Oil Profits Explained

As people choose to point the finger at oil companies instead of understanding the oil industry, the federal government has responded by investigating price fixing. Even Jon Stewart doesn’t understand why oil profits are so high. It’s time for U.S. citizens to educate themselves instead of blindly throwing blame.

Why are prices high?

Supply and demand

Pretty basic idea here, also the biggest reason: supply is not increasing, demand is.

US refineries run as close to maximum output as they safely can, and it’s still not enough to quench our demand. When our local refining takes a hit, like with Katrina, we have to buy already refined products from overseas, which is much more expensive.

We’re not the only people who want the products either. Demand in Asia and India has steadily increased as they become more modernized. One advantage places like Japan have: they haven’t meddled in the Middle East’s affairs, so they can likely build stronger and closer relationships with the oil producing countries.

Ethanol

Most gasoline sold in the US has an additive called MTBE. This allows the gasoline to burn more completely and thus more cleanly. The Energy Policy Act of 2005 is fazing MTBE out in favor of Ethanol. One reason is a concern that MTBE may contaminate groundwater. A more suspicious view is that it is a political move to aide farmers who grow corn.

Either way, this switch has caused refiners to change how they produce and distribute gasoline. Ethanol absorbs water so it can’t be transported through the pipelines, or it would damage your car. When California outlawed MTBE in 2003 they experienced some supply disruptions, something the northeast has been dealing with recently. Disruptions and changes to procedure both lead to increased prices.

Unrest in production environment

“The oil companies scour the freaking globe, going to the most gosh-forsaken dangerous places on earth to find the stuff.”

And to do that, it costs money to protect our people and our assets. There is also uncertainty that the product will continue to flow out of the area. This uncertainty leads to an increase in price. And we’re not talking just about everyone’s favorite hot spot. Unrest in Nigeria and the anti-American sentiment in Venezuela’s government are also causing prices to rise.

But you know what? Oil is cheaper than bottled water and has risen in price slower than inflation.

Since supply prices are higher, wouldn’t that mean the oil companies are paying more for their raw materials? What allows them to make more money?

This is a popular misconception for those not familiar with the industry. Fully integrated oil companies operate in the entire supply chain; finding oil, pulling it from the ground, shipping it, refining it, then selling it.

In reality, oil companies are still paying the same amount to get crude oil, since the cost to them is the labor and equipment already in place. Then they can sell it to the market at the going rate, which provides them their central source of profit. Their midstream trading works to acquire oil for their refineries at the lowest possible price. The lower the price they pay, the larger the refining margin. The final step is selling the refined product, where they again sell on the open market to optimize profit.

So, even though prices are higher, strong trading allows an oil company to increase their profits.

Who is price fixing? If you say no one, then explain why all the stations on my block sell for the same price. Wouldn’t someone operate more efficiently, allowing them to charge less?

Price fixing in the vast international commodity market would be as easy as adapting a polar bear to a tropical climate; sure it can be done, but it’s darn near impossible.

Oil companies do not own most gas stations in the US. They sell their product to marketers who pay them to use their brand of gasoline. Many times the connection to these marketers isn’t even a direct one. There is often a middleman that purchases and transports the finished product. Prices at the pump are set by so many different people; it would take a mass conspiracy to achieve price fixing over the entire market. Besides, if you do a little math, the price at the pump usually makes sense.

Now, on a smaller scale, you could start to believe local stations are price fixing because they all sell at the same price. Even I don’t understand how prices go up 10 cents over night, then another 4 during the day. Logic would say that the price at the pump should be determined by the price the station pays for the gasoline, with some consideration of things like operating costs.

When you look at the breakdown of gasoline prices and where the money goes, it becomes pretty obvious that the local mom and pop station doesn’t make much per gallon of gas; likely less than 10 cents, probably more like 4-5 cents. Much of the profitability of stations comes from internal sales of beverages and food. When I worked in fast food, I was told the cup, ice, and syrup mixture for a dollar drink probably amounted to 30 cents! Heck, just compare paying a dollar for a 20oz bottle in a machine to the $1.29 or higher at a gas station.

So low margins on the actual gasoline sale seem to explain why stations can’t afford to reduce their margins on gas, but not really why they always seem to match with their competitors. Since we are in a free economy, gas stations have the right (some say the responsibility) to charge as much as they can for their product; it’s simple supply and demand. So, if their neighbor decides to charge 2 cents more, they are free to go out and up their prices to match. It’s only when they chat with each other about what they want to charge that it becomes a problem.

Why should I not be mad at the oil industry? Why shouldn’t the government tax those profits?

Reinvestment

In the first quarter of 2006, ConocoPhillips reinvested 114% of their net income back into the business, working to find more oil and maintain aging refineries (it’s well documented that the newest US refineries are over 30 years old). A lot of the reserves are in unstable places, the companies have to protect their employees with safe housing, guards, and more. If you take part of their profits, operating in some of the more oil rich areas may become too financially burdensome. Having oil companies pulling out of regions like this would make the situation at the pump even worse.

Lean Years

While this isn’t a very big argument, it is worth noting that the oil industry went through tough times in the 80s with oil prices around $10. The government did nothing to help when the companies were struggling. Now, the market has allowed the strong oil companies to prosper, which is the American dream. Why should that allow the government to tax them above and beyond any other industry? Besides, who do you think in the end would likely pay the extra cost?

Being mad at the oil industry doesn’t make sense. They strive to operate as safely and cleanly as possible, with an often unnoticed effort to preserve the surrounding environment and help the communities they are in.

Can I be mad at Exxon’s $400 million golden parachute for their retiring CEO?

This is your choice.

On one hand, Lee Raymond took the reigns of Exxon in 1993 and turned it into the biggest company in the US, supplanting Wal-Mart. He managed to cut millions in annual costs and increased returns in record fashion. With the merger with Mobile, he had to make some tough decisions, but offered a fairly generous severance package. While you might disagree with his style, or dislike the size of his company, he did some great work and deserves to be compensated for it.

On the other hand, Exxon wasn’t a struggling company when he took the reigns. He made some smart deals to grow the company and increase their oil supply, but his accomplishments don’t equal $400 million, especially in an industry with such low profit margins.

Who can I blame?

Your government

Oil companies are not responsible for investing in alternate energy. That’s like asking airlines to find a better mode of ground transportation. The oil industry’s responsibility is to operate as responsibly and profitable as they can. They have to do this to satisfy their shareholders who invest their money to allow them to operate.

Alternate energy is the responsibility of university and government research. The US government has largely ignored the impending scarcity of oil and not provided research grants to help find ways to make alternate energy cost efficient.

The government is also going to be holding the bag when it comes to infrastructure.

Yourself

US demand for oil is astounding and still growing. Otherwise smart men and women fill up their large SUVs and drive by themselves to work. We insist our house stay a comfy 75 degrees in the dead of winter. Our grass has to be bright green and bug free. We treat oil like it’s unlimited, but it’s time to realize we are individually responsible for reducing the dependency.