The media and certain politicians have been clamoring about this taboo word in American business – windfall profits. Each of the two major presidential candidates have made their positions publicly known regarding their stance on oil company profits in relation to the rising price of fuel. While they both have grievous fallacies in their logic that defy common sense economic principles, in this essay I would like to evaluate the particular stance of the presidential candidate Barack Obama. He has pledged to tax the “windfall profits” of the oil companies, citing the oil industry’s $132,000,000,000 profit last year. The intent of this article is not to open a salvo on Senator Obama as an individual or to lambast the seemingly universal platform of the Democratic Party regarding the oil industry, rather the purpose of this article is to shed some light on what I believe to be the most overused and misunderstood term of this election season.
What is a windfall profit? It is a term whose definition has been changed over the course of politics to benefit the populist motives of the particular group in power. Throughout history up through the latter part of the 20th century, a windfall profit was defined as: a profit, or capital gain, derived from an investment in which the receiving entity did not contribute to the creation thereof. This may seem complicated, but in actuality the concept is very simple. As an example, let us take two striving entrepreneurs, Jack and Sally. Jack believes he has invented a new shampoo bottle that can revolutionize the shampoo bottle industry. Jack approaches Sally to convince her to contribute capital towards his shampoo bottle venture. Sally, believing that the idea would not be profitable, declined any financial backing to Jack. Thus, Jack pursued his shampoo bottle venture exclusively. Ten years go by, and Jack’s shampoo bottle idea finally takes off, and Jack becomes an overnight millionaire. Just to show Sally that his idea was in fact marketable, he sends his old friend Sally a check for $10,000 of his shampoo bottle earnings. Sally graciously accepts the gift. Which of these two individuals would be pegged with a windfall profits tax? Using the historically accepted definition of a windfall profit, it would seem that Jack’s millions of dollars would be recognized as ordinary operating income, seeing as though he had a risk, or financial investment, associated with every step of his shampoo bottle venture, from the conception of the idea to the manufacturing of the bottles. He had everything to lose in his investment, so any capital gain derived from it is legitimate. Sally, on the other hand, had no part to play in Jack’s shampoo bottle business, yet she received a large sum of money from Jack’s company, effectively reaping the benefits of the company’s success without having any basis or risk in the company itself. Poor old Sally is going to have to pay a windfall profit tax on her check from Jack.
Now that the definition of windfall profit is out of the way, how do Senator Obama and his party feel this scenario can be applied to the oil companies with their $132 Billion profit? That number in and of itself is mind blowing, isn’t it? The rich tycoons at big oil are making $132 Billion profit in a time when gas prices are $4 per gallon, doing an injustice to the working man. It’s the government’s job to step in and stop these corporations from ripping off American citizens, right? And the best way for the government to intervene is, naturally, to step in and tax those “windfall profits,” reducing the company’s inclination to make those dirty profits again. While the simple number, $132 Billion, may invoke strong emotions that are beneficial for empowering a particular political party’s voting bloc, that number in and of itself is not the whole story. I will take this opportunity to break down profits of ExxonMobil to see exactly where that $132 Billion came from. According to ExxonMobil’s audited income statement, their profit margin for FY2007 was 9.72%. For simplicity’s sake in my examples, I will use 10% as their profit margin, which in reality will overstate their actual income by tens of millions of dollars given the sheer volume of sales ExxonMobil recorded, but it will also make the numbers easier to calculate and follow for the sake of this essay. Given a 10% profit margin, we can conclude that for every $1 XOM invested, they received $1.10 in return. That 10 cent return on investment, multiplied by the gargantuan volume of investments, or risks, the company made, those meager returns on investment eventually amount to a massive $132 Billion over the course of 12 months of business. Now let us delve into whether a 10% return on investment is suitable for the company. An individual can find a decent, low risk Certificate of Deposit with around a 5-6% interest rate. All that is entailed with a CD is that the individual deposit his capital for a pre-specified period of time, and in return the financial institution pays the individual a pre-set amount of interest for the individual giving the financial institution the privilege of utilizing the individual’s funds. Given the definition of a CD, we can conclude that CD’s are considered very low risk investments that yield anywhere up to a 6% return in given market conditions. Now let us transition into the investment risks of oil companies such as ExxonMobil. In the oil industry, sunk costs are very common. Before an oil company drills for crude, they must pay geologists to determine to the best of their abilities whether the company will find any crude in the hole. They must pay environmental firms to conclude that there will be no adverse environmental effects from drilling in that particular location, and they must pay the federal and state governments exploration fines and protection costs to have the ‘privilege’ of being able to drill for crude in this great country in which we live. Once it’s said and done, ExxonMobil can spend over $1 Billion on preparation for drilling a hole in the ground, and they may or may not get any crude out of that hole. The risks are very high, and once the exploration and preparation costs are sunk, there is no way for XOM to re-obtain that capital. Given the high regulation and risks entailed with the oil industry, some would say that a 10% return on investment is considerably low when taking into account the fact that you can just as easily invest your money in a low-risk CD and get a 6% return on it. If this example alone is not convincing, consider the mid-1990s when oil companies sustained just as many risks as they do today, yet their profit margins were only 5%. Given this situation, would a wise investor contribute capital to a high-risk industry that gives a 5% return such as the oil industry, or a low-risk investment that gives a 6% return, such as a CD? The everyday risk averse investor would stick with the CD.
Now that we know where the profits come from and why they are the way they are, I will attempt to grapple the ever-prevalent idea that oil companies are overcharging Americans, and making too much money off the back of the working man, that they are “price gouging.” It has been given that ExxonMobil’s profits were 10%, or 10 cents for every $1 of fuel sold. Some say this is too much. Rather than disagreeing with that argument, which by the way, I do, I will take another approach. The federal tax on a gallon of gasoline is 18 cents. The average state tax on a gallon of gasoline is 42 cents. Thus, on average, 60 cents of every gallon of gasoline you put in your tank goes to the government. Using the current average price of gasoline, $4, we can conclude that the government receives an exclusive 15 cents of every $1 of gasoline sold (60 cents / $4 per gallon). In other words, ExxonMobil, who is in the business of extracting crude and distributing gasoline, earns 10% on their core business, while the government, who shares none of the industry risks that ExxonMobil has, righteously receives 15% of the earnings. Am I wrong for seeing the inherent flaw in the status quo? For those out there who claim the oil industry is price gouging, I ask the question… who exactly is gouging whom?
Now that the groundwork has been completed, let us transition back to the term “windfall profit.” Once again, windfall profit is defined as: a profit, or capital gain, derived from an investment in which the receiving entity did not contribute to the creation thereof. Politicians like Senator Obama would have us believe that the profits earned by ExxonMobil are to be considered “windfall,” and therefore should be taxed accordingly, effectively placing a double tax on the company’s earnings – a tax on gross income, and then second tax on the resulting net income. Since this message is clearly clouded in political spunk, I believe the best way to approach this is to take the oil industry and break it down into something that I call “The Gas Cycle.” What are the steps involved in the process of an oil company to bring gasoline to bear in the consumer market? In my gas cycle, the six-step cycle includes: Exploration, Extraction, Transportation, Refinement, Distribution, and Collection. Taking each step of the gas cycle, we will decide whether the expenses incurred by oil companies are directly attributable to the terminal earnings, thus excluding those earnings from a windfall profit category. Do oil companies make a direct investment in the exploration and extraction of crude? They most definitely do, spending billions of dollars every year in search of fresh crude reserves. Do oil companies make a direct investment in the transportation, refinement, and distribution of gasoline? Once again, yes they do. They pay for the oil tankers to transport the crude halfway across the world, and they spend billions of dollars every year increasing refining capacity and streamlining refining and distribution operations throughout the world. Are the collections from the sale of the distributed goods therefore attributable to ordinary operating income or are they considered a windfall profit that should be double taxed? Using our historical definition of a windfall profit, a profit, or capital gain, derived from an investment in which the receiving entity did not contribute to the creation thereof, I would conjecture that the answer is No. Operating income of oil companies does not qualify as a windfall profit, and should not be treated or taxed as such. Not to mention, believing that increasing the tax on corporate profits is an effective method to go about lowering the price of the good that the corporation supplies is counter-intuitive at best, and it completely negates centuries of proven economic principles – but this is another argument for another article.
Given that it is incorrect to classify oil company profits as windfall profits, I have a longstanding question that I’d like to throw into the debate arena. Since it has been our very own government officials who have been shrieking about the windfall profits of oil companies, it made me contemplate the government’s role in the oil industry, and to what extent the government’s income from the sale of gasoline was considered legitimate. We know that oil companies have everything to gain and everything to lose in crude exploration – just a few bad drilling decisions could lead to a company the size of ExxonMobil going under in an industry as internationally competitive as theirs. What financial basis does the government have in the gas cycle? What investment does the government have to lose if the oil company drills a dry hole? What financial risk do they carry in the success of crude exploration? They carry no risk, yet they still receive more income from the sale of gasoline than the oil companies themselves do. So I ask this question, “between the oil companies and the government, whose ‘windfall profits’ should we really be concerned with?”
