Pelosi and Putin Share Common Ground in Economic Rent

RelevanceThe Clean Energy Act sponsored by new House speaker Nancy Pelosi is a barely veiled attempt to raise tax revenues from oil companies that are perceived by politicians to be profiteering from unusually high oil prices. This follows similar moves by Putin (who pushed through the forced sale of some of Shell’s gas assets in Russia to a state owned entity), and the UK’s Finance Minister, Gordon Brown, who has increased oil company corporation tax from 30% to 40%.

The pressure on politicians to target economic rent at times of high prices can be severe. And such pressure can be irresistible – after all, targeting oil companies is a good vote winner and relatively easily accomplished. Also, oil companies can be an effective source of funds to plug government deficits: they are perceived to have plenty of money and it’s easy to collect the tax.

But such moves by politicians can prove to be a double edged sword, and to understand why, we first need to understand the concept of economic rent. This key aspect of the oil and gas industry should be studied by all who have an interest in the sector.

Analysis: Economic rent is defined as “returns in excess of the supply price of investment”. In other words, economic rent is created when investors achieve a return greater than their required return when making the investment. This is important in the oil and gas industry because governments create petroleum fiscal regimes that (amongst other things) target the economic rent, leaving just enough for investors to be happy. The complication occurs because, although we know that economic rent exists, we do not know what it will be in the future. Some of the reasons for this include:

  1. The amount of oil present is not fully known at any one time.
  2. We do not know how the oil will be developed in the future.
  3. Exploration and development costs vary by region and over time.
  4. We do not know what future oil prices will be.

The complaint of the oil industry has been that governments are overly quick in raising taxes in the good times (usually when prices are high) but very slow in lowering taxes (if at all) when prices are low. Thus investors feel that they are exposed to the full force of the downside risk of the investment, while getting only restricted access to the upside.

Generally, investors like fiscal regimes that allow for adequate risk based returns over time and that are stable. By continually tinkering with the system, Pelosi, Putin, Brown and others are guaranteeing that investors will require higher returns in the future.

14 February 2007

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