No More Oil Subsidies!

I smile every time a pundit tries to link escalating gas prices to our president.  Not because I am satisfied with the erroneous connection, but out of amused exasperation at the hypocrisy that continually plagues polarizing talking heads.  Gas pricing is a function of market dynamics, meaning that it is driven by supply, demand, and speculation.  Any action by President Obama to influence pricing would be governmental regulation, which opposes conservatives’ fundamental advocacy of smaller government.  The only organizations that can truly impact pricing are the oil companies whom our tax dollars continue to subsidize.  Domestic oil companies are set to rake in windfall profits as pricing continues to rise.  It’s time to ask for those subsidies back.

Most Americans do not understand that half the oil consumed by the United States is produced within its borders.  The United States consumes almost 18 million barrels daily (MBD), of which 9.1 MBD comes from our own drills.  We are the largest oil consumer in the world, using 22 percent of total global production. We are also the third largest producer of oil, just behind Russia (9.9) and Saudi Arabia (9.7).  The other half of U.S.-consumed oil is imported from several nations.  The  largest exporter of oil to the U.S. is Canada, which accounts for 2.3 MBD.  Saudi Arabia, Venezuela, Mexico, and Nigeria are all next in line, with each exporting roughly 1 MBD.  Surprisingly, and despite all the rhetoric, Iraq ships just 400,000 barrels a day, a mere 2 percent of our total oil consumption.  In total, the United states only receives 10 percent of its total oil supply from the Middle East.

So if the U.S. consumes oil almost exclusively from North America, how does the Middle East impact pricing?  What consumers need to understand is that the largest global producer of oil has the greatest control on pricing.  Even though the United States receives only 10 percent of its imported oil from the Middle East, that region of the world accounts for 30 MBD, or 34% of global oil production.   The Organization of Petroleum Exporting Countries (OPEC) is a cartel of participating countries that unify production and pricing to maintain greater control of supply and demand.  OPEC supplies the majority of oil to the world’s Eastern Nations (China, Japan, India, etc).

straitSo why are gas prices rising?  Bordering Iran is the world’s greatest natural choke hold of oil transportation.  Almost 17 MBD pass through The Straits of Hormuz on their way to consuming nations.  Iran has threatened to close the Strait, which would result in incremental increases in cost to transport oil out of the region.  Since OPEC nations control the largest collective supply, any price increase due to their control will impact the worldwide marketplace.

American oil companies do not have to raise prices as no incremental production costs are being reflected, as in the Middle East.  The problem is increased market demand for cheaper U.S. oil can drive prices up (i.e. China would prefer to buy our cheaper oil instead of OPEC’s more expensive offering).  U.S. companies understand competition, and would much rather raise pricing with OPEC than undercut competition in the short term.  Why?  Oil is highly inelastic and consumers will pay for gas regardless of price.  Over the next several months, as oil prices stay high, U.S.-based oil companies will deliver some of the most profitable quarters for their shareholders, taking full advantage of Middle East instability.

There is no better time to withdraw the subsidies our government pays to domestic oil companies.  Each year domestic oil companies take $4 billion of taxpayer dollars and add it to their bottom line.  As noted previously, subsidies have no impact on domestic oil prices, nor does increasing U.S. production through additional drilling.   Any incremental oil production will be sold at the market prices, regardless of those subsidies, unless companies are willing to break away from OPEC direction.  As gas prices continue to climb at the pump, understand that capitalism is in full swing.  Oil company shareholders could not be happier, and they should thank both Iran and the American taxpayer.

9 Replies to “No More Oil Subsidies!”

  1. Good read Matt. Although you failed to mention the importance of properly inflating your tires in this scenario. A properly inflated tire with a good ol’ fashioned “spit shine” is really the most important thing that we as citizens can do.

    Help spread the good word.

    Hope you guys are doing well.

  2. Yes, inflating your tires has, albeit small, an impact to our oil consumption. Family is well and settled into Ohio life. We miss you guys and most of our friends from AZ. Hope to get back soon.

    Thanks for reading Stephen!

  3. The economic arguments here are fundamentally flawed (and this is coming from someone who is AGAINST “big oil” subsidies).

    First, and to get this straight, the “end subsidies for ‘big oil'” is a political mantra employed by the left to garner votes. There are very few Americans who understand energy and energy markets in any capacity, but, from the left’s view, it’s easy to get votes if you can get a large part of the population to turn against a small part of it. Painting “big oil” as a nasty, evil, “they’re taking our tax money” entity is another ploy to attract votes that falls in to the same boat as “the rich aren’t paying their fair share in taxes” (which, in the same tune, gets poorer, non-rich votes).

    To claim, “windfall” and record profits is also fundamentally economically flawed. If I had a company and I made $1 trillion per year but it took $980 billion to make it, I would have made $20 billion (a seemingly huge number) in net profit. While that number looks huge, it’s only a 2% profit margin. To claim “windfall” profits, looking at the number nominally and not qualifying it is economically poor. The fact is, the ROI for oil companies is low (in a relative sense, and yes, that’s what matters) compared to most industries. Tech, for example (which is not a commodity, unlike oil that is), is 25-35%. With such a low profit margin, it’s very difficult for a company to invest in itself. Why would the industry ever expand in its own nature, pushing more technologies and efficiencies, if the profit margins were so slim?

    Secondly, to claim that somehow tax/subsidy policy does not flow through to the customer is also far off. It absolutely does (think “big tobacco”). Do you think that “big oil” would just on it’s own good heart say “well, we are getting no more breaks, we are now making less money, making our profit margins slimmer… let’s eat it and not pass that cost on to the customers?” Why wouldn’t they? Why would they just be okay with making less money in an already tight field. Oil subsidies, from an economists point of view, are needed to offset the steep costs of R & D that are needed in this very specialized field (research, exploration-heavy, in a COMMODITIZED field…). It’s very difficult for an oil company to differentiate itself from competitors. If subsidies weren’t available, economists theorize that less and less choice would exist in the market because it would be difficult to differentiate an oil company from it’s competition. This would cause profit margins to be slimmer, causing less oil companies to maintain the market.

    Third, again, keep in mind, I’m against the government subsidizing anything on the grounds of free market principles and constitutionality (the free market should be allowed to run itself) including milk which is heavily subsidized… the $4 billion subsidy by the government is incredibly small. Being that the government spends approximately $3.8 trillion every year (about $122k per second), oil subsidies amount to about 9 hours of funding. The argument that this should be ended (the purely economic argument, not the free market or constitutionality argument) doesn’t flow with the money saving it does for the government’s budget. It’s not a major outsource for government funds, and the impact it would have on the government’s bottom line is minimal/unnoticeable. To focus on the “end subsidies for big oil” when it shows virtually no change in the government’s pocketbook but does help the price of gas (the economic average for the price of gas without subsidies would is that a gallon of gas would be approximately $15.40) shows that this truly is another example of the left trying to grab the votes of people who don’t know about a subject. To me, it’s sleazy, and it’s another way to pull the wool over the easily-swayed voter’s eyes.

    1. I agree with most of your points, especially with subsidies and their relation to free market principles. But let me tackle your claims:

      Since 75% of US consumed oil comes from North America, most of which is produced by US companies, pricing with the marketplace is what drives “windfall profits”. Let me use your example to demonstrate:

      If it cost $980 billion to make the oil and companies sell for $1 trillion, then the margins are slim and the profits are negligible. But what if the pricing goes up by 30% and the cost of oil does not change? in this example the profits would grow grow from $20 billion to $320 billion (windfall profits).

      We saw this concept quite clearly when Exxon revenues went from $459B to $301B to $383B (2008, 2009, 2010) with production barely changing! Net income went from $45B to $19B to $30B over the same time frame which is an amazing change from year to year. If, by your claim, margins would hold constant and incremental costs would be passed to the consumer, we should have seen pricing remain flat through these past several years as production costs have not changed from our main supplier of oil.

      But here is the challenge with using basic economic principles to describe a complex pricing market removing elasticity from the equation; US companies take pricing with the market even though their costs do not change. SO if OPEC is experiencing higher costs to produce their oil (like the Straits of Hormuz issue called out above), US oil changes pricing to match due to market demand (if we kept our prices low, we would undercut the largest oil producer in the world, and demand would skyrocket for our product, eventually driving prices up anyway). This is why your margin story above does not play.

      If Exxon was to pass through the removed subsidy to consumers, effectively raising prices, they would be undercut in the exact same method as if we kept prices constant in the example above. Since we do not control the largest share of production, we are pricing followers, which is why subsidies will not be passed through.

      With the subsidies and a series of tax benefits, in 2010 with a record $40 billion in profit, Exxon only paid a net effective tax rate of 17%. Tell me why again they need the subsidy?

      1. I’m not sure how you can say my points are invalid.

        First, you cited this: “If it cost $980 billion to make the oil and companies sell for $1 trillion, then the margins are slim and the profits are negligible. But what if the pricing goes up by 30% and the cost of oil does not change? in this example the profits would grow grow from $20 billion to $320 billion (windfall profits).”

        Okay, so what if it drops by 30% and the oil companies LOSE lots of money? You can’t have it only one way. The fact is the AVERAGE profit margin has been around 8% for decades. In averages, highs like you have described and lows that I have just described average out to make 8%. So the claim of “windfall” profits is a one-sided argument. If you’re not going to acknowledge that it’s a ½ argument claim, you’re not fully looking at the situation. For statistics sake and for accuracy sake, you can’t argue that windfall profits exist when the average is what it is; that would be poor economics and poor business management. If oil companies experience a boon because of some exogenous condition, so be it. There will be losses to offset that condition at some point, too. You even described this yourself (Net income went from $45B to $19B).

        For your next paragraph. “But here is the challenge with using…” it’s the exact same case. If prices jump due to speculation, exogenous forces, etc… sure… oil companies will experience a short-term jump in revenues if everything else stayed the same (which doesn’t often remain the case). But again, as stated in the last paragraph, when prices tank and profits dry up, you don’t acknowledge the effects of this on the companies.

        You said, “If Exxon (focusing on one player in the market is not good econ)…”

        – you seem to forget that oil subsidies are passed through the market. It wouldn’t be Exxon. This would be a completely static price bump. Exxon would not simply face the effects of this; all companies would. To look at it this way as you have done is very shortsighted. If oil subsidies went away, and for numbers purposes the average price of a gallon of gas jumped to $7.00, the AVERAGE price would be that way for all. It’s not like it would only affect Exxon, and Exxon would not be undercut. Again, with yes, a very inelastic market, in a HIGHLY commodotized, low-profit sector, undercutting is nearly impossible (hence why these subsidies exist, hence why they exist for agriculture, too). At the end of the day, in spite of whatever syntactical gymnastics are played, ALL oil companies would have to raise their prices in lockstep. If cigarettes had a dollar tax removed, their prices would fall by $1. This is the same for removing the subsidies from oil companies.

        It seems that you don’t realize that gasoline is viewed as a commodity. This is why profit margins are so slim, and this is why subsidies came into place in the first place (as mentioned, it exists in agriculture, too). If you take away the subsidy, all competitors’ prices jump. You mention undercutting, but when margins are so slim, how do you undercut? You quickly reach a point where you can’t because you have no better value to offer in a commodotized industry. It’s that simple. Fundamental economics of inelastic commodity markets holds very true. It’s as simple as the average gallon of gas jumping from $3.50 to $7.00 across the board. No one is excluded.

        And again, you have focused on “$40 billion in profit.” Please stop doing this. $40 billion in profit is meaningless. Quantifiably, it sounds big. Qualify oil company’s profits and it’s not. So please stop chanting this as it it moot.

        Again, I’m sorry to say, from an economic standpoint, the case for eliminating “big oil” subsidizes is just not there from the case you’re making. Now, if you want to talk about the issues surrounding this case with respect to:

        1. Unconstitutional subsidies (is this a power that was granted in the Constitution envisioned by our forefathers – the power to simply give money to some selected entity while discriminately not giving it to others…)
        2. The attempt by the left to gather votes around this “get a large group of potential voters to turn against a smaller group” – a la “the rich don’t pay their fair share” (which they absolutely do)

        I’d be happy to address those. But again, economically, the case just isn’t there.

  4. Elephant, you’re clearly pro oil. Where are you getting your information? Are you an insider or just quoting what they tell you?

Leave a Reply