory posture towards the industry, no one wants to start a new refinery today. Few banks or other investors would have the stomach to put their money into such a venture, regulatory requirements would be strict, and the amount of time the refinery will be able to continue operation will be difficult to predict.
Today, fossil fuel accounts for 80% of global energy consumption while renewables such as wind and solar account for 11%. The energy mix of the world has changed over time, and it will change again. However, until newer sources of energy become a significant alternative, the present United States administration needs to stop suppressing its own energy sector.
The United States has abundant energy reserves to support itself and its friends today, and it also has tremendous ingenuity to implement the innovations needed for tomorrow’s economy. All that is needed is that these vast talents and resources be allowed to achieve their potential unimpeded. Consumers will be happy and the electorate will see real improvements in their lives.
