A Brief Note On Oil Industry Profits

by Don Boudreaux on April 25, 2006

in Prices

The airwaves, newspapers, and cyberspace are crowded these days with cheap and disgusting accusations that current oil-company profits are "out of control," "obscene," and "windfall."

I’ve not blogged on this issue yet because, frankly, I’ve nothing new or interesting to say.  The case for price controls, for government-mandated non-price rationing, and for a tax on so-called "windfall profits" is so lame, so utterly gossamer, that pointing out its flaws seems to be an exercise in stating the obvious.

So I offer you only this thought suggested to me by my friend Brian Summers: Too bad homeowners don’t post their property taxes, and the prices of their homes, the same way that gasoline retailers post their prices. 

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{ 36 comments }

Don Mynack April 25, 2006 at 3:52 pm

Why don't gas stations post the pre-tax price? That way, they could show consumers how much they actually pay the government when they fill up.

Not that I'm a huge opponent of gas taxes. They are about as fair a tax as you can levy, I reckon.

Christopher Meisenzahl April 25, 2006 at 6:07 pm

Don, have you caved in to "big-oil" so easily?!? ;-)

liberty April 25, 2006 at 6:22 pm

It may be stating the obvious, but isn't that what economists are for? Stating and proving the obvious is what economists do best.

Sadly the media and congress and president are so blinded by what they pay at the pump, even the smart ones have taken on the oil companies as the culprit. Normally intelligent Tucker Carlson has called the oil company CEO pay "repulsive and wrong."

It is the duty of smart economic-minded folk to point out why this line of thinking is wrong and is dangerous as it may encourage politicians to take away profits and destroy the industry; economists must remind people of history and explain what should be done instead.

Ivan Kirigin April 25, 2006 at 9:08 pm

"oil company CEO pay "repulsive and wrong.""

I would say that the rate of growth in CEO compensation recently is pretty ridiculous. BUT, i still find such statements idiotic. Public companies are self correcting for the most part.

It's funny when you figure the price of gas compared to the difference in price of fuel efficient cars. It would take $6+ gas to begin to justify the cost difference between a small sedan and the same sedan in hybrid version.

That, combined with the pretty small percentage of income spent on energy, makes me think talk of oil prices is usually news for news sake.

happyjuggler0 April 26, 2006 at 12:24 am
Helen's_kid April 26, 2006 at 2:11 am

High gasoline prices are no problem for China, they have plenty of American dollars to spend on oil. All the cheap Chinese items should be showing a price increase, soon. I've noticed plastic products increased in price. Anything that has oil as a component has to increase in price. Eventually gasoline will be like property along the coast, affordable to the very rich, only.

Keith April 26, 2006 at 7:26 am

Qoute from Helen's kid: "Eventually gasoline will be like property along the coast, affordable to the very rich, only."

I thought that's what "we" wanted. Less oil, less pollution, less "green house gases", less interest in the Middle East, etc. What's the big deal?

John Pertz April 26, 2006 at 9:36 am

Is there anyone out there who finds it a bit perplexing, if not hypocriticaly sadistic, that Charles Schumer, who is calling for the possible break up of the big 4 in the name of standing up for the little guy, is also the same guy who wanted to charge all Americans an extra thirty percent of whatever they buy from China? On that same note, President Bush and his Republican cohorts have done nothing but create an enormous federal deficit and yet they have the audacity to probe into the actions of the oil companies when they themselves have done more to defraud the American public than any corporation could ever dare to dream of doing. The sadest part of all is that the American public will end up getting all pissed off at the oil companies and give thanks to their wonderful congressman. However, this will all be in vain as the only reason the bureaucrats called for the probes in the first place was to take the heat off of their own shoddy political record.

save_the_rustbelt April 26, 2006 at 10:07 am

"Public companies are self correcting for the most part."

That is the funniest thing I have heard in a long time.

save_the_rustbelt April 26, 2006 at 10:11 am

Supposedly the oil companies are raising retail prices becuase their costs have gone up.

As any sophomore accounting student knows, if your price and product cost go up in proportion, you gross margin and profits remain roughly the same.

Obviously, retail prices are climbing much faster than product costs.

Why. Price fixing, open and public retail price fixing, backed by the best political protection money can buy.

Let the oil companies make all of the profits they can – legally.

Half Sigma April 26, 2006 at 10:22 am

I agree 100% with the original post.

Regarding CEO pay, I don't see why the CEO pay should rise with increasing profits–any moron could increase profits when the commodity the company sells goes up in price.

The windfall belongs to neither the government or the CEO's–it belongs to the shareholders, the real owners of the company, the people who had the foresight to invest when prices were low.

Daniel April 26, 2006 at 10:59 am

The CEO pay issue strikes me as largely irrelevant, it is just the portion of profit captured by management rather than the investors.

bbartlog April 26, 2006 at 11:01 am

if your price and product cost go up in proportion, you gross margin and profits remain roughly the same.

Do you mean profit margin or profits? In the latter case you are trivially wrong, in the former case just wrong. It should be obvious that if your margin on $3 gas is 20% you'll be making twice the absolute profit you did if you had 20% margin on $1.50 gas. But even if you are talking about profit margin, there are a lot of entries in the corporate financials below 'net sales' and 'cost of goods sold' that would, by virtue of not increasing linearly with these first two quantities, tend to improve profit margin as prices increased.

We haven't really gotten to the bottom of your confusion, though. Are you talking about gas stations, which do set retail prices and which do have higher costs? Or are you talking about oil companies, which set wholesale prices and which don't have higher costs anywhere near the revenue increases they've realized through higher oil prices? Do you understand that owning a good that is in short supply can increase prices without collusion? Do you realize that if oil were priced above the market clearing price, surplus oil should be piling up somewhere?

John Dewey April 26, 2006 at 11:29 am

rustbelt: "Supposedly the oil companies are raising retail prices becuase their costs have gone up."

Oil refiners and gasoline retailers raise prices for a much simpler reason: because they can. It's simple supply and demand. We should want the oil refiners and gasoline retailers to raise prices when they can. Market pricing is by far the least objectionable way to ration a scarce good.

Bryan April 26, 2006 at 11:31 am

"Too bad homeowners don't post their property taxes, and the prices of their homes, the same way that gasoline retailers post their prices."

The site http://www.zillow.com gives you a pretty good estimate of the home value and the exact amount of property taxes (since they're a matter of public record).

kebko April 26, 2006 at 11:47 am

"It would take $6+ gas to begin to justify the cost difference between a small sedan and the same sedan in hybrid version."

Isn't that completely dependent on how many miles you drive per month?

John Dewey April 26, 2006 at 12:24 pm

Half-sigma: "Regarding CEO pay, I don't see why the CEO pay should rise with increasing profits–any moron could increase profits when the commodity the company sells goes up in price."

Could any moron have successfully decided where to invest billions in search of that scarce commodity? and where not to?

Could any moron have successfully evaluated the political risks in dealing with three dozen governments of oil and gas producing nations?

Could any moron have successfully determined the optimal mix of capital to invest in each of Exxon's many businesses, including petroleum exploration, oil and gas production, refining, chemicals, and retailing?

Could any moron have decided what share of profits should be reinvested and what share should be distributed to shareholders in order to maximize the return to those shareholders?

Could any moron have chosen the right set of lieutenants to successfully guide a $370 billion company that has 84,000 employees operating in 100 different nations?

Managing the world's largest corporation requires much more than just sitting around waiting for the price of oil to surge. But we shouldn't expect just any moron to understand that.

Noah Yetter April 26, 2006 at 1:49 pm

"Why. Price fixing, open and public retail price fixing, backed by the best political protection money can buy."

Oh really? If I drive down the road to 20th & Youngfield, I'll find three gas stations, a 7-11/Citgo, a Phillips 66, and a local independent chain. Frequently their prices vary by 10 or even 15 cents.

Some price fixing.

Obviously "the plural of anecdote is not data" applies, but let's be serious. Open your economics 101 textbook and look up price fixing. Once you understand why cartels inevitably break and price fixing doesn't work, get back to us with a real argument.

John Pertz April 26, 2006 at 3:00 pm

I think the point of this exercise is to understand that the white hot rhetoric that is coming out of Washington right now has nothing to do with making anyone's life better. This is all about self interest and vote maximization. Read the rhetoric carefuly and you will begin to see that this is nothing more than political exploitation of the worst kind. If you believe otherwise then you are simply self deceived. Its election season folks, its time to get back on the side of the "PEOPLE" again. Remember Charles Schumer and Dennis Hastert are trying to act on behalf of our best interest. HAHHAHAHHAHAHAHAHHAHAHAHAHAHHAHAHAHAHAH

Half Sigma April 26, 2006 at 3:33 pm

In response to John Dewey's defense of overpaid CEOs,

My point was that whether or not the CEO is a moron, the big boost in oil company profits directly the result of rising prices for the commodity has nothing to do with the CEO, so the CEO has no more right to claim a share of the "windfall" as the government. The CEO is no better than Chuck Schumer, he is trying to steal money that belongs to the shareholders.

Having been an investor in this industry for many years, I've seen a lot of dumb CEO decisions, like overpaying for acquisitions, losing huge amounts of money by forward selling oil and gas when the prices were low. I'm not that impressed.

I'm more impressed by the geologists who interpred the 3D seismographic data. That's impressive stuff. Those guys are probably getting paid less than they deserve. The guys who do the real work never get the rewards.

Half Sigma April 26, 2006 at 3:38 pm

"Managing the world's largest corporation…"

I don't even understand why Exxon and Mobil had to merge to create the world's largest corportation. I just don't see the synergies. If you want to invest in an oil company with growing production, you invest in a small company. That's why the small producers have much higher valuations than the large companies. Conoco Philips has an especially low valuation due to negative sentiment regarding the boneheaded acquisition of Burlington Resources at the worst possible time for Conoco Philips.

The Exxon-Mobil mearger obviously has negative synergies in the political arena, drawing unwanted attention to the industry and ruining it for everybody.

Yes, the oil company CEOs waste all their efforts doing pointless deals that actually reduce shareholder value. They don't deserve to make any more than I do.

liberty April 26, 2006 at 3:51 pm

>My point was that whether or not the CEO is a moron, the big boost in oil company profits directly the result of rising prices for the commodity has nothing to do with the CEO, so the CEO has no more right to claim a share of the "windfall" as the government. The CEO is no better than Chuck Schumer, he is trying to steal money that belongs to the shareholders.

1. The big boost in profits, as has been pointed out is not a direct result of higher prices. I will leave that to others to argue as they know more than I do, but your eagerness to ignore the facts doesn't make what you say true.

2. More importantly, your conclusion is horribly wrong. The CEOs are not stealing and have do right to the profits they are given. They are paid by a private company that has made contracts, the shareholders have agreed that the CEOs be paid. There is no theft. The government, on the other hand, if it were to add a profit tax, is stealing. The government has nothing to do with making the profits and have not entered into a contract with the shareholders.

Geoffrey Brand April 26, 2006 at 4:57 pm

True…Oil companies are making money right, left, and center because their average cost has not gone up nearly as much as the prices they are receiving..

Oil companies are limited by production and refining capacity in the short-run. Their short-run marginal costs start to sky rocket as they near short-run capacity.

You make profits off of average costs.. Prices are determined on marginal costs.. Marginal demand is at or near short-run capacity even at these price levels …Hence the high prices..

If oil companies tried to be nice and reduced oil and refined product prices…Increased demand would cause shortages…(Long lines at the gas stations again)

Sad, oil companies have to make these “obscene” profits… and there’s nothing they can do about it.

Half Sigma April 26, 2006 at 5:31 pm

During times of plentiful supply, the price of a commodity will sink to the level of the marginal cost of production for high cost producers. Which means that in times of plentiful supply, the high cost producer is losing money.

But then a shortage occurs, and until production increases all producers will be making big profits, because profitability is highly leveraged to the price of the commodity.

Right now we are in a time of shortage, so oil production that was breaking even when oil was $30/barrel is now making lots of money.

The big companies like Exxon-Mobil are "integrated," meaning they make money from both upstream and downstream activities. In the U.S. market, there is also a shortage of refined product on account of hurricane Katrina taking out the refineries, as well as the fact that no new refineries have been built in a long time, so downstream profitability has increased as well.

The CEOs didn't cause Hurricane Katrina and they didn't cause the worldwide shortage in oil, so if they are taking advantage of the higher prices to give themselves raises then they are stealing money from the shareholders just as Chuck Schumer is stealing money from.

As a voter I have no say in who is running the country, and as a shareholder I have just as little say in who is running the company. The big mutual funds, operated by the same companies that seek investment banking business from the CEOs, are the ones who control the CEO's salary.

John Dewey April 26, 2006 at 6:43 pm

Half-sigma: "I don't even understand why Exxon and Mobil had to merge to create the world's largest corportation. I just don't see the synergies."

Obviously someone saw something you didn't. Exxon-Mobil … BP-Amoco … Conoco-Phillips … Chevron-Texaco-Unocal. Do you think all the smart people at all these corporations might just have a clue about the profitability of big oil mergers? Is it possible that executives who spent their entire lives in the oil industry may know something you don't?

"Yes, the oil company CEOs waste all their efforts doing pointless deals that actually reduce shareholder value. They don't deserve to make any more than I do."

Well, let's just look at the results.

The Exxon Mobil merger was announced in 1998. From January, 1998, through April, 2006, Exxon shareholders realized a 110% increase in the value of their stock. Compare that with the 42% increase in the DJIA or the 31% increase in the S&P 500.

So how was shareholder value reduced?

EOM's income growth the past 5 years exceeded both industry averages and S&P 500 averages.

EOM's 5 year return on equity also exceeded industry averages and was about double that of the S&P 500. The company's 10 year ROE averaged over 20%.

Oil prices dropped to under $10 a barrel briefly in 1999, and back again to $16 a barrel at the end of 2001. Despite huge swings in the price of oil, Exxon's ROE never dropped below 12% from 1996 through 2005.

How did those morons accomplish that, Half Sigma?

liberty April 26, 2006 at 7:23 pm

>The CEOs didn't cause Hurricane Katrina and they didn't cause the worldwide shortage in oil, so if they are taking advantage of the higher prices to give themselves raises then they are stealing money from the shareholders just as Chuck Schumer is stealing money from.

You were making sense up to there. So, if they didn't directly cause the price to rise, they are stealing? When the price drops, are the people stealing from the CEO?

xteve April 26, 2006 at 10:13 pm

Half Sigma, if you really believe what you're saying, why don't you sell your shares?

Half Sigma April 27, 2006 at 10:17 am

Dewey: "Well, let's just look at the results.

The Exxon Mobil merger was announced in 1998. From January, 1998, through April, 2006, Exxon shareholders realized a 110% increase in the value of their stock. Compare that with the 42% increase in the DJIA or the 31% increase in the S&P 500."

Why you are comparing XOM to the general market? The proper comparison is other oil and gas companies, and XOM has underperformed. The XOI index, composed of big oil companies, is up 145% since Jan 1 1998, XOM has clearly lagged it's peers, but its peers have sucked too compared to smaller and more nimble companies.

Anadarko Petroleum is up 256% in the same period. Occidental Petroleum is up 238%. Denbury Resources, a company I've invested in, is up 244% since Jan 1 1998.

So I fail to see why the guys running XOM are getting paid anything at all since they apparently have destroyed shareholder value.

xteve: "Half Sigma, if you really believe what you're saying, why don't you sell your shares?"

Because it's a positive sum game so it's profitable even though management is stealing more than their fair share.

liberty April 27, 2006 at 1:47 pm

Smaller firms will grow by a larger percent even if the only difference is size and both have gains because of a higher price, Sigma, so that proves nothing.

John Dewey April 27, 2006 at 3:42 pm

Half Sigma,

I will concede that Exxon's stock price has underperformed the XOI for the past 16 months. From 1998 through 2004 it did match XOI. As I noted earlier, Exxon provided consistently high returns over the entire period.

Note, though, that by using the XOI index, you are comparing a number of merged energy giants with each other.

Your original claim was:

"oil company CEOs waste all their efforts doing pointless deals that actually reduce shareholder value."

You are now using several merged energy giants, the XOI index, to try to make the case that another energy giant reduced shareholder value through merger. My argument all along was that these energy mergers – all the large ones – did not reduce shareholder value as you claimed.

Your second argument – that Anadarko and Denbury Resources returns far outperformed Exxon – just doesn't make sense to me. These are tiny companies relative to Exxon. They are concentrated in the exploration and production end of the total energy business. Because of their much smaller size, their individual exploration projects expose shareholders to relatively more risk.

Exxon, on the other hand, has diversified the risk to shareholders through both economies of scale and through vertical integration.

Were I investing in Anadarko or in Denbury, I would expect much higher returns than I would from Exxon. A better analysis would include adjusting the returns of the smaller, undiversified companies for their higher risks.

Half Sigma April 27, 2006 at 3:55 pm

"They are concentrated in the exploration and production end of the total energy business."

Perhaps there was even more money to be made downstream. Independent refiner Valero Energy, up 716% since Jan 1, 1998. Damn, that's a good return.

Another company I invested in, Canadian Natural Resources, up also 716% since the stock began trading in 2000.

Your point was the Exxon-Mobil management deserves to make a lot of money because of the great job they are doing, but in comparison to other oil and gas companies, whether huge or tiny, they come up short.

save_the_rustbelt April 27, 2006 at 4:40 pm

"Oil refiners and gasoline retailers raise prices for a much simpler reason: because they can. It's simple supply and demand. We should want the oil refiners and gasoline retailers to raise prices when they can. Market pricing is by far the least objectionable way to ration a scarce good."

In this pasrt of the country I see absolutely no sign of any shortage of supply. I see no sign that supply is different at $3.00 than it was at $2.50.

Apparently we believe there is a shortage because we are told there is shortage.

John Dewey April 27, 2006 at 5:32 pm

"Your point was the Exxon-Mobil management deserves to make a lot of money because of the great job they are doing"

No, Half Sigma, that was definitely not my point. I never made any statement about how much money Exxon-Mobil management deserves. I only disagreed with your two statements:

"any moron could increase profits when the commodity the company sells goes up in price."

"the oil company CEOs waste all their efforts doing pointless deals that actually reduce shareholder value."

John Dewey April 27, 2006 at 5:51 pm

rustbelt,

You cannot see a shortage because there is none. The market clearing price is exactly what prevents a shortage of a scarce good. That's why the free market is the least objectionable method of rationing most goods and services.

bbartlog April 28, 2006 at 1:42 pm

I see no sign that supply is different at $3.00 than it was at $2.50

It is not likely to be hugely different, since demand for gasoline is fairly inelastic in the short term. I've seen an elasticity estimate of .2 (at the margin) which implies that a 20% increase in the price would only result in a 4% reduction in consumption. But of course, this also means that a 4% increase in demand could (if gallons supplied remained constant) increase the price by the margin you describe.
In any case, how do you think that you, personally, would perceive a shortage, if not through higher prices? Do gas station owners whisper to you that their tanks are near empty? Do you monitor the output of oil wells, or the traffic of tankers through the straits of Hormuz? I grant that in the presence of price controls, you might perceive a shortage by sheer lack, as happened 30 years ago; but absent that I find your comment mysterious…

Alcan April 30, 2006 at 4:58 pm

This Rustbelt guy is a real moron. A few questions and a comment:

Why would oil companies be the only business' in the entire free world who would not try to maximize their profits?

A shortage is a function of price, there is not a shortage at market price; but if you could lower the price back to $30 which would shut off much of the production from Alberta amoung other places, do you not think demand would exceed supply?

Oil company profits are also boosted by the simple fact that they are not allowed to reinvest profits in exploration and refinery building in this country. Tell Exon or BP that they can start drilling in Anwr and lets see if they don't invest about a billion dollars, thereby increasing their depreciation expense and lowering their profits in anticipation of a bigger return down the road.

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