Comment: US can manage energy cost without ‘punishing’ industry

July 28, 2008
Driven by public outcry over $4/gal gasoline, the US energy policy debate is beginning to shift toward discussions for a return of punitive, self-defeating measures directed at companies that produce the nation’s fuels.

Driven by public outcry over $4/gal gasoline, the US energy policy debate is beginning to shift toward discussions for a return of punitive, self-defeating measures directed at companies that produce the nation’s fuels. Congress is once again considering two previously tried “remedies” for controlling US energy prices–the imposition of “windfall profits” taxes on US oil and gas producers and the imposition of price controls on domestically produced oil, gasoline, and other petroleum products.

Lawmakers no longer are widely discussing governmental incentives for the oil, gas, and biofuels industries to facilitate development of additional supplies as a means of better controlling US energy prices.

This article revisits the 1970s and 1980s, an inflationary period in which the federal government intervened with price controls on oil and products and the imposition of a windfall profits tax on oil production. As a regulator during this period of maximum regulation, this author developed a unique perspective that may be missing in current energy policy debates.

Government can act beneficially by encouraging development of an adequate and affordable energy supply, including innovative Department of Energy (DOE) programs that support the growth of renewable fuels projects. These could be adapted to support large increases in the supply of all fuels.

What won’t work

The first major attempt by the federal government to control inflation was undertaken during World War II under the Office of Price Stabilization (OPS), which imposed price ceilings and rationed a wide range of products and commodities needed for the war effort.

In order to curb what was believed to be widespread inflation in 1970, Congress passed the Economic Stabilization Act (ESA) giving the president broad powers to regulate prices and wages. In 1971 President Richard M. Nixon used the act to impose price and wage controls on all sections of the economy, using a newly formed Cost of Living Council, headed by John Dunlop. Wage and price controls were lifted after several months on all but the oil industry, and the newly formed Federal Energy Office (FEO) assumed responsibility for the administration of price controls on domestic oil and petroleum products. Shortly thereafter, the Federal Energy Administration (FEA) became a permanent agency, and DOE subsequently absorbed FEA’s operations.

Nixon’s price control program covered the period from November 1971 through December 1980, when Congress enacted the crude oil windfall profit tax with the support of President Jimmy Carter.

Nixon’s price controls

Nixon first used the ESA of 1970 in August 1971. In Phase I, he instituted a price freeze, imposing price and wage ceilings on the products, services, and wages of most US businesses. In November 1971, a Phase II price control regimen allowed all firms–other than those in the oil and gas industry–to increase prices, based on average increases in their costs. Initially, Phase II ceilings had little impact on petroleum products prices because crude oil prices had remained stable. But during the winter of 1972-73, heating oil shortages arose, and price controls contributed to the shortages.

To encourage production of additional heating oil, Phase III price controls, instituted in January 1973, allowed oil companies to pass through their increased costs through price increases. But by March 1973, large heating oil price increases put public pressure on the Nixon administration to reimpose stricter price controls on heating oil. As a result, Special Rule No. 1 was issued, which reestablished heating oil price ceilings for the 23 largest domestic oil companies.

Phase III remained in effect through August 1973, creating a number of unforeseen problems. Imported oil prices began to increase, but Phase III price controls did not allow the 23 refiners to pass through their increased costs to independent resellers or consumers. As a consequence, refiners began to reduce oil imports and cut back product sales to independent marketers.

Old vs. new oil

The ensuing shortages aroused public pressure on Congress and the administration and resulted in Congress’s enacting the Emergency Petroleum Allocation Act (EPAA) in November 1973. This act froze existing buyer-seller relationships as they existed in 1972. It also created a two-tiered system of price controls on domestic oil, namely “old oil” and “new oil.”

Old oil was determined by computing the average monthly amounts produced from each oil-producing property in 1972 (the base production control level or “BPCL”), and the “ceiling price” for each barrel of old oil was its posted price at the start of Phase III. New oil was any oil produced from that same property above the property’s BPCL. New oil could then be valued and sold at the free market price.

In addition, price controls on products became more complex. Some products were decontrolled, while others, such as gasoline, diesel fuel, and heating oil, could be increased above their historical base prices through a complex set of allocations of unrecouped costs. This scheme was flexible and porous enough to allow most refiners to sell at market prices. It also created a regulatory nightmare for the FEO and FEA.

Because thousands of oil-producing properties in the US produced only marginal amounts of oil at a relatively high cost, many producers were unable to operate these properties at a profit if only old oil prices could be realized. Consequently, thousands of low-producing wells were shut in. To encourage producers to operate these properties, FEA instituted a stripper well exemption in November 1973.

A “stripper well” was defined as one that produced less than 10 b/d, and the exemption allowed operators to sell stripper well crude oil at market prices. However, the stripper well exemption created another set of complexities having to do with how to compute production from operating wells, shut-in wells, and wells used for waterflooding on unified properties. In addition, the creation by regulation of multiple tiers of domestic oil required a complex system of “certifications” and imposed a new set of enforcement responsibilities on FEO and FEA.

In addition, by imposing price controls only on old oil, an important allocation problem ensued that had not been foreseen. At the time, there were hundreds of refineries operating in the US, many of which did not have access to old oil, as integrated refiners kept this low-value oil for their own use. Many of these nonintegrated refineries then had to acquire imported oil and exchange it for domestic oil received by pipeline, paying the imported oil price. As a consequence, refiners who had access to old oil were able to make much larger profits on the sale of gasoline, as gasoline prices could be supported by reallocation of costs not recovered on the sale of other refined products.

In order to address this disparity, in December 1974 FEA adopted an “Old Oil Entitlements Program.” This program was an attempt to equalize the percentage of old oil used by each refiner, based on the industry average percentage of old oil being used each month. It required some refiners to buy entitlements and others to sell entitlements, based on excesses or deficiencies they had using the average price of old oil. In these programs, refiners with excess old oil actually wrote checks to refiners who had shortages of old oil.

Again, unintended consequences ensued.

Unintended consequences

The program was an attempt to equalize profits across refineries, but it really didn’t work that way for very long. Refiners who were being forced to buy entitlements for old oil began to increase their oil imports rather than issue entitlement checks to their competitors. This had the effect of equalizing the entitlements differentials between imported and controlled oil. It also put small refiners at a disadvantage, as they could not compete even after receiving entitlements benefits.

To allay this distortion, FEA enacted a “Small Refiners Bias” granting small refiners additional old oil entitlements. This created still other distortions. Old oil began disappearing because refiners and traders began “foreignizing” old oil through complex tier trading schemes, many of which were illegal. In addition, many refiners having to make entitlements payments began filing claims of hardship to FEA in order to receive exemptions from making entitlements payments to other refiners. And to get such exemptions, claimants had to use an elaborate and costly FEA administered appeals process.

As the price of oil began to rise again in 1975, Congress passed the Energy Policy and Conservation Act (EPCA) of 1975, which placed a price ceiling on new oil commencing in February 1976. This required adjustments to the entitlements program. The entitlements program was modified again in April 1976, giving entitlements to importers of residual fuel oil into the US East Coast. Middle distillate importers were then given partial entitlements to allay shortages of heating oil, diesel fuel, and jet fuel that occurred in February and March of 1977. Additional special entitlements were created for low-quality California crude oil, for Puerto Rican petrochemicals, and for purchase of crude oil for the Strategic Petroleum Reserve.

Finally, by May 1979, the Carter administration placed petroleum price controls on hold, and by the end of his term, most price controls on petroleum and petroleum products had been dismantled. President Ronald Reagan abolished all remaining controls by January 1981, and the EPCA formally expired in September 1981.

From all of these actions, the administration learned that price controls on energy really do not work except for very short periods of time. The EPAA and the EPCA came about in part as a response to the 1973 Arab oil embargo and the run-up in oil and petroleum product prices that ensued. But as is often the case, attempts to ease market distortions created other distortions that were unforeseen, and the US created a regulatory “tar baby” instead of a remedy. Even though the country is facing similar market pressures today, it should not repeat the mistakes made in the 1970s.

Market set prices

Worldwide market forces set oil prices. If domestic oil prices are subject to price controls, they will adversely impact domestic producers, create disparities between have and have-not refiners, require elaborate allocation schemes (such as the old oil entitlements program) to be instituted, foster creation of complex rules and regulations, and stimulate widespread circumvention efforts on the part of those regulated. An increased government enforcement effort would then be needed in order to achieve a modicum of compliance.

Further, controlling prices of some petroleum products and not others creates market distortions. These price distortions lead to shortages and ultimately to black market activity. And most importantly, as demonstrated by the 1970s price control program, such a program is unlikely to control prices to any measurable extent, as market forces always win out.

WPT won’t work

After decontrolling oil prices in 1980, Carter reached a legislative compromise with Congress allowing for the passage of a windfall profits tax (WPT) on producers of crude oil, as he feared that decontrol would lead to steep price increases. However the WPT, which went into effect on Mar. 1, 1980, lasted through January 1988. It initially was to be phased out over a 33-month period ending in January 1991 but was repealed in 1988.

The WPT was not a tax on profits; it was an excise tax on domestic oil production. It was imposed on the differential between revenues received for sales of domestic crude oil at market prices and amounts that would have been received at designated base prices. Base prices were adjusted monthly to reflect inflation and state severance taxes applied at the point of first sale. Base prices were established for Tier 1, Tier 2, and Tier 3 oil, as previously defined under the EPCA, and exemptions given to small independent producers, to government entities, and to other preferred groups.

Over 1980-88, the WPT produced $227.3 billion in tax revenues, which the US Treasury collected but did not return to consumers. The WPT did not generate as much revenue as was predicted because oil prices did not increase as expected. And in 1986, the price of oil collapsed, and WPT collections were greatly reduced. The only real impact the WPT had was counterproductive; it contributed to the reduction of domestic oil production by 3-6% and to an increase in oil imports by 8-16%. As with price controls, this punitive measure provided no direct benefit to the consumer and may have contributed to higher energy prices.

One can easily be misled into believing that it is sound energy policy to set ceilings on oil company earnings and earmark the windfall profits tax revenues collected to support government-sponsored energy policy initiatives. But based on experience, such a WPT applied against oil company profits would more than likely prove to be counterproductive. It takes continued and substantial investment to find oil, to upgrade and expand refining capacity, to perfect energy alternatives, and to build distribution and marketing infrastructure.

To remain competitive, oil companies must reinvest today’s profits in projects needed to meet future energy demand. Because these reinvestments are often high-risk, imposing a WPT on oil companies presumes that the government is in a better position to decide how to reinvest in the energy sector. It also presumes that if excess profits are left with oil companies they will not reinvest. These presumptions are wrong. Because it is in the best interests of oil companies and their shareholders to reinvest in projects they believe will be viable, most of them do.

Further, there is no evidence to suggest that in periods of higher profits, oil companies increase dividend distributions and curtail reinvestment. By imposing a WPT, the government would only undermine the ability of oil companies to provide investment needed to support energy development.

Positive government acts

The Energy Independence and Security Act of 2007 (EISA) recognizes the need for increasing production of biofuels, improving vehicle fuel economy, obtaining energy savings through improved lighting and building energy efficiency, increasing energy supply through alternative energy research, facilitating increased use of US-produced coal through development of carbon capture and sequestration systems, and improving energy efficiency in energy transportation and transmission infrastructure.

The Energy Policy Act (EPACT) of 2005 authorized DOE to offer loan guarantees for energy-related projects that offer innovative technologies. DOE backed 16 such projects with $8 billion in guarantees in 2007 and is about to provide $38 billion more in 2008.

Presidential candidates and congressional members debating energy policy have proposed a number of programs the government could promote to provide substantial added supplies of secure, affordable energy.

These include support for the development of nuclear power plants; sustainable supplies of clean, renewable energy; clean coal technology; hydrogen-powered vehicle development; drilling in the Arctic National Wildlife Refuge; passing new corporate average fuel economy (CAFE) standards for automobiles; and federal financing of energy projects through grants, low-cost loans, loan guarantees, tax rebates, and a strategic energy project fund.

Industry support

Another article recently published in Oil & Gas Journal discussed EISA at greater length (OGJ, Mar. 17, 2008, p. 24). Although some consider EISA a positive and constructive piece of energy legislation, it would fall short of its goal to increase the US’s fuel supply substantially enough to reduce dependence on imported oil. EISA’s key weakness is the fact that the renewable fuels standards contained in the legislation mandates the biofuels goals without providing incentives needed by the private sector. Hundreds of biofuels plants would be needed to generate the large volumes of biofuels mandated, and billions of dollars of investment capital must be raised.

There are a number of recommendations the government could take to stimulate investment in biofuels plants and related infrastructure, including research and development grants, tariff protections, low-cost project financing, and loan guarantees.

It is also recommended that tax incentives be made available to biofuels plant operators during ramp-up and perhaps price subsidies or conventional fuel surtaxes employed to support the higher cost of distributing and marketing advanced biofuels.

If mandates are issued to meet certain energy goals, direct government funding may be needed by those in the private sector to lessen the risk of such undertakings. These funding mechanisms should include direct grants, direct investment from venture funds or trust funds underwritten by government in qualified projects.

This list should also include low-cost loans that could be obtained by qualified sponsors from the US Treasury’s Federal Financing Bank coupled with DOE loan guarantees. DOE’s loan guarantee program, established under Title XVII of EPACT 2005, already provides a set of rules for qualifying projects and project sponsors for such loans and loan guarantees. Currently the program is authorized to provide only $38 billion in new loan guarantees, but this authorization can easily be increased as the program does not create a drain on the US Treasury or the US taxpayer unless a default occurs.

The government also should consider tax holidays for an initial period of years, along with accelerated amortization of new technologies being used, to reflect recapture of investments in new technology with uncertain useful lives.

Another funding mechanism to consider would be public-private joint venture arrangements that involve a public entity or authority other than the federal government. Under this type of joint venture, the private partner finances the project and operates it until it is profitable or for a fixed period of time. The private partner is then bought out based on the project’s going-concern value and the direct equity it has invested. This is often referred to as a build-operate-transfer (BOT) joint venture. BTO is another variation whereby the project developer is bought out early but operates the project for a fee.

The salient feature of all of these “positive” government measures is that they would only be made available to qualified sponsors of deserving projects that meet due diligence standards for commercially acceptable project risk.

No one solution

No one solution exists for achieving US energy policy objectives. It has been shown that finding organizations to blame and passing punitive measures against them is counterproductiive.

The ideas presented here illustrate ways that the US government can help the country produce more clean energy from secure sources. These measures emphasize using government backing to facilitate private sector initiatives that are based on sound business principals. By backing viable projects, such government support should result in implementation of successful energy projects and would go a long way in helping the energy industry meet government mandates.

The author

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Tim Sklar ([email protected]) is president of Sklar & Associates, a consulting firm specializing in biofuels project development. He is a CPA with expertise in project finance, due diligence investigations, viability assessments, and business plans. He has held positions in the federal government as research director of a presidential commission charged with developing policy recommendations on educational finance reform and as director of regulatory enforcement in the Federal Energy Administration. Sklar’s energy project experience includes petroleum refineries, power plants, power distribution systems, hybrid remote power generation systems, integrated oil seed crushing-biodiesel processing plants, and integrated pulp mill-cellulosic ethanol processing plants.