A Windfall Tax Is Bad Economics

This week, Exxon Mobil(XOM) said it earned nearly $10 billion in the third quarter. Other major integrated companies followed suit, with Royal Dutch Shell(RDS.A) posting results over $9 billion, and other majors such as BP(BP), Chevron(CVX) and ConocoPhillips(COP) weren't far behind.

That is a lot (a whole lot) of money for just 90 days of work. But that doesn't mean that our faithful governmental leaders should lay claim to a larger portion of the cash in the form of a windfall profits tax. In short, such a move would be detrimental to global oil and gas supply, and it amounts to nothing more than a tax on success.

Economics Lesson

Higher oil and natural gas prices are a result of only one thing: increasing demand in an era of tightening supply. An improving domestic economy combined with robust growth from developing countries such as China and India pushed demand for hydrocarbons higher. At the same time, it has become more difficult to find new sources of oil to replace those fields that are maturing and showing signs of production decline.

In this case, more difficult means more expensive, because companies have to drill deeper and in the deep water and in harsher environments just to keep up. And one reason we have fallen behind, creating a very tight oil and natural gas market, is that the economic incentive to drill those riskier prospects took time to develop. Oil companies are now drilling wells -- precisely because of $60 oil and $10 natural gas -- that they could not justify at lower prices.

Therein lies the economic lesson: Oil companies are in business to make profits for shareholders, who provide capital for companies to grow. The shareholders expect a return on their investment and also expect to be paid appropriately for risk. As exploration becomes riskier, the potential returns -- by basic economic axiom -- have to be more enticing.