Friday, April 28, 2006

Windfall Profits Good? Close, but not quite

Michael Kinsley is always an enjoyable read, and almost always pretty persuasive. He’s pretty sharp, and seems to have a political/ideological worldview not too far removed from my own. I was, however, quite skeptical of the apparent premise of his latest Slate column—that perhaps windfall profits on oil are justified after all. Having given it a fair reading, I am again impressed, but not convinced. He almost pulls it off! His writing indicates a generally solid grasp of market economics, and then he presents a carefully crafted, targeted case for why we might make an exception and tamper with the current oil market. He lists two reasons for the exceptionality of the current oil windfall:
First, it is unusually clear that these profits have nothing to do with productivity. Diverting them to the U.S. Treasury would have no effect on the incentive to extract more oil from American ground. Second, some or all of these profits are directly related to a situation that is imposing huge sacrifices—financial and otherwise—from others; that is, the Iraq war.

The first stated “reason” really reads like two reasons, one in each sentence. Certainly the difference in price between a barrel of oil a year ago and now doesn’t represent an increase in productivity. (Indeed, a elevated price for the same commodity due to scarcity will ultimately be inflationary, unlike an increase in price related to a qualitative improvement in the product, which, like productivity, creates net new wealth, but I digress…) But how does that change the relative (dis)incentives of profit and taxation? I see no obvious relationship here. Oil extraction has costs, which do fluctuate, albeit not nearly so wildly as the price, as Kinsley points out. Profits from selling oil represent a return on capital investment in drilling rigs, etc. as well as trained crews to operate the equipment. To suggest that taxing those profits does not affect the incentive to maintain that investment is just plain silly. Perhaps this is somewhat true for existing rigs in highly profitable locations. That is, certain fields have lower extraction costs than others, so fields that were highly profitable at $45 per barrel would now be making lots more per barrel (a true windfall), and taking away some of that extra money won’t stop that field from being pumped. But let us think carefully what economists call the marginal impact. There are certainly fields that were not so profitable at $45 a barrel, but now are. And the profit margin has everything to do with how attractive those fields are as investments. So maybe an oil company that is planning to invest in a new field today might just hold off or defer that investment, expecting that the government is suddenly going to reduce (or even eliminate) the profitability of that investment. In the long run, taxing oil profits makes oil cost more. Maybe that’s not so bad, if you’re worried about environmental impact, etc., but that’s not the argument in play here.

Kinsley’s second reason has a bit more bite, but doesn’t entirely hold up. He states, “…some or all of these profits are directly related to… the Iraq War.” Ah, but there’s a slight difference between “some” or “all” isn’t there? Here’s the short answer: it’s not “all.” An even cursory glance at the news from the last year will reveal political unrest in Nigeria, slow productivity growth in Russian oil fields, an anti-U.S. demagogue in Venezuela, saber rattling in Iran, terrorism in Saudi Arabia, and, yes, surging demand in China and India. Some of the issues in Iran and Saudi Arabia could be fairly attributed to Iraq, but most of the rest is mostly or entirely unrelated. So only some fraction of the price premium on oil from last year to now is directly or indirectly attributable to the Iraq war. Truly teasing out the premium that is due to Iraq and nothing else is problematic and perhaps impossible, but if you could, you might have a point. If you can truly quantify the impact of the Iraqi war on oil prices and then take that amount out of the oil company profits to offset the costs or help soldiers and their families, then, yes, you have an argument that can be morally defensible. But the economics still don’t add up.

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