As I have been reading reports of the current debate over the pending energy legislation, it occurred to me that there is a fundamental problem with the approach to CAFE standards. The Washington Post reported on the issue in today’s edition:

Senate, House Turn Focus to Energy Bills

Senate Majority Leader Harry M. Reid (D-Nev.) said after a speech to the Center for American Progress yesterday that the increase in auto-fuel efficiency requirements, known as the corporate average fuel efficiency (CAFE) standards, would be the most controversial part of the Senate package. It orders auto companies to hit a 35-mile-per-gallon target by 2020 and improve mileage 4 percent a year after that.

“I know that the auto industry is still wavering on this issue,” Reid said. “I met with the CEOs of the big three automakers last week, and here is what I told them: The debate on raising CAFE standards should be over. It will happen. And perhaps if they had joined us instead of fighting us these last 20 years, they might not be in the financial mess they’re in today.”

So what’s the problem? Isn’t raising CAFE standards a good idea? On the surface, yes. And I absolutely agree that our fuel efficiency in the U.S. is terrible and must improve. But the problem I see is that this attempts to address the issue in the same way that windfall profits’ proposals attempt to address the issue of high gas prices. There are plenty of high fuel efficiency cars on the market now. The problem is, people aren’t demanding them. They want their SUVs and big trucks. What people are really after here is a free lunch. They think increasing CAFE standards will make everyone else drive a fuel-efficient vehicle. Or, they think this will result in a dramatic boost in the fuel efficiency of those trucks and SUVs.

I see the point made by the auto industry, because this will force them to make vehicles that people aren’t demanding. This is incredibly inefficient legislation. There are other ways to increase the demand for fuel-efficient vehicles, rather than forcing auto makers to increase the supply (that doesn’t happen to be in demand). What this may do is restrict the supply of inefficient vehicles, thus boosting prices for them. And a secondary effect may then be that people will turn to more fuel-efficient vehicles. But it is an incredibly convoluted way to achieve that goal.

As I said, this is analogous to the windfall profits’ measures that have been debated. People see this as a free lunch. The oil companies will be punished by having some of their profits taken away, thus somehow resulting in lower prices for all (as the companies respond to this punishment?) It is legislation aimed at the wrong problem. Oil companies make big profits because there is high demand for their product. And fuel efficiency is low because there is high demand for trucks and SUVs. The current legislation being debated won’t change that.

There is no free lunch. Increasing CAFE standards is not going to increase the public’s desire to drive fuel efficient cars, nor is it going to result in a 35 mpg Ford Expedition.

He’s got my vote. He doesn’t take money from oil companies, and is going to punish them for their “windfall profits.” For some reason, Oil Watchdog does show him as having taken $157,390 from oil companies, and I still haven’t heard anyone define “windfall profits.” Of course he does take money from ethanol companies, but that’s OK because this is our key to energy independence (cellulosic ethanol, according to Obama, is our best “short-term” solution).

The best I can hope for is that if he does win the presidency, Bill Richardson is his running mate. I think Richardson is the one of the most knowledgeable politicians around on energy issues.

I have to be honest. Of all the candidates, I thought Obama was a breath of fresh air. But the more I hear him talk about energy policy, the more concerned I become about our future. I don’t think there is any doubt that he will be bad news for oil companies. On the other hand, I can’t stand Hillary. At one point, I really respected McCain for speaking out on the ethanol fiasco. That was before he flipped. I also fear that McCain will keep us in Iraq forever.

Regardless of who wins, I think they are going to preside over one of the most difficult economic periods in American history.

Introduction

I have been aware of Matthew Rothschild’s essay “A Gouging Market” (1) since it started making the rounds a couple of months ago. At the time, I decided not to respond as the article is largely one big whine. However, someone at The Progressive, a magazine that I occasionally enjoy, has deemed it fit to reprint in their June issue (it had originally appeared there in April). I think it’s time to put this one to rest.

Briefly, the article is one long whine about price gouging by oil companies. Rothschild makes a number of unsupported accusations and insinuations, and never defines price gouging (or windfall profits) despite railing against oil companies for gouging. The article oddly embraces two mutually-exclusive themes: Gas prices are too high, and we ought to be conserving. Doesn’t he understand that low prices will discourage conservation?

Selected Points

On to some specifics from the article:

Matthew Rothschild: Accusing oil companies of price gouging is like accusing sharks of swimming. That’s what oil companies do. In fact, that’s the imperative of the marketplace: to charge whatever you can get.

He sets the tone right away in his opening paragraph. A shark. Not just a fish, but a vicious predator that occasionally kills people.

Matthew Rothschild: Rather than having a multitude of ice cream parlors to choose from, the consumer can select from only a few oil companies, and they own not only the parlor but the cows and the dairies, too.

Plus, there’s another big difference between ice cream and oil. The choice of having an ice cream cone is a luxury. Driving a car, for many of us, is a necessity. That’s something the hardcore free market apologists don’t grasp.

There are also a few things here that Rothschild doesn’t grasp, so let me help out. Driving a car is based on the choices you have made to this point in your life. The fuel efficiency of the car you buy is a choice. How far you commute is a choice. So, we buy SUVs that get 14 miles a gallon, and then complain about gasoline prices. People have made their choices because of years of cheap gasoline. They should have known that low prices wouldn’t last forever, and now that the days of low prices are over, they scream and whine. They want the government to intervene. Oil is not as abundant as it once was, so the price has risen. Oil companies have made money as a result, and that’s just not fair, is it? They must be punished.

Europe knew that gasoline wouldn’t be cheap forever, so they heavily taxed fossil fuels to encourage conservation. This generated enormous funds for the government, limited greenhouse gas emissions, and prevented the sort of suburban sprawl we have here in the U.S. The cars in Europe are small and fuel efficient, and therefore they use far fewer fossil fuels per capita than we do in the U.S. Because they have made the right choices, they are less dependent than we are on petroleum.

Matthew Rothschild: “Gas station owners cannot force us to buy gasoline,” writes Alex Epstein of the Ayn Rand Institute, in an article entitled “The Myth of Price-Gouging.” “They can only offer us a trade, which we are free to accept or reject.”

But how free is the independent trucker, or the taxicab driver, or the traveling salesperson? How free is the service worker who can’t afford to live in the expensive city where she is employed, so she has to live thirty miles away, where there is no public transportation? Oil companies know that they have a lock on a crucial product. They’re charging accordingly.

When I get a migraine, I take a medication that costs $15 a pill. Now, I don’t have to take that pill, but it is the only thing that works reliably. I could instead suffer through the migraine for 3 or 4 days until it goes away. But I usually choose not to. Doesn’t the pharmaceutical company have me over a barrel? Yes they do, but I am glad I have that choice. I know that they are making profit margins that far exceed those of oil companies, but those profit margins are driving those companies to research new medicines that might keep me alive and healthy for many years to come.

It’s the same with oil. The oil business is very capital intensive. It costs billions to build a new refinery and to maintain existing facilities, which is why you don’t see Mom and Pop refiners sprouting up to compete with the big boys. The large capital sums required to operate this business is what has driven the consolidation in this business. Even ExxonMobil, as big as it is, is dwarfed by some of the state-owned oil companies like Saudi Aramco. They have revenues that allow them to invest in next generation technologies like XTL. Smaller oil companies simply could not compete at that level, because they would lack the necessary capital to put up the multi-billion dollar “entry fees”.

We already know what would happen if Rothschild got his way and windfall profits taxes were implemented, since it has happened before. Oil companies would have less money to invest in expanding capacity, and we would end up with shortages (and even higher prices). I don’t understand why we can’t learn from history in this case. (2)

Matthew Rothschild: It very well may be that what the oil companies have been doing over the last couple of years does not technically qualify as collusion.

I can just see the pained expression he must have had on his face when he wrote that sentence. Of course it doesn’t qualify as collusion. Technically, or otherwise. The oil majors have been investigated many times in recent years on charges of collusion and price gouging. They have been vindicated time and again, much to the chagrin of people like Rothschild who are convinced something foul is afoot. The FTC recently investigated charges of collusion following Hurricane Katrina, and once again found “price increases were approximately what would be predicted by the standard supply and demand paradigm.” (3)

Matthew Rothschild: “The real problem is legal manipulation of prices,” says Tyson Slocum, acting director of Public Citizens Critical Mass Energy and Environment Program. “The oil companies have gotten so big they don’t need to collude anymore. Advances in computer modeling have really aided the ability of the big companies to game the market.” So game it they do.

It is unsupported accusations like this that really annoy me. It’s nothing by slander. Again, ExxonMobil, the largest oil company in the U.S., controls 3% of the world’s oil. How is it that they are gaming the market? They don’t have the ability to game the market. The prices are set on open exchanges by willing buyers and sellers. Oil companies don’t post prices for their oil, and say “take it or leave it”.

Matthew Rothschild: And because the five largest oil refining companies in America control more than 50 percent of the market, they can individually decide to limit the supply of refined oil products. If ExxonMobil sees Shell taking gasoline off the market, it can do likewise, and they will all end up making more profits without ever needing to huddle together in a boardroom to fix prices.

And the smears continue. Above, he admitted that collusion is not going on. The FTC has found no collusion. Yet, somehow since 5 companies (not 1, mind you) control over 50% of U.S. refining capacity, “they” control the market (i.e., they really are colluding!) to fix prices. Ridiculous. If ExxonMobil sees Shell taking gasoline off the market… What? Have you checked refinery utilization lately? Apparently not, because fact-checking didn’t seem to be an important aspect of this article. Refineries are running just as hard as they can, so people like Rothschild won’t have to wait in gasoline lines or even better, deal with rationing. What kind of thanks do they get? People like Rothschild complaining that the price is too high.

Matthew Rothschild: Even George Bush, as ardent a defender of the oil companies as ever set foot in the Oval Office, has begun to make noises. With his popularity down at the freezing mark, he’ll say just about anything. But he won’t say “windfall profits tax,” even though, according to an Opinion Research Corporation poll (and this was back in September, before the current hike), 80 percent of Americans are in favor of it, including 76 percent of Republicans.

Do you really want to start basing policy decisions on the whims of the public? Didn’t the majority of the public favor getting into a war with Iraq? Does the majority favor it now? Does the majority still favor Bush as president? The thing about legislating and making decisions based on popular opinion as opposed to really considering the implications is that you might end up with something you didn’t anticipate.

Matthew Rothschild: Bush ruled that out in his April 25 speech. “What can the government do?” he asked. “One of the past responses by government, particularly from the party of which I am not a member, has been to have-to propose-price fixing, or increase the taxes. Those plans haven’t worked.” No, we can’t have that, can we? Never mind that the windfall amounted to $36 billion last year for ExxonMobil alone.

Rothschild never did get around to defining a windfall. What exactly is it? Is a profit on sales of 10%, as ExxonMobil made, a windfall? How about a pharmaceutical with a profit margin of twice that? What if I buy a house in California for $200,000 and sell it for $500,000? How much of that constitutes a windfall? What did I do to earn it, other than being in the right place at the right time? I would like to see some of these critics address some of these questions. Define “gouging” and “windfall”, and tell me when it is and is not permissible.

Matthew Rothschild: Bush and conservatives love to harp on the fact that refinery capacity is way down in this country, and they blame that on environmentalists. But as Slocum notes, a small oil company, Arizona Clean Fuels, has managed to navigate the bureaucracy and get all the permits it needs.

Right, and they have only been working on it for 10 years! Another 5 and they might have a refinery. Who wants to wait 15 years to have a working refinery? It is much easier to expand existing refineries than to build a new facility.

Matthew Rothschild: If it can do this, asks Slocum, “why can’t the world’s most powerful corporation?” He offers an answer: “ExxonMobil has no interest in creating additional refineries because it will drive prices down.”

I am sure that ExxonMobil has no interest in waiting 15 years to build a new refinery in the U.S. when they can simply expand existing facilities. That is what they have been doing. A little fact-checking (remember to do that next time!) would have shown that despite the fact that no new refineries have been built in quite some time, refining capacity has increased significantly in the past 20 years.

Matthew Rothschild: We should all live long enough to see the day when the Bush- Cheney Administration hauls ExxonMobil and the other big oil companies into court. What Bush didn’t propose is as telling as what he did. He didn’t propose busting up the oilopoly.

Yeah, that sounds like a great idea. That is if you want to eliminate the ability of the U.S. oil majors to compete with the likes of Saudi Aramco because they lack the size. Next generation fuel technologies do not come cheaply. You need size to compete. So let’s bust up the oil companies and rely on the national oil companies of the Middle East to keep us supplied.

Matthew Rothschild: The average car and truck on the road today gets only twenty-one miles to the gallon. In 1987, the average was twenty-two. We’ve been going backward. And in last year’s energy bill, Bush, the Republicans, and many Democrats, too, blocked an amendment to boost fuel efficiency standards.

“President Bush continues to ignore the most obvious and practical solutions,” the Sierra Club says. “The biggest single step we can take toward saving money at the gas pump, curbing global warming, and cutting America’s oil dependence is to make our cars, trucks, and SUVs go farther on a gallon of gas.”

I found this the strangest aspect of the whole argument. Complain that gas prices are too high, and at the same time complain that fuel efficiency standards are too low. It’s like there is no comprehension on Rothschild’s part with respect to cause and effect. Again, let me help. Fuel efficiency standards are low because we have had cheap gas for such a long time. Pushing gas prices back down will take away the incentive for people to start embracing conservation.

Matthew Rothschild: Americans cannot keep consuming 25 percent of the world’s oil when we have 2 percent of the world’s oil supply and 5 percent of its population.

LOL! Then why don’t we do everything we can to push gas prices back down? That should help. Right?

Matthew Rothschild quoting Representative Dennis Kucinich: “Congress must break the hold that the oil companies have on the politics of our country. Congress cannot stand by while the oil companies are stealing from the American people.”

Frankly, I find that insinuation disgusting. Oil companies are supplying a vital, but declining resource. They are making money as the price of this resource is increasing, and this is “stealing”? Then I guess the guy who made $300,000 on his house in California is also stealing.

Conclusion

In summary, I just can’t figure people like Rothschild out. Complain that gas prices are too high, while complaining that we use too much of it. Offer no solutions to the problem, other than one long whine and diatribe against an industry in which people sometimes lose their lives to provide your gasoline at a lower price than bottled water.

The oil companies are not the problem, Rothschild. The person who thinks cheap gas is an entitlement that must be maintained is the problem. We must embrace conservation, and higher prices have shown that they encourage conservation in Europe. If you don’t like the fact that oil companies are reaping the profits, get behind a higher gas tax so the government can reap a greater portion. But don’t kid yourself: Low gas prices aren’t going to benefit anyone in the long run.

References

1. A Gouging Market, The Progressive, June, 2006.

2. Glassman, James, “Windfall Profits” Tax on Oil Companies, Capitalism Magazine, September 26, 2005.

3. Epstein, Edward, Feds: No Collusion or Price Gouging, San Francisco Examiner, May 23, 2006.

Regardless of your position on windfall profits taxes on oil companies, one thing has been demonstrated again and again. Governments consistently fail to accurately anticipate the consequences. As oil prices have increased, governments have seen tax revenues from oil and gas grow significantly. But they apparently believe they know how to deal with a goose that lays golden eggs: Take some food away from that corpulent goose, but expect it to keep laying golden eggs.

The purpose for imposing windfall profits taxes is generally two-fold. First, a government can tell the citizens that despite their inability to control oil and gas prices, they are doing something by “punishing” the oil companies that benefit from these rising prices. Second, they genuinely see it as a rich source of revenue that they can squeeze without consequence. They think the only real people who will be affected are those who are directly involved with oil and gas companies.

History has shown again and again that this viewpoint is inaccurate. That hasn’t stopped recent attempts in California, with Proposition 87, and current attempts in Wisconsin to again try dipping into this “consequence-free” pot of money. While I favor the direct approach – tax oil and gas on the consumption side – recent attempts have focused on taxing it on the production side, while writing into the legislation provisions to prevent costs from trickling down to consumers. I have previously noted the stunning naivety of this approach, and that these attempts are destined for failure.

It turns out that we now have another example to add to the list in which politicians inaccurately gauged the consequences. The story more or less starts right after Hurricane Katrina. U.K. Chancellor and soon-to-be Prime Minister Gordon Brown detailed what he believed needed to be done to bring down gas prices:

Brown calls for oil price effort

Chancellor Gordon Brown has called for a “concerted effort” by oil-producing countries to bring down prices – but is not offering to cut taxes on petrol.

Ahead of expected fuel duty protests, Mr Brown told the TUC Opec countries to produce more oil and refine more.

Mr Brown called for more worldwide investment in refineries and alternative energies.

So, he told OPEC to produce more oil. I bet they got right on that. The last statement is the most interesting, in light of the move that Brown made just a few months later:

Brown doubles North Sea oil tax

Chancellor Gordon Brown has announced a rise in the tax levied on North Sea oil producers in the wake of record crude prices. Under the measure, the government’s supplementary charge on energy companies will rise to 20% from 10%.

Mr Brown also said there would be no further rises in the North Sea oil tax during this parliament.

Meanwhile, the extra revenue raised would be used to “help consumers most affected by the significant increases in global oil and energy prices” such as pensioner households, the government said.

“Governments levy taxes and we will do what we have to,” said a BP spokesman. “But any extra tax that we pay is money that is no longer available for investment in North Sea oil and gas fields.”

So, Brown called for more investment, and then doubled the surcharge (bringing the total corporate tax rate for oil companies to 50%). I guess he thought he would sit back and watch the revenues come rolling in, and then use those revenues to help consumers affected by higher energy prices. But not only do you discourage investment with these sorts of moves, rising oil prices also increase the costs of everything associated with the oil business. I could have told him that while his strategy might work in the very short term, it would certainly be akin to cutting a research budget: Short term gain, with often longer term consequences.

Brown’s reality checks have started to arrive. In a prescient article written in February 2007, Shadow Chancellor George Osborne got to the crux of the matter:

Gordon Brown is squandering North Sea oil assets

By squeezing the maximum amount of tax revenue from Britain’s oil and gas assets, Gordon Brown is putting further offshore investment at risk, George Osborne has warned.

Accusing the Treasury of failing to understand that the UK Continental Shelf is a mature resource competing for investment in a fiercely competitive global market, he went on: “They don’t recognise that investment in the North Sea cannot be taken for granted when there are potentially more profitable opportunities in West Africa, Mexico or Brazil.

In short, Gordon Brown risks denying future generations the benefits our generation has enjoyed from the North Sea. He’s more interested in cash today than investment tomorrow. The result is that Britain’s North Sea inheritance is in danger of being squandered.”

Last week, the treasury announced that things weren’t working out as forecast:

North Sea Revenues Drying Up

Source: Daily Mail; London (UK)

Publication date: 2007-03-22

BRIAN O’CONNOR

The Treasury is nursing a Pounds 5bn shortfall in North Sea oil and gas revenues after a sharp rise in tax rates failed to bring in the targeted result. North Sea revenues for 2006/7 were only Pounds 8bn, against a projected Pounds 13bn. Though North Sea production is declining, the fall cannot be explained by this alone. The UK Offshore Operators Association (UKOOA) says the Treasury did not foresee that a rise in crude oil prices would be followed by a sharp rise in costs as the industry scrambled for drilling rigs, skilled workers and specialist equipment.

Surprise! Thus is the short-sightedness of our political leaders.

Brown has admitted that things didn’t work out as planned, but blamed “factors outside the government’s control”:

‘Brown playing games on oil’

Falling North Sea oil revenues will force the government to borrow more than expected, it emerged today, drawing accusations of “panic” from opposition politicians.

Gordon Brown argued in an interview that borrowing remained on a downward trend but added: “What has changed our forecast is what happened to North Sea revenues.”

Mr Brown said North Sea oil revenues would be £5.5bn lower than expected for 2007/08 but argued that the reduction was due to factors outside the government’s control. “That’s no fault of the government. It’s lower production from the North Sea. We have to take that into account,” Mr Brown told the BBC’s Today programme.

No fault of the government? Again, read George Osbourne’s words above. Investment in the North Sea is affected by the tax rates. You have taken money away that could have gone into new investments and diverted it. So, even though North Sea production is in decline, these policies will accelerate that decline by discouraging new investments.

As I said, I support higher gas taxes. That is not my issue at all. My issue is that these politicians have an incredibly naive view and believe they can increase these taxes with no fallout on anyone but the oil companies. Time and time again they see this as a quick fix to budgetary issues, while pandering to a constituency outraged at higher energy prices. It’s just that it never works out they way they thought it would. But I’m sure that won’t stop them from trying again.

Yesterday I participated in a blogger conference call with the American Petroleum Institute. The topic was Industry Earnings and Recent Oil Prices, and the audio and transcript may be found here.

My question was a political question regarding the seemingly permanent hostile relationship between oil companies and Democrats. My question, and comments that followed:

24:15 MR. RAPIER: Okay. One more question from me, a political question: If you look at political contributions, the contributions from oil companies to Republicans are – tend to outweigh those of Democrats and, subsequently, Democrats have a pretty hostile view toward oil companies. And I’m wondering how we improve that relationship. This is one thing that’s always frustrated me, was that there just seems to be this incredible distaste from Democrats and I never understood why we don’t open up a better relationship here with them, the Democratic leadership.

I think we’re about to have a Democrat in the White House who’s threatening windfall profits and all kinds of things and I can’t understand why we don‟t sit down and open up a better dialogue with the Democratic leadership.

25:01 MR. PUGLIARESI: You know, I have a little story to tell you about that. I happen to have been in a little meeting with Bennett Johnston, the former, as you know, the former senator from Louisiana. And he‟s a Democrat. And he said, you know, he was talking about – I sort of asked him a similar question. You know, why is the Democratic Party at war with the oil industry? I mean, in 2006, it was a cash cow. It generated like $130 billion of revenue to the government. I mean, compare that to the problems they’re having with GM. You know, they should be doing award dinners for these guys. And he said, you know, when we had Democrats from oil-producing states, we didn’t have these problems, because then, the party was afraid – (chuckles) – to overdo it. So you may be – we may be ending up in that direction in the next year if the polls turn out the way they seem to be.

26:53 CINDY KILKENNY: This is Cindy Kilkenny from Fairly Conservative. And I trained as a political scientist and I have to say it’s definitely a wedge issue and it’s very insightful. And I grew up in Oklahoma. My family – my brother is still in the oil patch and he’s been, so I see both sides of this and I know how it’s being used and it‟s just about what it redeems for whoever wants it at that point.

I don’t expect this relationship to get any better with a new administration, but I would certainly like to see it improve. As I have said before, I am probably a little left of center (although I have little in common with the far left or far right), but I think the Democratic party has the more naive view of energy policy. I get the impression that the leadership thinks that if they could just drive the oil companies out of business, we would all live happily ever after on clean, renewable energy.

On May 15th, the Senate Committee on Energy and Natural Resources conducted a hearing entitled Short-Term Energy Outlook Summer 2007: Oil and Gasoline. You can listen to the web cast here. I have done so, and this essay will be about my impressions of the hearing.

You can find the testimony of the various witnesses at the links below:

Mr. Guy Caruso – EIA Administrator
Paul Sankey
Geoff Sundstrom
Kevin Lindemer

Mr. Sankey is an analyst with Deutsche Bank, Mr. Sundstrom represents AAA, and Mr. Lindemer is an analyst with Global Insight. The witnesses really knew their material, although Mr. Sundstrom seemed terrified and Mr. Caruso had to make sure some of his answers were “politically correct.” On one occasion he stated that the EIA does not foresee that cellulosic ethanol is going to scale up to even a billion gallons by 2030, and one senator said “Isn’t that in direct contrast to what the president thinks?” Then some pretty nifty tap-dancing ensued.

The Q&A, in my opinion, was an embarrassing display of partisan politics, and revealed serious deficiencies in some of the senators’ understanding of energy issues. Some Republican senators took the opportunity to push for coal-to-liquids and drilling in ANWR, and some Democrats did a bit of grandstanding over windfall profits – directly ignoring the answers the witnesses were giving them.

For example, Paul Sankey had explained that oil companies lost a lot of money in the 80’s and 90’s, and therefore investments fell off. A couple of different senators kept asking the same question again and again: “Yeah, but why aren’t they investing today, with record profits?” And Sankey kept telling them that they were.

Sankey didn’t mince words at all, and at one point told the committee to keep in mind that these record high prices are less than half the level of the prices in Europe.

Anyway, here were some of the more interesting exchanges which I transcribed myself. Senator Craig Thomas was the first to demonstrate that he didn’t understand the answer to a question:

Senator Craig Thomas: Most any time that you have great markets and so on, you also have investment, like in the refineries. When the market is there, and the price is high, I don’t understand the lack of incentive to invest.

Paul Sankey: The incentive is there, and the companies are now investing, it’s just not an issue that you can expect that 4 years after companies are making losses, that suddenly there is an exponential increase in investments in refining capacity. It’s just not that simple. It’s a very tough market out there for any kind of infrastructure investment, as I mentioned you have competition from the Canadian heavy oil sands, you have competition from Asia, in Europe; but these companies are increasing their investments. The fact is that the companies are deploying capital to the best of their ability. One disincentive for investment is brought about by uncertainties in regulation and government interference. One concern they have is that regulations will cause them to lose money if they invest now. In my opinion it’s in your interest to maintain a stable regulatory environment to encourage investment.

Senator Craig Thomas: I agree with that. But if lack of infrastructure is causing the price to go up, and the companies are not investing in infrastructure then it seems to be a bit of a contradiction.

So, right after Sankey says they are investing, Senator Thomas can’t understand why they aren’t investing. I lost count of how many times Sankey went through the investments that are taking place now.

Immediately after the above exchange, Senator Ron Wyden from Oregon apparently awoke from a slumber, because he asked the same question:

Senator Wyden: Mr. Sankey, quick question. You stated that in the 80’s and 90’s, there were poor returns for the companies, and that contributed to their problems. But now we also have the problem of starving investment in refineries, but we have record profits. Certainly that’s been the case for the last 5 or 6 years. Why wouldn’t the companies have invested in refineries and in the infrastructure – the things that were missing in the 80’s and 90’s – in the last 5 or 6 years?

Paul Sankey: This goes to the same point. You had losses as recently as 2002, and there have been changes in regulations – potential threats to gasoline as the fuel you want to make in this country. If you are talking about an investment of 2 or 3 billion dollars, it’s immensely expensive now to add refineries, and there are huge amounts of uncertainties over how much it will ultimately cost you because of all the other challenges that there are out there with global energy infrastructure competing away the staff and materials to do the job. But even amongst all that, we have some fairly significant investment going on right now. One of the subtleties here is that we may not be adding a tremendous amount of capacity, but in terms or our ability to upgrade more complex heavy, sour crude there is very definitely a surge of investment going on.

Senator Wyden: I can see the argument, and you make it eloquently in your paper for not going forward with investments in the 80’s and 90’s; it just doesn’t make sense given these record profits.

You have to wonder whether he heard a word that Sankey said. Is he just posturing? Or is he not paying attention? Or does he not understand that investments are actually being made (as I show in later)? Yes, these are the people formulating our energy policy.

The other exchange that I watched in disbelief happened between Senator Robert Menendez and Sankey:

Senator Menendez: Over the past few years, it seems that bracing for the onslaught of record high prices at the gas pump has become as common as planning for the summer vacation. And we see prices rise and fall, we understand the concept of a changing supply and demand chain, that’s not foreign to us, but when we see no singular event, no visible cause for the increase in prices, consumers scratch their heads and try to figure out what’s happening. This is the 3rd year in a row in which consumers are facing gasoline prices above the $3/gallon mark. Yet there’s no devastating hurricane this year; there’s no single event at a refinery or in an OPEC country that explains why, in the first half of May, consumers are already experiencing sticker shock. Mr. Sankey, when you say there is no price manipulation through the whole supply chain, then why do prices seem to spike during times of greatest motorist activities such as the summer, and Memorial Day weekend? Now, I am sure that demand is part of the answer, but it seems that we find that it is in these time periods that the prices spike. Is that just convenience, that it just conveniently happens that way? Is it just a pure coincidence?

Now remember, Senator Menendez just said that he understands all about supply and demand, and now is asking if it’s a coincidence that prices increase at the times of highest demand. If I had been a witness, it would have been hard for me to hide my disbelief at this question from another member of the Senate who happens to be formulating energy policy.

Paul Sankey: I would highlight once again, that BP has 2 of the 5 largest refineries in the U.S. effectively running at half capacity right now because of the safety issues. What happens in times of such tight capacity is that you have an extremely seasonal market. What happens is that at times of demand run-up, you begin to exceed available supply and prices rise exponentially, attempting to price out demand or encourage more supply. What you will find in such a tight market is that in winter you will suddenly get tightness in natural gas and heating oil, because there isn’t that available spare capacity to address the sudden seasonal rise in demand, and when you get to driving season – because everyone loves to go to the beach on Memorial Day – what you find is that you exceed available supply and then prices rise exponentially.

Then Senator Menendez gets his facts completely wrong:

Senator Menendez: Isn’t there a reality that we are paying for some industry decisions that actually reduced refining capacity in this country? I mean there was a time that we had greater refining capacity, and the industry reduced that refining capacity, and as a result of making that decision, consumers today find themselves with exactly the consequences that you have described in your testimony before.

Sankey then tried to explain something about the cycle, but did not correct Senator Menendez on the key point: Refining capacity has not been reduced; it is at an all time high. Some refineries have been closed down, but the expansion of the existing ones far surpasses the lost capacity from those that were shut down. See my essay addressing this.

But Senator Menendez continued:

Senator Menendez: My point is that the reduction in refining capacity helped drive up the cost.

Your point is incorrect, and you misinformed a lot of people when you made it. Perhaps this kind of misinformation explains some of your anger at the oil industry?

But don’t take my word for it. Visit the EIA and see the numbers for yourself. Refining capacity has increased by 2 million barrels per day in the past 10 years. And in the past 5 years? The years that Senator Wyden complained that no investments were being made? Refining capacity has increased since 2002 by 700,000 barrels a day – 250 million barrels a year. To put this in perspective, that amount is equal to 10.7 billion gallons, or about double the entire ethanol production in the U.S. That’s the amount of refinery expansion that a number of senators on the committee pretended never happened because they believe no investments have been made (and this on top of the investments to upgrade heavy, sour crudes and to produce ULSD and ULSG).

Final Thoughts

I don’t know if the committee members are really so uninformed, or whether they were just playing politics. You got the impression watching the web cast that they were making some statements just to make sure those were picked up by the media, regardless of whether they were accurate. Senator’s Wyden’s comments are a perfect example. It was clearly explained to him that investments are being made, and then he turned around and asked why they weren’t investing.

The comments from Senator Menendez may be another matter. He may actually believe that refining capacity has been reduced. But he is on the energy committee. He should understand the overall picture. This is important stuff, and we can’t have energy policy being formulated by people who are either proceeding with half-baked ideas, or are just interested in scoring political points.

There is also one thing that all politicians must come to grips with. Let me make it crystal clear that I firmly support tough environmental regulations. I support the move to ultra-low sulfur diesel (ULSD) and gasoline. I support phasing out benzene in gasoline. I would also point out that Senator Wyden has been actively involved in this issue. But the politicians have to understand that these regulations do have consequences. If you tell refiners they must install equipment to produce ULSD, there are four things to keep in mind.

First, this necessarily redirects capital that might have gone into expanding refining facilities. Second, it increases the costs of producing the fuel. Third, this additional level of processing reduces the overall product yield. Fourth, and perhaps of greatest importance, it increases the complexity of the refinery. Those are the consequences. The more complex the refineries are, the more unreliable they are going to be. So, when you formulate these sorts of rules, don’t sit around and scratch your heads and ask “Gosh, I wonder why gasoline prices are going up?” A big part of the reason gasoline prices are going up is because of the policies you have enacted. Many of which – as in the case of the aforementioned environmental regulations – I agreed with. Nonetheless, these are issues that helped crimp supplies and add to costs.

But I have to tell you that I am sick of this crap. I want you guys to put your heads together and formulate a coherent energy policy. Stop playing politics with this. It is far too serious a matter. Also, the committee members need to get up to speed ASAP on energy issues. We don’t need members on the energy committee who have a tenuous grasp of these issues. Finally, listen to what your experts are telling you. If you are going to call expert witnesses to testify, don’t completely ignore their testimony just so you can spew your canned sound bites. START SOLVING SOME FLIPPING PROBLEMS!

I have a few essays in the queue (including a nifty biodiesel story), but I thought I would comment on an article in today’s Deseret News out of Salt Lake City. The article was entitled “Will U.S. Slap Tax on Big Oil Profits?”. (1) A few excerpts from the article, followed by my comments:

Republican Sen. Arlen Specter said Sunday that the U.S. Congress should consider taxing the “windfall profits” reaped by oil companies as a result of surging crude oil prices.

I understand the frustration with high gas prices even as oil companies rake in record profits. But what is Specter trying to accomplish? Does the good senator believe this will magically bring the price of oil down? Will it cause OPEC to open the taps, flooding more oil into the market? Or is the real purpose to punish oil companies for making money, so he can boast about it during his reelection bid? Would he stipulate that the money be allocated to somehow reducing our demand for oil, which is the real issue?

Specter, of Pennsylvania, earlier this month introduced legislation to strengthen antitrust enforcement of the oil and natural gas industry to counter the consolidation of production and refining operations. Sen. Byron Dorgan, D-N.D., is proposing a 50 percent excise tax on profits from oil sold at more than $40 a barrel.

Let’s think about that for a moment. A lot of oil is expensive to extract, and only becomes economically viable as oil prices climb higher and higher. As oil prices climb, the incentive to pump more oil increases. If more oil can actually be pumped, it should eventually result in an oversupply situation, and prices will come back down. (This is why the oil industry is cyclical). If more oil can’t be pumped, then prices won’t come down.

However, neither situation is helped by slapping a tax on oil over $40 a barrel. In fact, such moves decrease the reward for marginal producers, which may lead them to shut in production. Since foreign producers won’t be paying that tax, what do you think is going to happen? U.S. production will decrease further, imports will increase, and oil prices will remain high. If high oil prices are the objective, then this is a way to accomplish that objective.

“Windfall profits, eliminating the antitrust exemption, considering the excessive concentration of power are all items we ought to be addressing,” Specter said Sunday on CNN’s “Late Edition” program. “Anybody up for election this year ought to be working very hard, taking it very seriously.”

Oh, I bet they are. That’s why they ignore the real reasons for rising oil prices, and aren’t doing anything to address those issues. They are posturing and pandering, trying to make sure they get themselves reelected. The founding fathers would be rolling over in their graves if they saw the level of mediocrity that permeates our government today. Nobody has the guts to stand up and tell the truth.

Sen. Carl Levin, D-Mich., said President Bush should call oil company executives to the White House and tell them he’ll support a new tax on their profits unless they lower prices.

“I’ll bet that the price of gasoline would come down within a matter of days,” Levin said on the CNN program. “We need a windfall profits tax because these profits have been absolutely obscene.”

Wow! Is Levin this uninformed? Does he think oil company executives set the price of oil? Does he not understand that oil is a global commodity, and if China or India are willing to pay more for oil than we are, then that is going to drive the prices up? That’s sort of like asking a company to lower the value of their stock, because you want to buy some, but think it’s too expensive. It’s the price it is because that’s what buyers and sellers in the open market have agreed upon for a value. Oil company executives do not set the price of oil. This only happens in politician’s dreams.

Bush, in California over the weekend to promote his initiative on alternative fuels, said a lack of refining capacity in the United States and the thirst for oil in emerging economies such as China and India are contributing to increased energy costs. He said he recognized the price of gasoline is hurting consumers and warned that the price is likely to go higher.

Like him or hate him, Bush is correct about this. I bet even the good senators would agree with this. So, let’s pose a question. A lack of refining capacity is a problem that is putting a lot of pressure on gasoline prices. Expanding refineries takes lots of capital. If we extract more money from the oil companies in the form of punitive taxes, are they likely to spend more money or less money on capital projects? Now, is this likely to make the refining bottleneck better, or worse? Again, if your goal is to have gas shortages and drive the prices even higher, then they are on the right track. Like I have said before, we tried this already and it didn’t work. (2) From a 1990 Congressional Research Service report:

“The windfall profits tax reduced domestic oil production between 3 and 6 percent, and increased oil imports from between 8 and 16 percent. This made the U.S. more dependent upon imported oil.”

This report should be required reading for legislators who think a windfall profits tax is a good idea.

Specter has focused his attention on oil industry consolidation and competition. “We have allowed too many companies to get together to reduce competition,” he said.

There were more than 2,600 mergers in the oil industry in the 1990s, according to James Wells, director of natural resources and the environment for the Government Accountability Office. A study by the GAO, Congress’ research arm, found that concentration of market power may have added as much as 7 cents to the price of fuel, he said.

As much as 7 cents? I think Senator Specter has identified the culprit. Gasoline prices are “as much as” 7 cents higher than they would be had they stopped those mergers. This is clearly the source of spiraling gas prices. If it was “as much as” 7 cents, I wonder what the lower estimate was. It really sounds like Specter is on a wild goose chase.

While politicians pander, I am still waiting for someone in government to have the guts to suggest that a potential solution to this problem is to encourage Americans, somehow, to conserve. I am waiting for someone to explain that cheap oil is not an American birthright, and as long as China and India compete for the same oil, there will be no more “cheap” oil. Of course more expensive oil will enforce conservation eventually. Maybe the politicians are much smarter than I think, and this is part of the plan. If we adopt the policies they are advocating, oil prices will spiral out of control, gas will no longer be affordable, and we will finally start conserving. Maybe there is a method to their apparent madness.

References

1. “Will U.S. Slap Tax on Big Oil Profits?”, Deseret News, April 24, 2006.

2. Glassman, James K., “Windfall Profits” Tax on Oil Companies, Capitalism Magazine, September 26, 2005.