Increasing Gasoline Prices & Misguided Energy Policies

I paid $2.77/gallon for gasoline this morning, a noticeable increase over prior days. This upward trend in prices is reflected in many media reports, like this Washington Post article.

Seeing the price increase this morning reminded me of a Wall Street Journal editorial (available for a fee) from last week entitled The Ethanol Tax:

Rising gas prices…are the result of the rising price of crude oil, as well as lingering hurricane damage. But even the government is admitting that some of the price increases and regional shortages are the result of the ethanol love-fest that Congress engaged in last summer as part of its energy bill.

Congress has long required the use of such "oxygenates" as ethanol and MTBE in gasoline. Midwest drivers have tended to rely on locally produced and corn-based ethanol, while places where ethanol is expensive to ship -- such as the East Coast and Texas -- have used petroleum-based MTBE. But the ethanol lobby wanted more market share, and so last year's energy bill included a giant new ethanol mandate, while at the same time denying liability protection for rival MTBE makers that are getting sued for having sold a product that Congress had once mandated.

MTBE makers are now fleeing the market; most oil companies will drop the additive entirely on May 5. So bye-bye to a significant portion of the domestic fuel supply, which already stretched ethanol producers have no hope of replacing any time soon…

One eminently sensible short-term solution would be for the feds to drop the 54-cent-a-gallon tariff on imported ethanol, which would particularly help coastal areas. But eager to show the Bush Administration's own deference to the ethanol lobby, Energy Secretary Sam Bodman defended the tariff last week, saying it was necessary so that foreign producers "can have no advantage over American companies."

Heaven forbid foreigners should be able to compete with a heavily subsidized domestic ethanol industry that is getting rich off U.S. drivers. Politicians in Washington are blaming high gas prices in part for their low approval ratings, and as usual the voters are right.

The posting, Rancid Pork Leaves a Bad Taste in Your Mouth, includes a link to Energy-Bill Follies, a Cato Institute analysis of last year's energy bill, in which the authors state that "virtually every section of the bill represents a rejection of free markets and limited government." Read the report for specific details.

How can such wrong-headed policies be implemented to the detriment of consumers? One primary explanation is that politicians - aided and abetted by a misguided public debate - have very limited understanding of microeconomics as well as an inability to grasp how additional energy sources, economic growth and jobs are created only by the private sector, not by the public sector. Their ignorance leads to a misinterpretation of economic events and deeply flawed public policies based on the false belief - to paraphrase Jerry Taylor and Peter Van Doren of the Cato Institute - that capital is best allocated by vote-maximizing politicians who are unlikely to know what they are doing rather than by market actors disciplined by profit and loss.

This behavior pattern is nothing new as Taylor and Van Doren provide a litany of historical examples of costly government misadventures in the energy sector, while also making these comments on 2005 energy bill:

...The [1,724 page energy] legislation is premised upon the idea that energy markets are different from other markets and that they require political micromanagement. But price signals play the same role in the energy sector that they play in the rest of the economy. Unfortunately, neither Congress nor the public is content to leave energy choices to producers and consumers. Tax subsidies and regulations create investment and consumption patterns that would not exist if decisions were made by market actors...

How Government Makes Us Pay Higher Gasoline Prices provides another example of how consumers are paying higher gasoline prices due to misguided energy policies.

Backing up to the basics about gas prices, an article entitled Gas prices around the world: Think you pay a lot for gas? notes how gas prices are even higher elsewhere in the world:

...Drivers in some European cities...are paying nearly 3 times more than those in the U.S.

The main factor in price disparities between countries is government policy, according to AirInc, a company that tracks the cost of living in various places around the world. Many European nations tax gasoline heavily, with taxes making up as much as 75 percent of the cost of a gallon of gasoline...

One of the regular public complaints is that the oil companies are gouging consumers. If so, you would expect to see disparate prices across different markets, something that doesn't show up in this ExxonMobil data on international fuel prices before and after government taxes. The opinion piece explains why:

...Crude oil is a global commodity, publicly traded on world markets. Refined gasoline is also a widely-traded commodity, strongly linked to the price of crude oil but often reacting sharply to other short-term factors such as hurricanes, unplanned refinery outages or sudden rises in local demand - recent changes to fuel specifications are a good example...

On average, crude oil alone accounted for 53% of the U.S. pump price last year, with refining and marketing costs accounting for a further 25-30%...

Pump prices in many other countries are significantly higher, mainly because gasoline taxes are so much higher. As a result, U.S. consumers pay a lower price and that price is heavily influenced by the price of crude oil.

Or, as Taylor and Van Doren state:

World crude prices - and thus retail gasoline prices - are established in commodity spot markets. Exxon Mobil executives do not plot in back rooms to decide what to charge at the pump...

Furthermore, oil companies are facing growing geopolitical risks to their businesses as more governments, who are unfriendly to the free world, take increasing control over oil and gas resources.

Another common complaint is that the oil companies are compiling so-called windfall profits. Yet this Exxon commentary on oil profits, based on third-party data compiled by BusinessWeek and Oil Daily, notes:

Our earnings are indeed at a record high, driven largely by the price of the commodities we sell...

...[the] oil and gas industry earnings averaged 7.7 cents per dollar of revenue during the second quarter [of 2005] compared with the overall industry average of 7.9 cents. ExxonMobil earned 8.6 cents for every dollar of revenue...

Last year [2004] alone, our new capital investments approached $15 billion...

While earnings rise and fall with oil prices, our investments do not. That $15 billion was invested in a year when the oil price averaged just below $40 and earnings were high. But we also invested $15 billion in 1998, when oil dipped to $10 a barrel and annual earnings - at $8 billion - were far lower...averaged over the last ten years our annual capital expenditures for the future of the company exceed our earnings.

Ours is a capital intensive business where investments can take many years to develop...

A review of Exxon's 2005 financial report shows they spent an additional $18 billion on capital expenditures in 2005.

As many politicians and media people hyper-ventilate on "windfall profits," do you think they understand that basic accounting principles mean that Exxon's annual capital expenditures of $15-18 billion represent actual cash outlays which are not reflected as offsets to the current year's accounting earnings?

Using Business Week data, Q3 2005 oil and gas industry profits report a similar story: The industry profitability of 8.2 cents on the sales dollar was both not radically higher than the American industry average of 6.8 cents on the dollar and was below the profitability rates for 9 other major industries.

Taylor and Van Doren offer further thoughts on the meaning of Q4 2005 Exxon profits and the potential for government intervention:

...in the fourth quarter 2005...[Exxon] reported a 10.7% profit margin...it is hardly remarkable...

If you are after big earners, check out Yahoo (a 45.5% profit margin), Citigroup (33.4%), Intel (24%) or Apple (22.7%).

Returns on invested capital over a longer time frame are even more telling. Analysts at [the investment banking firm] Goldman Sachs found that returns on invested capital in the oil and gas sector form 1970-2003 were less than the U.S. industrial average over that same period...

Political threats to impose windfall profit taxes are counterproductive for two reasons.

First, they threaten to institutionalize a form of one-way capitalism in which investors are allowed meager profits, but more robust earnings are punished. Who would want to park their money in an industry like that?...

Second, the U.S. already has a corporate income tax in place to harvest a share of those windfall profits regardless of which sector produces them. Any policy that subjects income from particular industrial sector to more onerous taxation because they are the villain de jure is bad public policy. In essence, it gets the government in the business of allocating capital to different sectors of the economy...

The entire conversation [about government intervention] is misguided. Whether ExxonMobil is making good or bad decisions with its operating capital is not the government's business. Even if it were, politicians are not in a position to intelligently discuss the matter...

If consumers were better served by lower corporate earnings, we'd all be visiting Zimbabwe for economic advice.

The posting, entitled Finding New Sources of Energy: Contrasting How Free Markets Allocate Economic Resources Without the Perverse Outcomes Generated by Government Meddling in the Marketplace, adds these thoughts to the debate:

...Over the past quarter century, oil companies directly sent more then $2.2 trillion in taxes...to state and federal governments - three times what they collectively earned in profits...

...corporations don't pay taxes, people do. Folks like us will really pay those new taxes, either through higher prices at the gas pump or through lower returns in our 401(k)s. Small profits for companies means smaller returns for our retirement funds...

...taxes [paid by oil companies] pumped more than $63 billion into federal and state coffers last year alone...

The history of the '70s and early '80s also explains the advantages of the price mechanism to both energy efficiency and the environment. The most rapid gains in energy efficiency in the U.S. took place when prices were very high...

Today, we are again seeing the positive incentive effects of high oil prices. The recent run-up has encouraged a new class of entrepreneurs and scientists to search for technological solutions...

Ironically, the best way to cap the upside to the oil price is to encourage new energy producing technologies by limiting the potential downside to the price...this incentive-laden approach eliminates any reason for politicians and government bureaucrats to attempt to identify the best energy solutions independent of market forces...

Last week amid rising oil prices, some heat was generated when it was publicly disclosed that Exxon's recently retired CEO, Lee Raymond, had received a retirement package valued at $400 million. Now, I am not going to defend whether $400 million is the right magnitude for a retirement package but, since it is annual meeting season and that means corporate proxy statements are filed with the SEC, I thought it might be useful to read the Exxon proxy statement and get the particulars. How many people will believe Mr. Raymond is getting cash now valued at $400 million? The details don't tell such a juicy story. Here are the three major components of his retirement package:

$183 million is from Restricted Stock Awards: These awards come with restrictions on their sale. If awarded prior to 2001, they cannot be sold until after retirement. If awarded in 2002 or later, only one-half of them can be sold 5 years after the award with the balance only available for sale after 10 years following the award. Most importantly, the estimated value of these Restricted Stock Awards is based on the current Exxon stock price. Should it decline at any time over the next decade - a real possibility given the volatility of the price of oil - the value of these awards could decline modestly or substantially. (See page 21 of the proxy statement for details.)

$98 million is the net present value of Mr. Raymond's company pension after 43 years of service. The pension appears to have been paid out in a lump sum manner with the value determined by his compensation in the last 3 years and actuarial estimates of how long he is expected to live. Importantly, the core pension plan for the company upon which this calcuation is done is the same for all 86,000 Exxon employees. (See page 25 of the proxy statement for details.)

$69 million is the current value of stock options. Again, this estimated value is based on current Exxon stock prices and could change prior to any sale. (See page 23 of the proxy statement for details.)

Finally, the posting entitled Inviting a More Balanced Debate About America's Energy Policy highlights some challenging questions for politicians and citizens about tradeoffs, with these concluding comments:

We cannot complain about prices or our lack of energy independence unless we first agree to make the hard choices necessary to increase our available supply of energy resources...

Instead of simplistically blaming the oil industry, true leaders would engage in a reasoned and substantive public debate about the various alternatives so support can begin to coalesce around choices which represent an informed consensus for our society.