In the debate over tax breaks for the oil and gas industry, there are two big canards being circulated that – like dirty oil in a crankcase – serve only to gunk up the works. One concerns what industry companies will do if they’re assessed more taxes, the other is the industry’s conflation of cost and price.
Industry apologists and advertising say, basically, that if the U.S. reverses any historic tax breaks, the industry will take its ball and go elsewhere. Good-bye, American jobs!
And, at least as bad for politicians, they say the new costs will drive up the price of gas.
The message is clear: government hands off our tax breaks! But neither argument stands up to scrutiny. Here’s why.
Recall that, before Standard & Poor’s downgraded U.S. Treasuries a notch, much ink was spilled over what would happen as investors fled these degraded investments. Then S&P made its dramatic move – and investors flocked to Treasuries.
The flaw in the original angst: Where else could investors go? In fact, many analysts had looked at just this angle and concluded that even if U.S. credit-worthiness slipped a notch, there simply weren’t a lot of better alternatives.
So if the tax landscape changes, where do oil and gas companies take their money and jobs to get better deals and profits than the U.S.? Oil wells take years to locate and drill, and their output gradually declines. Oil producers can never slack off looking for new resources to develop.
U.S.-based and other oil majors aggressively invested in other countries in the past – but in the last five decades, they’ve been progressively frozen out by national oil companies (or NOCs).
Mexico and Venezuela, for instance, have huge reserves but national policies that restrict foreign investment. Ditto Saudi Arabia and other Middle Eastern countries. All went through periods when investor-owned oil companies (IOCs) like Exxon, Shell, and BP controlled some or all production, and they have all opted for national control.
Emerging nations have looked at history and aren’t about to turn their reserves over to foreign IOCs. Check out Brazil, where development of its huge new off-shore reserves is being controlled through NOC Petrobras. Foreign money may be welcome, but foreign control is not.
Other areas with more latitude for IOCs also tend to be unstable, such as Nigeria or Colombia. Look at Exxon and Shell experience with oil theft and insurgent sabotage of pipelines in the Niger Delta.
And IOCs have new competition for resources to develop from government-backed Chinese oil companies, which are also combing the globe for opportunities as Chinese oil demand soars.
The search for new reserves is tough enough that Exxon just signed onto a venture with Russian oil company Rosneft. Exxon is giving Rosneft shares in Gulf of Mexico and Texas wells and is using its drilling technology to develop Rosneft fields in the Arctic and the Black Sea. Rosneft doesn’t have the Arctic technology – yet, anyway. Rosneft is 75% owned by the Kremlin
How risky is this venture? Consider Shell, which invested a reported $20 billion in Russia’s Sakhalin 2 offshore fields before it was forced to sell out to Russia’s Gazprom in 2006. Or look at BP’s experience with TNK-BP, a joint venture with four Russian billionaires, which has spent years in courts fighting customs, tax, and shareholder disputes. In both cases, original contracts favoring the IOCs didn’t protect them in the long run.
The U.S. is among the few places were oil investors can be certain their contract and property rights will be sustained by the court system. And it has substantial reserves off its shores – and perhaps in oil shales, which are beginning to boom with new extraction technology.
For all the complaints about slower leasing in the Gulf of Mexico after the Deepwater Horizon disaster, U.S. oil reserves are being made available to oil companies, drilling is happening, and U.S. production is rising.
If these companies can make better profits elsewhere, they’ll go. That’s true at any time. But weighing costs, risks and profit projections, where can they do better with their investment dollars? Will the loss of a few tax breaks suddenly reverse the financial projections for their U.S. drilling?
The fact is there just aren’t that many alternatives where resources are available to IOCs and the government and laws are stable enough that investment risk isn’t stratospheric. The loss or dimunition of a few tax breaks is not likely to be the deciding factor in decades-long investment strategy.
Which leads to the other canard: the confusion of cost and price.
We’ve seen multiple advertising campaigns that warn raising taxes means energy will cost more. For oil particularly, this isn’t true.
In markets, cost and price are not the same unless one producer, or a cartel of them, holds a monopoly. Otherwise, the producer takes a risk that the price at which his product sells will be higher than his cost of producing it. If he’s right, his business prospers; if he’s wrong, he goes bust.
The difference between cost and price is profit. If the cost goes up but the price doesn’t, the producer’s profit margin is squeezed. But in a market, competition keeps the producer from raising his price to compensate for cost increases – people won’t buy his product, they’ll go to a competitor.
There’s a highly liquid world market in oil. The price of crude here is part of that market. It doesn’t matter where oil is pumped – it goes first where the highest price is being paid. If the Chinese will pay a higher price, that’s where Texas oil will go. For decades, the US paid the highest price and got all the oil it needed. Now, consumers elsewhere are buying cars and competing for the oil, and the price everywhere is going up.
But the price moves independently from the cost of extraction. No producer can go to the market and say, “This barrel cost me $100 to produce so you have to pay me that.” If the world price is $80, that’s what he’ll get.
So when we’re talking about removing tax breaks, we’re talking about increasing producer cost. There is no automatic translation into fuel market price.
The industry itself is so aware of this fact that one of the most actively traded market indicators is the crack spread.
No ordinary consumer buys crude oil – we buy refined products. Crude is bought by refineries, they process it into products like gasoline, diesel and heating oil, and they recoup the costs of crude and processing by selling those products.
The crack spread is the difference between the spot price of crude and the spot price of refined products, and it sometimes goes negative – meaning the refineries are losing money. They’re paying more for crude than they can charge us for gas. They are in a competitive market – if Americans don’t drive as much as expected, the price of gas goes down, and it doesn’t matter if the world price of oil has gone up. The reverse is also true: big driving demand can mean higher gas prices even if the crude price drops.
So the arguments that removing tax breaks will mean either less U.S. investment or higher fuel costs are disingenuous at best. Neither is an automatic result.
What removal does mean is a lower profit margin for producers. There may be valid arguments for retaining the tax breaks, especially for smaller producers. But right now, those arguments aren’t being made.