LIFO in the Oil Patch

The Wall Street Journal had a really nice piece about how it’s a well known “secret” that the oil industry uses LIFO accounting rules to reduce their tax bill.   (this strategy only works when oil prices are going up.) LIFO stands for “last-in first-out” which means you value the inventory based on the cost of the most recent oil purchase.  The Journal article explains,

“Oil inventories are typically valued each year using prices at the start of the year, said Les Schneider, partner at the Washington, D.C., law firm Ivins, Phillips & Barker and an expert on inventory taxation. If a refiner builds up one million barrels of oil inventories over the course of 2009, it could value that crude at the January 2009 price of roughly $40 a barrel. But if the refiner ends 2010 with 1.5 million barrels in storage, the additional 500,000 barrels would be valued at around $80 a barrel, the January 2010 price.”

 The cost of that sold inventory reduces the company income, which in turn reduces the amount of income tax paid.  The article points out that this practice is so widespread that even as supply levels go down at the end of the year, prices don’t follow at the same rate.  Investors not in the know (like me) can be fooled into thinking there’s a price spike coming, when in fact inventories will make their way back at the start of the year because actual demand hasn’t changed.

Speaking of demand, the Journal had another tidbit on this topic in Heard on the Street this week.  Apparently the President’s deficit commission decided this earnings management tool is an area where the Treasury department might pick up some bucks.  Among their recommendations was a proposal to disallow LIFO for anyone.  The report focused on the oil companies’ current LIFO reserves, which are estimated to be worth about $10 billion in additional tax dollars if this accounting principle were to be eliminated. 

Of course oil companies aren’t the only people to use LIFO.  The article goes on to say the AICPA estimates about 36% of companies value their inventory that way.  Tax issues aside, LIFO is considered by many astute financial types to be the most accurate form of reporting inventory value.  The logic is that bias toward the current price of whatever the company sells is a more realistic snapshot of the company’s  current financial prospects. 

While there may be a tax advantage to LIFO in an inflationary period, or when the price of your inventory is rising, the opposite is also true.  Presumably whoever wrote the report must have heard that the big fear these days is actually deflation, so eliminating LIFO in that scenario won’t help the deficit at all.  What happened to all the talk about reducing the deficit by cutting complexity in the tax code?