The truth about “Big Oil”

H.L. Mencken said "For every problem, there is a solution that is simple, elegant, and wrong." I think of this quotation every time I hear a politician thunder on about the obscene profits supposedly being made by oil companies at our expense, and propose yet again to levy a “windfall profits tax” on them.

Yes, in good times oil companies make a lot of money, as do many other kinds of companies. In bad times they lose their shirts. With oil at $130+ a barrel, things look good for them now. A decade ago oil was dirt cheap and they were losing their shirts.

The oil business has two problems:

• Investment is highly risky. On land it costs $2-50 million to drill an oil or gas well, depending on how deep it has to go (and most new wells today have to go very deep). Offshore drilling costs are in the range $50-100 million or more per hole. Even with today’s advanced prospecting techniques many holes are “dry holes’, or don’t produce enough to pay for themselves. Production costs are enormous. Offshore rigs can cost $1-2 billion apiece, and can be a total loss after a severe hurricane. Refineries cost around a billion dollars. Pipelines and shipping terminals can cost tens of billions (the Alaskan pipeline cost about $8 billion in 1977 dollars, which is about $28 billion in today’s dollars.)

• Demand is unpredictable. After the 1973 Middle East oil embargo when oil prices skyrocketed, people thought that oil was surely a good investment. Ten years later oil was only at about $29 a barrel and lots of companies in the oil business went under. Now it looks again like investing in oil and gas ought to be a good strategy, but by the time investments in new production capacity is ready to produce (8-15 years), oil demand may well have dropped again, especially if “green” conservation ideas and alternative energy sources get a good deal of investment in the next few years.

In the face of this, why would anyone want to invest in oil and gas production? Well, if the potential profits are high enough, they can attract investment even if the risk is high. That is the case for oil.

If on the other hand the government, with “windfall profits” taxes, sees to it that there are no “obscene profits” in good times like these, that will make investment in this risky area thoroughly unattractive, and as a consequence there will be no incentive to expand the production capacity (oil wells, shipping terminals and pipelines, and refineries), or even maintain the facilities we now have.

In fact, we haven’t built a new oil refinery in this country in 30 years. That’s one of the main things that is constraining the gasoline supply in the U.S. and driving our prices up. And the reason we haven’t built one is that there isn’t sufficient incentive for anyone to risk a billion dollars on such an investment.

Whether politicians simply don’t understand the basics of market economics, or whether they can’t stand to let the truth stand in the way of an appealing political slogan, this proposal to tax the windfall profits of “big oil’ comes up from both parties every time oil prices go up. Strange that when oil has had bad times, they never seem to have felt an urgent need to bail the industry out as they have auto companies and banks.

So the next time you hear a politician try to make cheap points by proposing to heavily tax oil companies, remember H.L. Mencken’s quote, "For every problem, there is a solution that is simple, elegant, and wrong."

UPDATE - 10/31/2008 When this was originally written crude oil prices were approaching $140 a barrel. Now, two months later, crude oil prices have plummeted to about $70 a barrel. This is exactly the sort of instability that makes investment in oil so risky. I rest my case.