Republicans vs. Oil

This article appeared on on November 8, 2005.

It’s unclear whether the Senate Commerce and Energy Committees’ joint hearing Wednesday on oil prices and profits is an exercise in economic ignorance or cynical opportunism. It is clear, however, that the Republican party is in the midst of an intellectual meltdown. For whatever reason, the Party of Reagan now sees merit in cross-dressing as the Party of Nader. But they are playing with political and economic fire, and the resulting conflagration might well torch the very energy economy they are ostensibly trying to save.

Let’s begin with a review of what happened the last time Congress tried to protect consumers from “Big Oil.” When Richard Nixon enacted his strict retail price-control regime in 1971, service stations ran out of gas and motorists were forced to wait in staggeringly long lines to get what fuel remained. Burned by the fiasco, Congress adopted the Emergency Petroleum Allocation Act of 1973 (EPAA), which essentially removed price controls from the pump and instead applied them upstream into the wholesale domestic oil market.

Indeed the gasoline lines and physical shortages disappeared, but the cap on profits from domestic oil production discouraged investment in new domestic supply, increased reliance on imported oil, and increased the upward pressure on world crude prices. The Energy Policy and Conservation Act of 1975 (EPCA) tightened the wholesale oil price controls established in the EPAA and exacerbated the economic dislocations associated with it.

All the economic post-mortems that have been undertaken on the EPAA/EPCA regime paint an ugly picture. Harvard economist Joe Kalt calculates that domestic oil production was 0.3 - 1.4 million barrels per day lower than would have been the case had wholesale price controls never been slapped on the U.S. oil industry. Economist R. T. Smith calculates that the lost production and higher demand that resulted from the price controls increased world crude-oil prices by 13.5 percent. The net effect of the price controls, according to economist Robert Rogers, was to increase the price of oil products for American consumers.

Even in the teeth of such a policy debacle, Congress was unwilling to abandon their jihad against oil profits. So to replace the EPAA/EPCA laws set to expire in 1981, Congress passed the Crude Oil Windfall Profit Tax of 1980. The act, however, was a misnomer — it was an excise tax, not a profits tax — and, like the price controls before it, the law discouraged new supply at the very time that production should have been encouraged.

Amazingly, none of this history has deterred Congress from resurrecting calls for price controls and windfall profits taxes. Even conservative senators such as Majority Leader Bill Frist, New Hampshire’s Judd Gregg, New Mexico’s Pete Domenici, and Iowa’s Charles Grassley are publicly entertaining a return to the disastrous ideas of the past.

Are oil profits so offensive that they somehow cloud the mind? It doesn’t appear so. According to data collected by Goldman Sachs, return on invested capital in the oil and natural sector from 1970-2003 was less than the return on invested capital in all U.S. industrial sectors on average over that same period. Even more crude metrics such as net profit margins (net income divided by revenue) demonstrate that the oil business is nowhere near as profitable as the public imagines. In the second quarter of this year, for instance, the net profit margin of the oil and gas companies on the S&P 500 was about 9 percent, whereas the net profit margin for the S&P 500 as a whole was about 8 percent. The much-ballyhooed third quarter earnings reported last week do not appear to represent a substantial increase in net profit margins beyond what we saw in the second quarter figures.

Calls for the industry to reduce prices flounder voluntarily upon ignorance. “Big Oil” does not dictate fuel prices. Contracts between oil companies and refineries — and between refineries and retail outlets — typically tie the purchase price to the spot market price in whatever trading exchange is most convenient. Hence, fuel prices are ultimately established by thousands of market actors engaged in spot markets — a group that is almost certainly immune to political jawboning and incapable of fixing prices even if they wished.

In sum, Congress can no more repeal the law of supply and demand than physicists can repeal the law of gravity. If you restrict the profits you can make for something, you’ll get less of that something. If you restrict prices, you’ll get less conservation. High prices are unfortunate for consumers, but they accurately reflect market realities. They are already setting off a chain reaction that will lead to a collapse in time. High prices do more to encourage conservation and production than anything Congress could dream up.

It is tempting to absolve Congress from blame for ignoring all this, given that it takes a lot of political courage to tell an angry public that price controls, windfall profit taxes, and anti-gouging legislation is counterproductive. But it’s worth remembering that, even in the teeth of the most explosive oil-price spiral in history and with the prospect of a tough reelection fight on the horizon, President Jimmy Carter nonetheless used the executive powers granted him in the Energy Policy and Conservation Act to aggressively peel away the price controls he inherited when he assumed the presidency. And President Carter was eventually beaten by a candidate — Ronald Reagan — who promised to go even further to liberate the industry from government interference.

If Jimmy Carter can speak the truth, so can Bill Frist — or so one would like to think.

Jerry Taylor is director of natural-resource studies at the Cato Institute in Washington, D.C.