On Oil Company Operations

When the quarter ended for most oil companies at the end of September and the 10-Q statements were filed with the SEC, staggering net incomes were recorded. The most notable of these is Exxon-Mobil's nearly $10 billion at the bottom line for three months ending September 30. The total profits for the 5 largest privatised oil companies exceed $30 billion. Such a seemingly disgusting level of profits was not to go unnoticed by politicians from both sides of the aisle. Claims of price gouging consumers during the aftermath of hurricane Katrina when oil prices were over $70/barrel and gas over $3/gallon (some places in the South over $5) have been thrown around and executives from Exxon recently appeared in Congress to defend the company's enormous profits. Lawmakers are now discussing passing a windfall profits tax on oil companies that have made realtively large, in terms of dollar amout, profits this last quarter. What I am about to write may seem as though I am coming to the defence of the oil industry. Let me be clear, I am not doing that. From what I have seen and heard over the last month, I think politicians are doing a terrible job of sorting through this mess of oil profits, price gouging, supply capability and what to do about it.

This is not just one simple issue that we can look at and determine that oil companies deserve to be taxed simply because these companies made a profit. There are three key issues that need to be critically analysed, but separately addressed. There are probably many more than just these, but they are what I deem the most important. Now, I routinely get emails from Amy Klobuchar, Mike Hatch and other Minnesota DFLers as well as see campaign advertisements for politicians across the country. From my observations over the last couple months, the politicians logic is as follows: ExxonMobil makes almost $10 billion in net income during a quarter in which two major hurricanes struck, thus all oil companies must be price gouging. It certainly is easy to proclaim this while standing on ones speaker's/soap box, appearing to be the defender of gas guzzlers the all mighty consumers.

Let's go back in time a ways to begin. In the early and mid 1980's there was a recession in the U.S.; extremely high interest rates choked off any possible economic growth and stagflation ensued. With growth at a stand-still, there was little demand for fossil fuels from OPEC and other oil exporters. The price per barrel plummeted - bad news for producers, great news for consumers and a stalled economy (we have cheap oil to fuel our growth! cheap and plentiful oil boosts population thus increasing economic growth!). In an effort to prevent bankruptcy, many international and privatised companies merged together to maintain operations, create value through synergies, etc. Look at the names of non-state oil companies: ExxonMobil, ChevronTexaco, YPF-Repsol, TotalElfFina, RoyalDutchShell, BPAmoco. All of these at one time used to be individual companies. World economic circumstances and financial business goals drove the companies together. Over the next 20 years oil prices would increase (with much volatility) as the world economy began to grow again. In the mid to late 90's it was the U.S. and then emerging markets began to grow at incredible rates after that. Growth and the availability of cheap fossil fuels are linked: growth depends on cheap sources of energy, and as growth continues, this cheap energy source becomes more and more scarce as demand becomes more than production capacity. So we arrive in the oughts (the 00's) after one gulf war and in the middle of another. China and India are the two most talked about industrialising powers, especially when pondering how to satisfy the energy demands of over 2 billion (almost) new energy users. Also of note is the fact that energy is becoming more and more expensive to discover and extract and that while demand increases, refining capacity does not. These circumstances leave the world in a peculiar state.

So we have now condensed many small and medium sized oil producing companies while the price/bbl was historically low and end up with a smaller number of very large companies. What is the next step from here? It is 2005. For the whole of the new millenium the world economy has boomed, for the most part. Emerging markets such as China, India, Brazil (and greater South America), Eastern Europe, Turkey, Southeast Asia and so forth have put huge pressure on producers to meet these new energy requirements- be it coal, gas or oil (norther and western Europe have been rapidly expanding into renewable/alternative energy). For all of 2005, world production capacity was full. In fact, demand was more than possible production, which is one of the two big reasons that oil, gas and other fuel prices have been increasing since 2003. Now along comes one big mean hurricane during the 3rd quarter and wipes out a significant amount of both production and refining capacity. C'mon politicians...what do you think was supposed to happen?

These very large oil companies now have vast reserves after buying small companies and merging together with competitors. The M&A's occurred whilst the p/bbl was relatively low and now these enourmous companies exist at times when its oil reserves and production capacities are huge, though glabal demand is bigger. There is really only one mechanism to bring the two sides to equilibrium and that is price - something not set by the oil companies (though they can influence it at certain times). Something I find a bit funny and coincidental is that right at the time that these profits were being reported, I was reading in Matt Simons' book the chapter were he said that in the future we will see oil companies making huge profits (!!!). This is because they must have something to compensate for declining production and reserves from oil fields. Infact, ExxonMobil field production had declined somewhere around 4% this year compared to last. Well, can't say someone hasn't tried to get the message out.

A few notes about the financials: Exxon made 10 billion in net income. This came from 100 billion in revenues, more than some national economies. 10% net margin is good, not fantastic and not poor compared to all other industries of the world. For every one dollar of revenue, 10 cents are profit. To compare, financial services companies have about 15-20% net margin, and grocery stores probably have .5-2% margin. So why this talk of price gouging when they had normal profits? And what happens to all of this profit? It goes into the grubby hands of business executives doesn't it! Not quite, net income is after performance bonuses (an entirely separate issue on whether they truly deserve these or not). 20-25% is being paid back to shareholders as dividends (and to the gov't as dividends tax) and the rest is being plowed back into the company to finance new projects. What they do with these billions of dollars is probably where I and the executives differ.

This all leads me to a new question: Why is it "wrong" for the oil companies to make profits? A long time ago they started bearing a massive amount of risk by investing huge sums of money into equipment and logistics to extract and ship oil, the oil which gives us Americans a wonderful quality of life. Profit is the reward for bearing that risk just as loss was the punishment in the 80's. Exxon paid/accrued 6 billion dollars in taxes this quarter so why triple tax the company on post tax profits? Also, because we live in this so called free market economy, we should not be necessarily forced to buy only oil. Free markets have mechanisms that allow us to choose alternatives if something becomes too expensive (thus demand for oil will drop, and lower prices will follow). I know for a fact that this "choice" occured in Minneapolis when mass transit ridership increased sharply due to high fuel prices. Personally, I drove my car less, and rode my bicycle and motorcycle much more. Unfortunately this is on such a small scale that its impact was mostly unnoticeable. Most consumers bore the brunt of the price hike whilst dipping into nostalgia of 2000 with 90 cent/gallon gas, awaiting the better days of lower fuel prices.

I guess this was just my longwinded way (it took me almost 3 months to complete this) of showing that politicians' logic is flawed. I don't want to give off the impression that I am coming to the defence of oil execs. I certainly do not hold them to be people of high moral and ethical conduct and am sure there are many sleazy and corrupt business leaders among them. However, one cannot point at the profits recorded and yell "price gougers!" My understanding of economics and current oil industry operations (and I admit, they are probably naive and incorrect) tell me that one has to prove such a charge a different way. To do this would require someone to come forward as an anonymous leaker with documents providing evidence that excutives knowingly increased the price of oil for the sake of higher profits, and not to cause shortages of supply or any other type of logistics related problem. But really, having those oil execs testify before Congress without swearing them in under oath was one of the worst ideas ever (I blame the repubs for that one).

If anything, this should be the biggest red flag ever waved infront of the leaders of our country, screaming at them to look at how frail we are as a country and economy. The issue of oil in/dependence is a far greater threat to our national security than Iraq and probably terrorism ever was or will be. It is just so much easier to point you finger and blame " the bad guys" than to even begin to tackle a problem (or admit we have one) head on. We've become a nation drunk on oil and until we experience some sort of painful collective loss - probably our way of life - we will continue on our binge drinking path.