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.

If there is no economic incentive to step out and take economic risk, new sources of supply aren't likely to be explored. And if that exploration doesn't happen and demand wants to grow, energy prices will go still higher. In fact, the lack of new supply (because there is no economic incentive to explore) combined with burgeoning demand would, in theory, lead to much higher prices, likely in the form of price spikes. Spikes, in turn, would lead to a much more pronounced economic impact: hyperinflation, which would be followed by severe demand and economic contraction.

If you think today's high prices are bad, think about what it would be like if there were an artificial economic disincentive -- such as a windfall profits tax -- to deter new supply. That's not something I want to think about.

A windfall profits tax is misguided, ineffective and counterproductive. There isn't a single tax that has ever spurred investment. Taxes don't create incentives; they act as disincentives. The same will be true with any windfall profits tax proposal for oil companies.

Politics as Usual

High oil prices make for great politics. Nobody is in favor of them, and high oil prices are a great cause to rally against. And therein lies the problem with energy and politics: It's much easier to be against something than it is to be in favor of something that takes effort.

Instead of rallying against high energy prices, politicians should be focused on initiatives that would lead to more supply and more efficient energy consumption. That list could include such "difficult" initiatives as focusing on environmentally friendly ways to explore in places such as the Outer Continental Shelf, the Rocky Mountains and Alaska. It could include incentives for developing more durable hybrid vehicles and new concepts in co-generations. The list of options is endless.

The point is this: If we took half the energy Congress has spent in recent weeks bashing energy company profits and focused it on ways to improve the supply picture and our energy infrastructure, policy might actually have an impact.

I will give the politicians credit on one front: So far, nobody has hidden behind the facade that the windfall profits tax is needed to help balance the budget. Rather, this time the windfall profits tax is undressed for what it really is: a tax to punish the oil companies for making too much money.

Given that to be the case, should we assume the same politicians will come to oil companies' aid when oil prices return to the mid-$10s and they are losing money while still producing the energy needed to power the global economy?


This is not a commercial for the virtues of big oil. Companies such as Exxon, Shell and others have a responsibility to be good corporate citizens and reinvest in the communities that have supported them over the years. New sources of energy, new refining infrastructure and programs to make energy use more efficient are all areas where the majors can make a difference.

But at the end of the day, they need public support and public policy to help, not hurt, their efforts. Exxon Mobil can't build a new refinery to supply the West Coast with less costly fuel if Californians will absolutely not stand for a new refinery on their land. Chevron can't explore for more oil along the Atlantic Seaboard if doing so is against the law.

An energy policy that recognizes the need for new sources of supply and can balance the environmental issues with that supply need will go a long way toward addressing these issues.

A windfall profits tax would do nothing but make our energy future uncertain and investing in energy companies more difficult.

It really is that simple.

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At time of publication, Edmonds was long Exxon Mobil, although holdings can change at any time.

Christopher S. Edmonds is partner and managing director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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