June 22, 2008
Energy Prices, Offshore Drilling, and an "Excess" Profits Tax
Energy Prices, Offshore Drilling, and an "Excess" Profits Tax-Becker
Increases in energy prices sharply accelerated during the past year, as the price of oil more than doubled, and gasoline prices in United States rose by 25 percent. Responding to these price increases, Senator McCain and President Bush have called for an end to the 27-year old federal moratorium on offshore drilling for oil and gas in US waters, while Senator Obama supports a continuation of the ban. McCain has also indicated that he is reconsidering his opposition to drilling in the Artic region of Alaska. In another response to the energy price boom, Obama has proposed an excess profits tax on oil companies, while McCain has come out against such a tax. What does economic analysis contribute to an evaluation of these proposals?
Supporters of a continuation of the moratorium worry that offshore drilling and oil leakages will kill many fish, and damage beaches and other coastal areas. These are potential risks, but whether to continue the moratorium involves a balancing of the advantages of drilling against environmental and other risks. These risks have not been affected by the rise in energy prices, but the benefits from drilling clearly have increased. Additional oil (and gas) from offshore drilling would lower US spending on imported oil, and thereby reduce the transfer of wealth from Americans to other oil and gas producers. Larger domestic energy supplies would also improve energy security in the event of a disruption in the supplies of oil and gas from major producers located in places like the Middle East and Nigeria that have had terrorist attacks on oil production facilities.
Even if offshore drilling started tomorrow, it would take several years before actual production began since construction of platforms in deep water and installation of equipment take time. The value of ending the moratorium now would depend not on energy prices and risks of disruption this year or the next, but on the situation beginning in several years and extending over the following decade. Some oil specialists are predicting a rise in the price of oil to $200 a barrel during the next few years. I have argued previously why such a large price increase is unlikely (see my post on May 11); indeed, oil may very well retreat from its present level of over $130 a barrel. Still, as long as world GDP continues to grow over the next decade at a sizable pace-which is likely- the price of oil will remain far above what it was in the 1990's.
This means that the financial and other benefits from offshore drilling are likely to greatly exceed the benefits at the time the moratorium was imposed, for oil was then much cheaper even in inflation-adjusted terms. The increasing share of imports in the oil consumed by the United States, and the rise in oil prices, explain why the value of imported oil rose more than five fold since the 1980s. This is why cost-benefit calculations of whether to end the moratorium and allow offshore drilling have shifted in the direction of allowing drilling. Although the risks of offshore drilling are much harder to quantify than the benefits, I believe the shift in the benefit-cost ratio has been large enough so that the time has come to allow drilling. Norway and Great Britain, to take two examples, have allowed drilling in the North Sea for many years without suffering major environmental damage. To be sure, in the end oil companies are the ones who have to decide whether the gains from drilling are worth the risks, including lawsuits if there are damaging oil spills, but these companies seem eager to start drilling offshore.
The proposed excess profits tax on the earnings of oil companies would discourage the search for additional oil, and hence would have the opposite effects on this search from a relaxation of the moratorium on offshore drilling. An excess profits tax that is expected to persist for many years discourages further exploration for oil simply because much of the profits on new oil production would be taxed away. In 1980, President Jimmy Carter introduced a windfall tax on oil companies to prevent them from profiting a lot from the high price of oil due to the Iran-Iraq war. An evaluation by the Congressional Research Service, a think tank that provides reports to Congress, concluded that the tax significantly reduced domestic oil production and raised oil imports. Disillusionment with the tax led to its abandonment in 1987. Yet the lessons from this fiasco have been forgotten, for since the post-Katrina rise in gasoline prices in 2005, members of Congress have made regular attempts to introduce legislation with a sizable excess profits tax on oil companies.
Even those Americans who worry a lot about global warming and other global pollution form the use of oil should be reluctant to discourage oil production offshore or elsewhere by American oil companies. Lower production by American companies would cause a rise in the world price of oil. Moreover, increased production by other countries would tend to offset reduced production by the United States, so that the effect on global warming and global pollution is likely to be modest. However, the increase in wealth transferred from the United States to the Middle East, Russia, Venezuela, and other oil-producing countries could be substantial.
Oil Prices, Offshore and Alaska Drilling, and Excess Profits Taxes--Posner's Comment
Although I worry more than Becker does about the environmental consequences of the production and consumption of oil, and although I want oil prices to remain high--indeed to continue rising--I largely agree with his analysis of the rival proposals for dealing with the present "crisis": allowing more drilling for oil on the outer continental shelf and in Alaska versus imposing an excess profits tax on the oil companies. I agree with him that the former is a good idea and the latter a bad one. But I will qualify my agreement by suggesting policy adjustments to minimize the adverse effects of allowing more drilling or of imposing an excess profits tax.
Expanded drilling in U.S. territory (including our territorial waters) will reduce both U.S. dependence on foreign oil and the wealth of foreign oil-producing countries, many of which are hostile or potentially hostile to the United States. These are important benefits. But there are also significant costs. Any increase in the production of oil from the seabed and from the fragile Alaskan tundra will create environmental damage, both directly, because of the environmental damage caused by the drilling itself (such as, in the case of offshore drilling, the dumping into the ocean of "drill cuttings"—the solids that are brought to the surface in drilling an oil well), and indirectly, as a consequence of increased production of oil, because of oil spills by tankers, traffic congestion and highway wear and tear, and, most ominously, increased carbon emissions from the burning of oil as a fuel. Becker notes correctly that the less oil we produce, the more that foreign nations will produce. But given the high price of oil, increasing out oil production will increase total world production rather than just substitute for foreign production. So there will be more tanker spills and more carbon emissions if offshore and Alaska drilling is allowed, since the supply of oil will be greater.
The problems created by an increased supply of oil can be minimized by an increase in the federal gasoline tax (better still would be imposing a tax on carbon emissions, since such a tax would create an incentive to reduce the amount of emissions per unit of gasoline consumed) calibrated to prevent gasoline prices from declining as a consequence of increased production of oil and hence increased supply. Already the shock of $4 a gallon gasoline has caused a modest decline in U.S. consumption of oil, yet $4 is little more than half the retail price of a gallon of gasoline in most European countries. Distances are shorter in Europe, and so U.S. gasoline prices would not have to double in order to make substantial inroads into our oil consumption. But they should not be allowed to fall as a result of increased world supply due to offshore and Alaska drilling.
A gasoline or carbon-emissions tax must not be confused with a tax on the profits of oil companies, which, because of the uncertainties involved in exploring for oil, will, as Becker points out, reduce the incentive to find and exploit new domestic oil fields. (In contrast, a heavy tax on gasoline will increase the incentive to find energy substitutes for oil.) In addition, imposing excess profits taxes sends a bad signal to the business community: that success will be penalized. And there is a danger that the proceeds of the tax would be used to subsidize the purchase of gasoline in order to reduce gasoline prices. The demand would rise without stimulating domestic production, so we would have the worst of all possible worlds: high consumption of oil and increased dependence on foreign production. But in the unhappy event that an excess profits tax is imposed, at least it should be limited to profits from existing oil fields, to minimize the dampening effect on the incentive to develop new fields.
Because the environmental risks of offshore and Alaska drilling are greater than those of drilling for oil on land in the lower 48 states, an environmental excise tax should be placed on the oil produced from offshore and Alaska wells. It is not enough to rely on the tort system to provide sanctions for oil spills. Many of the environmental effects of drilling for oil are individually too small to invite tort suits, yet the cumulative effects can be very large. That is true with respect to effects on fisheries and on the frequency of tanker spills. The more oil that is transported by sea, the more spills there will be, but it will rarely if ever be possible to ascribe a particular spill to a particular producer of the oil that was spilled. An environmental tax is therefore necessary to induce the oil companies to internalize the environmental costs that their activities impose.