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By Robert Rapier on Aug 13, 2006 with no responses

California’s Proposition 87

Introduction

I have intended to write this essay for a couple of months, but I have really struggled with what I wanted to write. Voters in California will decide on Proposition 87 in November. I have a number of friends and acquaintances who support this initiative, and even one who helped write the language of the initiative. Therefore, this essay is difficult to write, as it may offend some people whose friendship I value.

I have no doubt that this initiative will pass, but I have a lot of problems with the way this campaign is being run, and how oil companies are being vilified in order to win support for this measure. To be certain, oil companies are looking after their own best interests and those of their shareholders in opposing this measure. But I believe proponents are pumping out a steady stream of misinformation, even as they accuse the oil companies of doing so. I also think some of the proponents are very naïve if they don’t think this will increase gasoline prices in California. However, I would like to see gasoline prices go up to encourage conservation. Ultimately, my struggle is with whether the end justifies the means, and whether the money raised will be funneled into the most appropriate areas.

Background

Proposition 87, commonly known as the Clean Alternative Energy Initiative, will impose a new wellhead tax on California oil producers. This is essentially what Hugo Chavez did in Venezuela – he decided he wanted a bigger slice of the petroleum pie and assessed additional taxes. At current prices, the new tax would amount to 6% of the value of a barrel of oil. If oil is selling for $75 a barrel, the tax on what the proponents call “excess profits” will amount to $4.50 per barrel. Proponents believe it will raise $4 billion in revenue from the oil companies, at no cost to consumers.

The initiative is being bankrolled by Vinod Khosla, and the proceeds will be directed primarily toward alternative energy, including Mr. Khosla’s ethanol interests. Mr. Khosla has said “just because I might benefit, doesn’t mean this isn’t a good idea.” True, but it creates a bit of a conflict of interest and gives rise to the potential that the funds raised will not be optimally deployed.

First, let me provide the links for the two opposing sides, so you can get more background information if you wish to do a bit of research:

Yes on 87

This is the website promoting the initiative, and they have lots of FAQs and background information. Opposing them, with their own set of FAQs is:

Californians Against Higher Taxes

Let me make it clear that I fully support alternative energy and conservation initiatives. However, not all alternative energy solutions are created equally. I have argued that corn ethanol, for instance, is undesirable for a number of reasons. Yet this initiative would funnel money toward corn ethanol, which is one reason I have a problem with it. It will help prop up an industry that already receives very generous government subsidies, while primarily just converting fossil fuels (natural gas, gasoline, diesel, coal) into ethanol. Corn ethanol promotes soil erosion, as well as herbicide and pesticide runoff into our waterways. On the other hand, the initiative would funnel money toward areas that I do support, like green electricity and biodiesel.

What Will Happen

I think the naïvety surrounding this initiative is stunning. Check out this passage from the Yes on Clean Energy site:

“Prop 87 would make oil companies — not consumers — pay their fair share for oil drilling, just like they do in Alaska, Louisiana, Oklahoma and even Texas. Oil prices will NOT increase. The California Attorney General has confirmed that Prop 87 makes it illegal for oil companies to pass the cost to consumers by spiking gas prices. And experts confirm the global markets won’t allow the oil companies to raise our gas prices either.”

This passage displays a stunning ignorance of how markets work, and how capital is allocated. Oil companies are going to be assessed $4 billion in new taxes, and consumers aren’t going to feel that? Please. Here is exactly what will happen. This is not speculation on my part; it is based on exactly how capital gets allocated.

When the initiative passes, oil companies will have a new tax to deal with in California. The returns on capital invested in California will drop, and it will be less profitable to extract oil in California. Each year oil companies determine where they will allocate capital to various refineries in the country based on expected returns on various projects. Refineries in various locations compete against each other for capital allocations, and now California will be at a bit of a disadvantage because they will be paying more for their crude. Not only will the returns from California be lower, but questions will arise as to when they might hold another initiative to increase the tax (ala Chavez). California refineries will get just a bit less of that capital, which over time will squeeze supplies. As gasoline capacity fails to keep up with demand, higher prices will result.

Now, pay attention to this next statement: One of the major proponents behind Prop 87 admitted to me that the scenario I laid out is likely, but he is counting on ethanol to step in and fill the gap. If you have followed my essays on ethanol, you know this is a great bit of wishful thinking. So, Californians will deal with higher gasoline prices. But guess what? I have no problem at all with that. It is the “truth in advertising” aspect of this that I have trouble with. And I also want to be able to say “I told you so.” The real irony of all of this, though, is that oil companies will be blamed for the higher prices and Prop 87 proponents will escape any accountability.

Paying Their Fair Share

Proponents have painted this initiative as a way to finally make oil companies pay their fair share in California. From a FAQ on the campaign:

“California deserves its fair share. Currently, oil companies pay California almost nothing to drill, while they pay billions of dollars in drilling fees to every other oil producing state. Prop 87 will set California’s oil drilling fees at levels similar to those in Oklahoma, Alaska, and Texas at no cost to consumers and with no increase at the pump. The California Attorney General has confirmed that Prop 87 makes it illegal for oil companies to raise gas prices to pass the cost of the fee to consumers.”

Here’s what proponents aren’t telling you. From Gasoline Taxes by State:

Oklahoma – $0.17/gallon
Alaska – $0.08/gallon
Texas – $0.20/gallon
California – $0.32/gallon

California has the 3rd highest state gasoline tax in the nation, behind only Hawaii and Nevada. I think California is getting their “fair share”, only they chose to get it in a way different from the other states mentioned. I would argue that having such a high gasoline tax has helped spur conservation more than if California had the $0.17 gallon tax of Oklahoma. This of course means oil companies are already paying a price by selling less product than they would if gasoline taxes were lower. The net revenue is probably about the same whether you have low gasoline taxes and an oil extraction tax, or high gasoline taxes and no oil extraction tax. What Prop 87 will do is put an oil extraction tax on top of one of the highest gasoline taxes in the country. That’s something proponents aren’t telling you.

Learning from History

Of course the U.S. has experimented in the past with windfall profits taxes. From a 1990 Congressional Research Service report:

“The windfall profits tax reduced domestic oil production between 3 and 6 percent, and increased oil imports from between 8 and 16 percent. This made the U.S. more dependent upon imported oil.”

Of course in California’s case, it will reduce state oil production and increase imports from other states. It will make California more dependent on oil imports from other states. It will increase costs for California refiners. Even proponents have to understand that increasing the cost of oil produced in California is going to make importing oil into California more attractive.

Another article recently caught my eye. It deals with California’s many failed attempts at reducing petroleum dependence:

How California failed in efforts to curb oil addiction

Some interesting excerpts for those who are determined to repeat history:

“For a quarter century, California has pursued petroleum-free transportation more doggedly than any other place in the U.S. It has tried to jump-start alternative fuels ranging from methanol to natural gas to electricity to hydrogen. None has hit the road in any significant way. Today, the state that is the world’s sixth-largest economy finds itself in the same spot as most of the planet: With $75-a-barrel oil, and increasing concern about the role fossil fuels are playing in global warming, 99 percent of its cars and trucks still run on petroleum products.

Oil and auto companies say they’re justified in resisting government mandates to roll out alternative technologies when they’re not convinced consumers will buy them. Donald Paul, Chevron’s chief technology officer, says California regulators essentially tell industry officials, “We know what the answer is. You guys just spend the money and everything will work fine.” He adds, “History has not shown that that works very well.”

Proponents of oil alternatives are pressing ahead. An initiative set for California’s November ballot would hit oil companies with an “extraction fee” on every barrel of oil they pull out in California, a top oil-producing state. The fee would range from 1.5 percent to 6 percent of the oil’s value, depending on the prevailing per-barrel price. Backers say the measure would raise $4 billion, which would fund research into alternative-fuel technologies and incentives for consumers and fleets to buy alternative-fuel vehicles.

The initiative is bankrolled by entrepreneurs including Vinod Khosla, a Silicon Valley venture capitalist who has been investing in ethanol and other alternative-energy businesses.”

The final paragraphs of that story really tell the tale of why proponents want to funnel more money into ethanol. Despite all of the government subsidies that the ethanol industry currently enjoys:

“Today there’s just one E85 station in California that is open to the public. It sits beside a highway interchange in San Diego. It was opened three years ago by Pearson Ford, a San Diego Ford dealer that was convinced alternative fuels would be the next big thing. The station offers gasoline and diesel, natural gas, propane, electricity, biodiesel and E85.

What it sells, though, is mostly gasoline and diesel. On a recent morning, it was offering E85 for $3.10 a gallon, about 6 percent less than the $3.30 per gallon it was charging for regular gasoline. But, because a gallon of E85 contains about 25 percent less energy than a gallon of gasoline, the E85 actually cost more per mile. Only a handful of cars pulled up to the E85 pump.

“I would like nothing better than to turn all my pumps over to alternative fuels,” says Mike Lewis, the station’s co-owner. “But I’m not willing to carry the alternative-fuel flag into bankruptcy.”

Promoting Hatred

This is where I have the biggest problem with the initiative. Proponents are using very inflammatory language to work voters up into a frenzy. This is nothing but demagoguery. In fact, Mr. Khosla wrote the following essay for The Huffington Post:

Big Oil’s Big Profits, and the Big Lies They’re Telling to Maintain Them

Of course the title is inflammatory enough, but the hypocrisy is what bothers me. Big oil is vilified for “big profits”, yet ethanol companies – which Mr. Khosla promotes – have far higher profit margins. An excerpt from the essay:

“It’s kind of like the tobacco companies that for years claimed that smoking doesn’t cause cancer. The oil interests are willing to publish any myth, and put any amount of money behind anyone who will support their untenable position.”

Following that essay, he wrote another:

The Big Oil Companies Have Been Ripping Californians Off — And Not Just at the Pump

Another inflammatory title, and more inflammatory rhetoric. Some excerpts:

“You thought you were being ripped off at the pump. You are, but that is only half of the story — the rip-off goes far beyond that.

As I blogged here previously, many of the big oil companies are raising prices at the pump while standing in the way of progress on immediately viable alternative fuels (while pretending through their vast network of slick lobbyists, consultants, ad agencies, PR firms and token investments, to be committed to alternative fuels) to lessen our oil dependence.

If the money and inside-Sacramento power of the big oil companies is going to allow them to rip Californians off, then certainly we Californians have the right, if not the duty, to join together and stand up for ourselves. But more on how they buy California (and National) politicians in a future blog (yes, post or email me your favorite big oil stories at vinod@yesoncleanenergy.com and I will feature them here).”

I honestly don’t believe there is any excuse for promoting this kind of animosity toward oil companies – even if you do stand to benefit financially from doing so. I am just waiting for the day that someone gets so wound up they decide to attack oil company employees on the way into work. It’s as if some people think that big oil companies are just a bunch of fat cats in an ivory tower plotting how to rip people off. In fact, oil companies are made of working men and women who sometimes give up their lives to make sure the gasoline keeps flowing. “Big Oil” is made up of the shareholders of oil companies, which span the gamut of backgrounds. So when hatred is spawned in the direction of “Big Oil”, these are the people who are the recipients of this hateful rhetoric. For the record, I have told Mr. Khosla that I disagree with these tactics. His response was “We will have to agree to disagree on this one.”

Conclusion

I don’t live in California, so I don’t have to vote on this initiative. There are some good aspects and some bad aspects, and forces on both sides are engaged in a pretty nasty campaign to win voters. The proponents needn’t worry. I think this initiative will comfortably pass because of the public animosity toward oil companies. I didn’t write this essay to influence undecided voters. I think the message of hope that Vinod Khosla is preaching is more readily accepted that anything the oil companies are saying. But my prediction is that after the tax is enacted, the gap between gas prices in California and the rest of the nation – already high – will increase a bit more. I am content with that outcome, but I have a feeling that a lot of Californians are going to feel like they have been ripped off.