A reader’s query about energy markets

Perhaps a more straightforward answer to the question is that oil is not an “input” from the perspective of a company that extracts oil from the ground — it is, rather, the product the company sells. And when the price of a commodity rises due to higher demand, as is the case here, sellers of the commodity make higher profits.

The problem here is that Exxon’s payments to Nigeria (or any country) are not fixed – they are usually negotiated as a production sharing contract (PSC). Exxon will get enough crude to cover its costs, and then the remainder will be split between the partners (depending on the structure, there could be other partners who have a claim on the venture as well). High oil prices are a double-edged sword for Exxon however, because if the price of crude is high, they will get fewer barrels as payment for their operating costs and a larger share will accrue to the country. Higher oil prices also encourage countries to renegotiate their contracts and while you could try to take them to international court, unless its so egregious (Venezuela) then its probably just best to let them have it. Finally, higher oil prices encourage governments to hook up with less scrupulous operators who are willing to give better terms. These smaller firms are much worse at safety and efficiency, and are less risk-averse so they are willing to take on projects with a negative NPV in the hopes of striking it big.

A windfall profits tax is a terrible idea because it raises the return on investment hurdle for US companies. If Exxon is bidding for a contract against another firm who is not from the US, all things being equal the rival will have the advantage because they don’t have the additional US tax burden. This results in fewer projects for Exxon, so they pay less taxes, distribute less profits to shareholders, and they hire fewer workers. That’s a lot of wealth that no longer comes back to the US. At a time when the economy is already weak, why would you try to handicap a very successful firm (that paid $40B in taxes last year) and enable its foreign competitors? So if Exxon is out of the picture, who are you going to buy your crude from? The Russian national oil companies? Venezuela? Any one of the corrupt regimes in Africa? Would you really rather see these players in control of the situation?

If you make it uneconomical for Exxon to produce oil then they are not going to do it (they already return billions in cash to shareholders each year through stock buybacks because they can’t find enough projects with a decent rate of return). If that happens, you’ll be giving 100% of the crude revenues to foreign governments (rather than the current split between Exxon and the foreign country) and you’ll be getting $0 in tax revenues (I’m pretty sure the government of Nigeria is not a US taxpayer). At the same time, plenty of good paying Exxon jobs in the US will be lost.

This windfall profits tax is a bunch of populist scapegoating that will have serious negative implications for the US economy.

You have to look at the cost of production to understand this. Most people think of a standard production model where the firms buys inputs at current cost, puts them together and sell a product. Most of the cost are variable cost and have to be repeated.

But oil is a very different industry. The overwhelming cost in oil production is fixed, or sunk cost. A firm spends money to drill an oil well. That accounts for the overwhelming bulk of its cost of producing a gallon of gasoline. The cost of that well is sunk or fixed cost and will not change as the price of oil changes.
This is the basic idea behind why a raw material producer like an oil company is highly profitable when the price of oil goes up. Unlike an auto company, for example, where most of their cost are variable cost and change from one period to the next.

The profits are the difference between the largely fixed cost from a well and the current market price. the current market price is supposedly set in the long run by the cost of drilling the new marginal oil well.

This is also the concept behind a windfall profits tax. If the sunk cost are $50/bbl and the market price goes from $55 to $100 profits go from $5 to $45.
Since all the cost are sunk the jump in profits from $5 to $45 is a windfall or/ and an economic rent and even if you tax this away from them it does not change their incentive to continue producing the oil that cost $50.

In theory that other $40 of new windfall profits are suppose to go into investing for new oil and a windfall profit tax reduces the profits available to finance new investment — the source of the overwhelming source of capital spending in the US system. But in practice Exxon and many other big oil companies are now paying out much of this “windfall” profit to stockholders in the form of dividends and stock buybacks rather then spending it on new oil drilling and exploration.

So the standard economic model where virtually all costs are variable costs most economist are use to dealing with really is a poor model for understanding oil economics.

As the others said, refining (think of it like a manufacturing business; crude inputs in and refined products out) is much different that oil production. Historically low margin business.

No, there is not an oligopoly or cartel in production. Truly this gets old to listen to. I live in Western Canada and there are literally hundreds of oil companies here. Thousands around the world.

Profits are high right now because reserves were developed historically at lower costs, and the oil sold from them right now benefits from the current high price. Finding and developing reserves is a multi-year, multi-decade cycle. Most oil companies now are worried that costs have risen dramatically, there is a significant risk that if the price is low in the future, there will be a long period of low or negative profits. That’s probably why they pay out higher dividends or buy back stock instead of reinvesting.

The fundamental principles of economics still apply very well.

Rexkillerson — a windfall profits tax should not have any impact on a US firms ability to compete on service contracts in a country where that government owns the oil. The windfall profit tax will not apply in a situation like that because the foreign government is the entity that owns the oil in the ground and makes “windfall” profits and they are not subject to US taxes.

Next time I see Lynne I’ll have to ask about her refinery statement. It seems a little odd, and she’s not the kind of person to spout nonsense.

Spencer is basically right. What he didn’t mention is that the US has lots of spare gasoline refinery capacity, except it’s located in Europe. In the refined products business, the North Atlantic Basin – Western Europe and North America east of the Great Plains – is basically one big market. What is exceedingly scarce is diesel fuel production capacity. In the last ten years there has been a massive shift to diesel-powered cars in Europe – now over 50% of all cars – and that has messed up a refinery slate that was built to serve a market that was 20% diesel and 80% gasoline. The end result is that the Europeans ship lots of gasoline over here, and we ship lots of diesel over there.

That’s why crude to gasoline crack spreads are so weak – $2 or $3 per barrel. It’s the diesel (AKA distillate) cracks that are keeping the refiners’ heads above water.

This situation has manifested itself in a few odd ways. For example, New York now has the cheapest pre-tax gasoline in the country, since it is the main port for gasoline imports. This certainly wasn’t the case, say, five years ago. Another effect: notice how expensive diesel is, now, in the middle of the summer? For as long as anybody can remember, diesel was always cheaper than gasoline in the summer. But not this year, for the first time since records have been kept.

One way US oil firms has gotten around the NIMBY objections to new refineries is to build ones in the Caribbean that are really dedicated to the US market.

So in a way shouldn’t we actually include the Caribbean refineries in the US refinery count?

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