Do windfall taxes make sense
Several countries around the world have implemented windfall taxes on energy and food companies, as these companies reported windfall profits in a period of high inflation. As households struggle with high inflation, several governments have begun to introduce various forms of windfall taxes. These taxes would then be used to fund grants and other relief efforts to ease the pressure of high prices for the masses.
The UK government has introduced a 25% tax on the profits of energy companies which would then be used to fund subsidies and subsidize prices for vulnerable sections of the population. Similarly, Hungary has introduced windfall taxes on banks and energy companies, while retailers, insurance companies, telecommunications companies and pharmaceutical companies will also pay smaller proportions of windfall taxes.
Spain and Italy have also followed suit, implementing taxes on their own industries. The rationale for windfall taxes may seem appealing, especially since windfall profits are seen as the happy outcome of geopolitical unrest. But implementing such taxes could be a myopic solution to a larger problem.
Moreover, these taxes could be unfair to oil companies that have endured a decade of low prices and weak demand for their products. From around 2014 to 2020, commodity prices remained fairly low, except in 2018. Companies involved in oil production barely earned a return above their cost of capital. Oil prices have even turned into “negative” territory in 2020, as demand for the commodity has dried up. Several oil producers have closed shop as ongoing operations have become unprofitable. However, as demand returned, prices continued their upward trajectory like other commodities.
Obviously, commodity prices are cyclical in nature and right now we are in a commodity bull cycle. Crude supply remains uncertain as demand continues to grow, resulting in high crude prices. With China unlocking its provinces, demand is only expected to continue to rise. As a result, commodity companies typically make small profits or even losses for years before a bull cycle begins, offsetting years of poor capital returns.
These companies generally do not benefit from tax breaks during downturns, but populist sentiment leads to the imposition of windfall taxes during upturns. Windfall profits made by commodity producers in some years are not an anomaly, but a feature of commodity trading. On the other side of the coin are the abnormally low profits that these companies report during periods of excess supply and weak demand.
Following the previous conclusion, oil companies usually grow during good times because they are full of cash. Oil producers begin exploration and rig construction activities in hopes of increasing their oil production, which in turn would mean higher profits. Additionally, these companies would have lower internal accrued liabilities to fund their capital expenditure plans.
Moreover, the introduction of a brutal tax would eventually force companies to reduce their expansion, while signaling an unstable tax regime. The increased regulatory risk would prompt investors and management to scale back or cut back altogether on the addition of new oil production capacity. But cutting back on new production would ultimately hurt consumers if supply ends up growing at a much slower rate than demand.
The race for higher environmental, social and governance (ESG) standards had already led to the reduction of new investments in oil and gas. Several US-based oil companies have been ordered by activist shareholders to stop drilling new wells and return the cash generated through dividends and buybacks. Investors in these companies also include pension funds and insurance companies – these companies ultimately receive lower dividends from oil producers.
By nature, commodity companies depend on the “supernormal” profits of a few years to compensate for the abnormally low profits of previous years. Unfortunately, arbitrary taxation could negatively impact the world as underinvestment in the oil and gas sector continues. Such taxation should be avoided at a time when investors and businesses are already facing uncertainty in the macroeconomic environment.
Although the Indian government considered introducing exceptional taxes in 2008 and 2018, it did not act on the proposals. India has generally struggled to attract investment in many of its commodity-driven sectors, particularly oil and gas. The introduction of such taxes could have negative consequences in the future.
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