An Old Mistake Why are they trying to punish the oil companies?JERRY TAYLOR & PETER VAN DOREN The post-Katrina gasoline-price increase seems to have unleashed madness in some GOP quarters. In a remarkable press conference in late October, House Energy Committee chairman Joe Barton and speaker Dennis Hastert demanded that the oil industry use its 2005 profits to build new refineries and pipelines — and they threatened the imposition of a windfall-profit tax if the oil industry refused. In the Senate, majority leader Bill Frist launched a public inquisition of the oil sector and is actively encouraging discussions on a windfall-profit tax; he is also recommending a new federal law against gasoline price gouging, and asking the industry to give “voluntary” assistance to the poor. And according to the American Petroleum Industry, the Bush administration is quietly testing the waters on a similar windfall-profit tax, whose profits would be used to expand federal energy assistance to low-income households. Gasoline prices have dropped more than 75 cents per gallon since their post-Katrina peak, but on the heels of the oil industry’s multi-billion-dollar quarterly profit reports it’s not surprising that many politicians have suddenly resorted to histrionics. What is surprising, however, is the number of conservatives who have happily cast their lot with the anti-oil contingent. Are Republicans’ memories so short that they fail to remember the last time heavy-handed policies were enacted, or are Republicans simply trying to pin the blame on someone — anyone — for the sky-high gasoline prices? Either way, the GOP is playing a dangerous political and economic game. If the public is encouraged to think of “Big Oil” as a public enemy, it’s unlikely that voters will hire Republicans to play sheriff. But more important, the policies Republicans are flirting with threaten to do serious, permanent damage to the oil industry. It’s instructive to dwell on what happened the last time Congress tried to protect consumers from “Big Oil.” The third phase of President Nixon’s price-control regime, instituted in 1973, prevented large oil companies from passing on to consumers the rising cost of crude imports. So oil companies reduced imports, and cut gasoline sales to independent gas stations in order to keep their own branded outlets supplied. The lines and shortages that form our collective memory of the oil crisis were the result of the Nixon price controls — not the largely symbolic Arab oil embargo. During the following years, Congress instituted a number of measures to remedy the situation, but they all had one thing in common: They distorted the market and created perverse incentives for oil companies, incentives that made America more reliant on foreign imports and increased the global price of crude. All of the economic postmortems undertaken of the 1970s price-control regimes paint the same ugly picture. Economist Joe Kalt calculates that domestic oil production was between 0.3 and 1.4 million barrels per day lower than it would have been without price controls. R. T. Smith, another economist, says that the lost production and higher demand that resulted from the price controls increased world crude-oil prices by 13.5 percent, which of course resulted in higher oil prices for American consumers.
Dennis Hastert
Roman Genn
As part of a political compromise that allowed the price controls to expire, Congress passed the Crude Oil Windfall Profit Tax Act of 1980. The title, however, was a misnomer: The law did not tax oil profits, but instead taxed each barrel of oil when the price per barrel went above a set government level. Like the price controls before it, the law discouraged the development of new supplies by increasing costs for oil companies. According to analysts at the Congressional Research Service, this tax reduced domestic oil production by 3–6 percent and increased imports by 8–16 percent before it was repealed in 1988. Now, as then, a windfall-profit tax would not actually tax profits; it would merely increase oil taxes, which would inevitably harm consumers. Are oil profits so offensive that we must go down this road again? One might think so given the recent uproar, but oil profits are not all that remarkable. According to data collected by Goldman Sachs, the median return on invested capital in the oil and natural-gas sector from 1970 to 2003 was less than the median return on capital invested in the stock market over the same period. In the second quarter of this year, net profits were 9 percent of sales for oil and gas companies in the S&P 500 and 8 percent for the S&P 500 as a whole. Profits, then, would have to be very fat for a very long time before the industry could claim to have returned even average profit margins from 1970 to the present. Calls for the industry to voluntarily reduce prices are also based on a false understanding of the market. “Big Oil” does not dictate fuel prices. Contracts between oil companies and refineries — and between refineries and retail outlets — typically tie the purchase price to local oil commodities markets. Hence, fuel prices are established by thousands of market actors buying and selling oil on numerous, decentralized markets; prices aren’t set by corporate CEOs in smoke-filled boardrooms. High prices are unfortunate for consumers, but they accurately reflect market realities. Congress can no more repeal the law of supply and demand than physicists can repeal the law of gravity. If you restrict the profits you can make from something, you’ll get less of it. If you restrict prices, you’ll get less conservation. High prices do more to encourage both production and conservation than anything Congress could dream up. The Republican call for more refining investment is even less explicable. First, returns on investment in refining have been less than the median returns in the rest of the economy since 1985. Forcing investment in a historically low-returning sector would seem to be the antithesis of good public policy. Second, it is absurd for politicians to tell private companies what they should or should not do with their private capital. In a free society, businessmen make that choice for themselves. Consider also how quickly the oil industry responded to disruptions after Hurricane Katrina. The storm took more than 10 percent of U.S. refining capacity offline and knocked out many of the pipelines needed to deliver Gulf Coast gasoline to the rest of the nation. By mid-October, 1 million barrels a day of U.S. crude production remained shut down (5.2 percent of U.S. consumption, 19 percent of U.S. production, and only 1.4 percent of world production). Simultaneously, 1.6 million barrels per day of refinery capacity remained offline (7.8 percent of U.S. consumption, 1 percent of world consumption). An economic analysis of those numbers predicts that a reduction in supply of that magnitude would result in a gas-price increase of 33 percent, or 84 cents per gallon. We saw exactly that as prices went from their August average of $2.50 to nearly $3.30 per gallon, but prices have since fallen back to below August levels. The market has responded: Imports are up 38 percent, and gasoline demand has dropped — all in less than two months. Motorists might think it nice if the oil industry had the reserve capacity to insure against major disasters, but business is not in the job of doing the public favors — unless the public pays for them. A company with excess capacity will have to pass that fixed cost along to consumers, and there will almost assuredly be another company, with less excess capacity, that can undercut the price. Refineries typically cost $2–6 billion to build, and managers cannot allow them to sit idle for long without triggering a (justified) stockholder rebellion. Politicians have no business calling for such excesses. Consumers are much better off paying relatively low prices most of the time and high prices when supplies are tight, than paying higher-than-normal prices most of the time in return for slightly lower peak prices. Investors will put money into the refining sector if and when they discover that profits can be gained by doing so. If profits can’t be made, it tells us that there is no shortage of capacity. In other words, if there’s a problem, the capitalists in our midst will solve it — without Dennis Hastert’s help. It takes a lot of political courage to tell an outraged public that the invisible hand of the free market works better than windfall-profit taxes, price controls, or federal interference with corporate investment decisions. It’s worth remembering that during the most explosive oil-price increases in history, and with the prospect of a tough reelection fight on the horizon, Jimmy Carter used his executive powers to remove the price controls he had inherited. And President Carter was eventually beaten by a candidate — Ronald Reagan — who promised to go even further to liberate the industry from government interference. Today’s Republicans in Washington could learn a thing or two. Messrs. Taylor and Van Doren are senior fellows at the Cato Institute. Mr. Van Doren is the editor of Regulation magazine.