President Obama recently proposed eliminating certain subsidies for the oil industry with the claim that as they are making billions in profits they do not need subsidies from the government. The industry countered that they were legitimate deductions recognizing real, if difficult to explain, needed expenses. Congress blocked the whole thing, but what were the real issues?
The question of whether a particular deduction is a legitimate expense or a government subsidy is frequently a matter of opinion.
Profitability is another question. Profitability is determined by percentage Return On Investment (ROI). It does not matter if the return is in billions of dollars or is mere pennies. A profit of ten cents on an investment of one dollar is an ROI of 10% and a profit of one billion on an investment of one hundred billion is a ROI of 1%. the one dollar investment is ten times as profitable. ROI is a signal to the market that more or less investment is needed in that particular area. Investment, and therefore, activity and research will move away from low ROI and toward high ROI.
Except (yes, in economics there is always an except) for the factor of risk. High risk activities require a high ROI. Low risk activities require a lower ROI. Since WWII, the oil and gas industry has been a relatively low risk business in the aggregate (which is the primary concern of large multinationals) and a high risk business in specific locals (which affects small independents more).
The subsidies/deductions were put in place at a time when the fledgling industry needed encouragement and the Government saw a need for more oil. Whether they are still needed today is a technical question that depends primarily on what is desired for the future of the industry. There are some good arguments both for keeping and for phasing them out. (NOTE: Phasing them out is not the same as simply ending them as was proposed by the Obama administration.)
So what happens if they are phased out or ended? Over the long run eliminating these subsidies/deductions will mean a higher effective tax rate on the industry which is a rise in cost and will result in higher prices for all oil products. The existence of these breaks is built into the current price and a change must cause a response. If such an elimination is phased in over several years, with some reasonable warning, the change would simply be absorbed and adjusted for with appropriately higher prices on all oil and gas based products. (Which means pretty much everything else will rise in price also.)
If these deductions are suddenly ended it has other effects. In addition to the above it would also produce some important short term results. One would be a small increase in Federal revenues. A second would be a (probably large) decrease in domestic drilling. This would happen because if a sudden change in profitability occurs it would force businesses to reexamine current plans before going forward. If the government chooses to inflict a sudden change on businesses, the costs of risk have to be recalculated. The most important things businesses need are stability and predictability. If rules that have been in place for a century can be suddenly obliterated without even an opportunity to adjust, then the whole issue of risk must be reconsidered. In climates of unpredictable change, the cost of risk would need to increase, thus Oil Company profits would probably also increase over the long run as a higher ROI was demanded by risk averse investors.
The environmental lobby has made it very clear that they believe the cost of energy should rise. This is a consistent position they have held for more than 30 years. They have reasons. I disagree with those reasons, but that discussion is for a different post. The Obama administration has consistently supported the environmentalist position. I respect that position even though I disagree with it. The proposed action of removing subsidies/deductions in the oil industry is entirely consistent with an effort to increase energy costs specifically in the area of fossil fuels.
What I do not respect is the effort to hide the fact that this action would increase energy costs and the fact that such an increase is specifically the reason for the proposal (plus the usual political jockeying). One of the primary things holding down the economy is uncertainty over potential future governmental regulations. (As I stated earlier, business needs stability and predictability.) Such sudden and dramatic changes in major rules are a threat to an economy that is already near frozen with fear of what the government will do next.
If this post causes you to have even more questions, good. Maybe you need to ask more questions.
Dan
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