Posted by: bmeverett | June 19, 2008

Maleficium Petroleosum

The late 17th century was a rough time in Congressman Ed Markey’s home state of Massachusetts. Population pressures, sickness, bad weather, crop failures and Indian attacks plagued the Puritan settlements around Boston. The cause of these troubles was obvious to just about everyone – Satan was loose in the colonies and his henchmen were perpetrating maleficium (evil deeds). If the evildoers responsible could be rounded up and punished, then things would get better. Even if a few hangings didn’t really help the situation, at least the public could see that the authorities were doing something. After all, that’s what’s really important.

Through the eyes of our modern, enlightened society, the idea that people, egged on by their leaders, could see their neighbors as witches and warlocks seems utterly incomprehensible, but then again Congress still has the ability to amaze us. On April 1, Ed Markey (D-MA) hauled senior executives of the five largest oil companies before the House Select Committee on Energy Independence and Global Warming and accused them of maleficium. Markey’s accusations, echoed by Jay Inslee (Washington), Maria Solis (California) and other Democrats on the committee (with a little help from Candice Miller, a Michigan Republican) run like this: (a) consumers are suffering from record high gasoline prices resulting directly from high corporate profits, (b) instead of investing these profits in badly needed renewable energy, the oil companies are engaging in “schemes to prop up the price of their stock”, and (c) to pad their profits, Big Oil has stolen $18 billion in annual public funds through unwarranted subsidies, presumably cooked up in midnight meetings with the Dark Lord Dick Cheney. The mob is angry, and, if the oil executives cannot convince the Committee that they are not in league with the Devil, there will be hangings which Congress will, alas, be unable to prevent.

Mr. Markey, a merciful judge, offers a plea bargain. If the oil companies agree to devote 10% of their profits to research on renewable energy (similar to tithing in the Puritan days) and stop demanding public subsidies to pad their already outrageous profits, then they can expect a lenient sentence. The first step naturally is to admit guilt.

John Proctor, immortalized in Arthur Miller’s The Crucible, ended up on the gallows after a competing tavern owner concocted some fantastic accusations, including multiple murders. Not quite as egregious as excessive oil profits, but considered serious at the time. The unfortunate Mr. Proctor discovered that defending against charges of witchcraft is a tough job, particularly when there is solid “spectral evidence” from some wailing teenage girls. Steve Simon, an ExxonMobil Senior Vice President, responded to the Committee’s blustering accusations with courtesy and moderation, clearly understanding that confrontation with Congressmen does nothing for his company and its shareholders. In the public interest, however, Mr. Markey’s charges require a more forceful rebuttal. Here goes.

It’s true that ExxonMobil earned $40½ billion in 2007, but who exactly is ExxonMobil? The Committee treated Mr. Simon as though he were Ebenezer Scrooge, a rich, selfish and mean-spirited miser. A corporation’s assets, however, are owned by its shareholders, not its management. In fact, a corporation has no money of its own, only funds held in trust for others.

In 2007, Robert Shapiro, a former Clinton Administration official, completed a study entitled “The Distribution of the Ownership of US Oil and Natural Gas Companies.” The Committee might want to have a look.

According to Shapiro less than 2% of oil company shares are owned by corporate insiders. About 29% of the shares are owned by individual investors, while the majority of the shares (about 70%) are held by institutional investors, including mutual funds, hedge funds, etc. A substantial share of the institutional holdings, however, is actually owned by or on behalf of others.

An estimated 27% of total oil company shares are owned by pension funds. For example, the College Retirement Equities Fund (TIAA-CREF) owns $3.3 billion in ExxonMobil stock, the California State Employee Pension Fund (CalPERS) owns $2.5 billion and the New York Teachers Retirement System $1.5 billion.

Another 14% of oil industry shares are held in IRAs and other private retirement accounts. Over 40% of American households have IRAs, and the average balance is $22,465.

About 30% of all oil company shares are owned by asset management companies excluding IRAs and pensions, mostly in mutual funds. For example, 6 Vanguard funds own a total of $13 billion in ExxonMobil stock, while four Fidelity funds own about $6 billion. Although some mutual fund owners are wealthy, many are not. In fact, 55 million American families (including 16% of households with annual incomes of less than $25,000) own mutual funds with an average account size of $36,000.

Just under a quarter of oil company shares are owned by individual investors outside their IRA accounts. Many of these investors too are middle class Americans.

Overall, the oil companies are among the most widely owned firms in the country, with millions of average American families relying at least partly on oil company profits to finance their retirement and their children’s college education. It’s simply not true, as Congresswoman Miller claims, that oil company profits “fatten the checkbooks of a few.” Unlike income taxes, whose burden on different segments of the society can be calculated with reasonable precision, Mr. Markey’s demands for the oil companies to give up 10% of their profits would inflict considerable but hidden pain on the middle class.

If Mr. Markey wants additional funds from the American middle class to finance advanced energy research, he should go through the difficult, but transparent process of taxing the public, rather than attempting to browbeat oil companies into taking the money from millions of people who may not even be aware that they own it. Not only does Mr. Simon have no obligation to give away ExxonMobil’s profits to appease angry legislators, he has no right to do so. Imagine a bank president announcing proudly to Congress that, as an act of corporate social responsibility, he plans to donate to charity each year 10% of the interest due to each of his depositors’ accounts. His future would probably be on the unemployment line, not in the Philanthropists’ Hall of Fame.

Do oil industry profits really have a major impact on pump prices, as Mr. Markey implies? Let’s take a look at how ExxonMobil earns its money. More than half of ExxonMobil’s 2007 earnings of $40½ billion came from producing 1½ billion barrels of oil and equivalent natural gas overseas, an average of about $17 per barrel. Oil prices averaged about $70 per barrel in 2007, so ExxonMobil received about one-quarter of the value of the oil in return for finding, developing, producing and transporting it with the attendant heavy capital expenditures and risks.

Mr. Markey clearly considers these profits excessive. Presumably, the companies did nothing to “earn” the money, but simply lucked out with the substantial increase in crude oil prices. (It would be interesting to see if Mr. Markey would apply this same logic to homeowners in his district, but that’s another story.) In any case, what would actually happen if the US government were to impose a “windfall profits tax” on these earnings, as advocated not only by Mr. Markey, but by Senators Obama and Clinton as well? Very simple. The next time a foreign government offers new potential oil and gas resources for development, ExxonMobil, ChevronTexaco and ConocoPhillips would be unable to compete for access. The US companies would be easily outbid by BP, Shell and Total (and perhaps even Chinese, Russian, Malaysian and other companies), who get to keep more of their earnings. As a result, the profits that Mr. Markey decries would go increasingly to foreign companies. US oil refiners would still have to acquire the same amount of crude oil for US consumers, but would now have to buy more of it from non-US companies. Furthermore, the investment capital and technical know-how available to develop new oil resources would be reduced, pushing oil prices up, not down. Is this really in our interest?

How about ExxonMobil’s profits from refining and selling oil (referred to as the “downstream”)? The company’s 2007 downstream earnings were $9½ billion – about a quarter of ExxonMobil’s total profit. They earned this profit by refining about 85 billion gallons of oil and selling around 110 billion gallons of petroleum products to consumers around the world. That works out to about 9¢ for each gallon sold. In return, ExxonMobil had to acquire the necessary crude oils, ship them to refiners, manufacture a wide range of fuels to increasingly tight specifications, including about 50 different types of gasoline, and transport the fuels by ship, barge, pipeline, rail and truck to consumers, investing an enormous amount of money in the process. The 9¢ per gallon, by the way, includes the earnings from convenience stores, car washes, oil changes, sales of tires and batteries, etc.

ExxonMobil’s 2003 downstream earnings were about 3¢ per gallon. It’s a bit of a stretch to claim that the jump in US gasoline prices from $1.60/gallon in 2003 to $2.84 in 2007 (an increase of $1.24/gallon) was due primarily to the 6¢/gallon increase in ExxonMobil’s downstream profits.

Mr. Markey needs to face an awkward fact. While ExxonMobil gets 9¢/gallon for doing all the work, the federal government gets 18½¢ in excise taxes for every gallon of gasoline sold, and the states receive on average an additional 28½¢ per gallon. Government, in other words, takes about 47¢/gallon – five times the company profit. If Mr. Markey is truly concerned, as he says, that the poorest Americans are now spending 10% of their total income for fuel, maybe excise tax reductions would be a good idea. In fairness, some of this tax revenue is dedicated to infrastructure and other important uses. Eliminating these revenues would mean reducing road construction and maintenance, but reducing oil company profits would also lead to lower investment in new refining capacity, service stations and transportation systems, not to mention critically needed new crude oil supply. The result would be higher, not lower gasoline prices.

All well and good, but perhaps the urgency of our environmental and national security problems requires that we do everything in our power to find new energy sources and facilitate the transition from oil to renewable energy. Mr. Markey’s demand for a tithe from the five largest oil companies for research would presumably generate about $12 billion per year in new R&D (10% of $120 in earnings). There’s a problem here, of course. When you reduce the rate of return, people invest less money. A “windfall profits tax” is thus far more likely to reduce profits rather than siphon them into government coffers, but let’s assume otherwise. Surely we could wrestle our energy problems to the ground with $12 billion a year in additional research. Or could we? Beginning with Richard Nixon’s Project Independence in 1974, the cornerstone of US energy policy has been research. Since 1978, the US government has spent (in today’s dollars) roughly $125 billion on energy research. These expenditures have produced some good science and useful experience, but not a single technological advance of any commercial significance. Not one.

Take, for example, fusion energy – the power of the hydrogen bomb – with its promise of limitless power using seawater as its fuel. Research on civilian applications of thermonuclear energy began in earnest in 1953. By 1976, the Ford Administration testified to Congress that available research leads “came close to assuring” the commercial availability of fusion power by the year 2000. The US government has now spent a total of $36 billion (in today’s dollars) on this research effort, and the DOE now suggests that commercial operation may be possible by the year 2050. Fusion may become the first government program in history to slip its schedule by 100 years.

The fallacy of government research programs is that we can buy certain technologies (like solar, wind, cellulosic ethanol or hydrogen) if we just spend enough money. In fact, research on any particular technology is a roll of the dice. You may get results, but then again you may not. It’s quite likely that new technologies will revolutionize the way we produce and consume energy during this century, but those innovations cannot be manufactured as an act of will, particularly when Congress spreads the money around to key congressional districts and preferred constituents. Technological advances flow from human ingenuity allocated by free and open capital markets, generally in ways and forms that can never be anticipated.

If Mr. Markey believes that Americans should continue to roll the dice on new energy technologies, he should make that argument to the American people and seek appropriations for that purpose. Every hardened gambler always believes his luck is about to change, particularly when he’s betting other people’s money. Besides, if ExxonMobil is to do the research themselves as a kind of community service for the crime of felony profitability, they will have to do so with researchers who are mainly chemical engineers, petroleum engineers and geophysicists. What do they know about solar photovoltaics, wind turbines and ocean currents? Why not leave that research to General Electric and other companies who are not only experts in these technologies, but actually want to do this work? In fact, Exxon tried its hand in the 1970s and early 1980s at solar energy, as well as computer chips, office machines and nuclear fuel rods, and fell flat on its face.

If the oil companies aren’t spending their profits the way Mr. Markey thinks they should, what exactly are they doing with all their ill-gotten gains? Are they in fact engaged in nefarious “schemes to prop up the price of their stock.”? In reality, a company can only do one of three things with its profits: hold them, reinvest them or return them to shareholders. Over the last five years (2003 through 2007), ExxonMobil’s total net income (profit) totaled $163 billion, but not much of that money (about 0.2%) went into the pockets of its management. Nearly $90 billion was reinvested over that time and another $23 billion saved for future investment opportunities. A total of $36 billion was paid out to shareholders as dividends. Like many companies, ExxonMobil has increased its dividend rate at a steady pace over the years, and many retirees rely on these dividends as a source of income. If the company has excess cash in any particular year, it has another way to return money to shareholders – a stock buyback. The company simply buys its own shares on the market and retires them. Since the number of outstanding shares is reduced, each remaining share is worth more. In any case, Mr. Markey might recall that raising the value of the stock is management’s job, not some kind of criminal enterprise.

Finally, is it true, as Mr. Markey claims, that oil companies “are using every trick in the book to keep billions in federal tax subsidies, even as they rake in record profits”? Most people would agree that profitable companies shouldn’t lobby Congress for gifts of public funds, but what exactly does Mr. Markey mean by a “subsidy”? He’s referring to two specific provisions of the Renewable Energy and Energy Conservation Tax Act of 2008, passed by the House but not by the Senate.

The first, accounting for about $14 billion of oil industry “subsidies,” is an amendment to The American Jobs Creation Act, passed by a bipartisan majority in 2004. This law gives companies an income tax deduction for manufacturing activities carried out in the United States, gradually reducing the corporate income tax for most American companies from 35% in 2004 to about 32% in 2009. As the title suggests, the law was intended to encourage job formation here at home. The new House proposal would eliminate this tax deduction – but only for the five major oil companies (ExxonMobil, ChevronTexaco, ConocoPhillips, Shell and BP). Other, smaller oil and gas companies would lose one-third of the deduction. Every other American manufacturing company would keep the full deduction.

Every April, Americans become acutely aware of the vagaries of the income tax system. We do demand, however, a modicum of fairness. Every individual US taxpayer, for example, is entitled to a standard deduction ($5,350 for 2007). A minimum-wage worker at McDonalds can have it. So can Bill Gates, if he wants. Imagine reviewing your Form 1040 and seeing a footnote stating, “The standard deduction is available to all taxpayers except Fred Jones and Mary Smith because nobody likes them, and Congress doesn’t approve of the way they spend their money.”

Mr. Markey’s definition of a “subsidy” is odd. Apparently, although you may think you are paying a 28% income tax, according to Mr. Markey’s logic you are receiving a 72% subsidy for which you should be rather grateful. Good children are happy when their parents give them an allowance. To the extent the oil companies have lobbied against this provision, it is only to seek the same tax treatment offered to every other manufacturing company in the US – hardly an outrageous request.

The second provision Mr. Markey is referring to is a change in the way foreign tax credits are calculated. Although this arcane subject is opaque to everyone but trained tax lawyers, the concept is very simple: each dollar of income should be taxed once, not twice. If, for example, a US company earns $100 in Country X and is required to pay that government a 30% income tax, the company repatriates $70 to the US. If the US assesses another 35% income tax on the $100 of profit, the company would end up paying 65% of its profits in income tax. The likely result is not more government revenue for the two countries, but less business activity and less profit to tax. Under our tax code, the US would allow the company to deduct its 30% income tax paid to Country X from its 35% US tax liability, resulting in a net US income tax of 5% and a total tax liability of 35% – the same as domestic US companies. Individuals are entitled to the same treatment of income earned abroad. This is tax equity, not a subsidy.

The proposed Renewable Energy and Energy Conservation Tax Act of 2008 would raise $4 billion by making more oil company income subject to double taxation. Why is this appropriate? It’s not as though ExxonMobil doesn’t pay any tax. In 2007, the company paid a total of $106 billion in taxes, including $30 billion in income tax. Mr. Simon made two key points in his testimony. First, ExxonMobil’s effective tax rate in 2007 was 44%. ExxonMobil shareholders of course pay these taxes and in fact have to pay even more US income tax when they receive dividends or sell their shares. Second, over the last five years, ExxonMobil’s US tax bill exceeded its earnings by $19 billion. Hardly a tax cheat.

Americans are currently understandably angry about the inequities of the Alternative Minimum Tax (AMT) passed in 1969 to target 155 wealthy individuals who paid no income tax. The regular federal income tax system eliminates double taxation for individual taxpayers by allowing a deduction from taxable income for income taxes paid to states, cities or foreign governments. The AMT denies this deduction, thereby subjecting individuals to double taxation – a blatantly unfair system. Nobody of course worried about the AMT at the time it was passed. After all, who cares about a handful of selfish rich people? By 1999, however, 1,000,000 people were subject to the tax. According to current estimates, without major reform, 33,000,000 taxpayers (one out of three) will be subject to the AMT by 2010.

The tax system ought to be progressive, but equitable. Congress instead wants to use the tax system to punish companies for behaving as successful commercial entities, rather than as public service institutions. The tax code is bad enough without allowing it to be further degraded in this way.

Samuel Sewall, one of the most enthusiastic judges at the Salem witch trials, ultimately came to regret his actions. For more than 30 years after the trials had concluded, Mr. Sewall set aside a day each year for “fast and penance.” Probably too much to expect today from Congressmen who seem beyond embarrassment. Those familiar with the ways of Washington shrug their shoulders at our modern witch trials. After all, Congressmen are natural publicity-seekers, and nobody was actually executed (at least not yet). It is important, however, that the public not come to believe Mr. Markey’s “spectral evidence” of oil company maleficium. Our economic and legal systems depend on truthfulness, logic, understanding and sound judgment by public officials, none of which was in evidence at the Committee.

Bruce M. Everett

Washington, DC

June 14, 2008


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