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Gasoline Prices Part II: Long-Term Factors

Introduction

In Part I, I discussed the short term factors that have resulted in the recent, rapid increase in the price of gasoline. But there are a number of underlying, long-term issues that have been major contributors. I will attempt to address them and answer a number of related questions, such as: Why have no new refineries been built in the past 30 years? Are U.S. refineries breaking down more than normal? Are oil companies purposely withholding supplies to keep prices high? Have environmental regulations played a role? Does the use of ethanol influence gasoline demand growth? The answers to some of these questions may surprise you.

Please note that my essays should not be confused with financial advice. Following Part I, I received a number of e-mails requesting financial advice. While there are often potential financial implications, I am not a financial planner. If you choose to make investment decisions based on what you read here, you are on your own.

Further note that it is not my contention that refiners are not benefiting from higher prices. They are. But my contention is that prices aren’t higher because they have increased margins. Margins have increased because prices are higher.

U.S. Refinery Capacity

The problem, I have read on many occasions, is that we aren’t building any new refineries, and that “limiting refinery capacity seems to make more money for oil companies than expanding it.” Claims like the following from the Foundation for Consumer and Taxpayer Rights – are quite common:

America’s big oil companies figured out long ago that they could make more money by making less gasoline. That’s why the industry hasn’t built a new refinery in 30 years. Since deregulation of the refinery business in 1982, oil consumption has increased 33% but oil companies have kept refining capacity near what it was 25 years ago. Why not? They know that the scarcer the product, the bigger the profit.

Even members of the Senate Committee on Energy and Natural Resources seem to believe this, with New Jersey Senator Robert Menendez recently commenting in a Senate hearing on gas prices:

Senator Menendez: Isn’t there a reality that we are paying for some industry decisions that actually reduced refining capacity in this country? I mean there was a time that we had greater refining capacity, and the industry reduced that refining capacity, and as a result of making that decision, consumers today find themselves with exactly the consequences that you have described in your testimony before.

There are elements of fact and elements of fiction in the preceding statements. So, what’s the scoop? Are oil companies cutting refinery capacity in order to boost profits?

In the past 10 years, refining capacity in the U.S. has increased by about 2 million barrels per day, which is equivalent to about 10 good-sized refineries. Capacity expansions equivalent to 8 more new refineries have been announced for the next 4 years (although some refiners have recently suggested that some expansions may be put on hold as a result of the stated goal of reducing gasoline consumption by 20% in 10 years – in order to avoid an oversupply situation). So while it is true that new refineries aren’t being built, it is certainly not true that capacity is stagnant. There are several reasons for expanding existing refineries as opposed to building new ones.

First, it is less expensive per barrel to expand an existing refinery than to build a new one. The estimates I have seen suggest that existing refineries can be expanded at 60% of the per barrel cost of building a new refinery. Second, the permitting process for building a new refinery is onerous. A group in Arizona has been trying to build a new refinery, and it took them 7 years just to get the permit. If they proceed and build the refinery, it will have taken 13 years from the time they started the process. (Even as I was working on this essay, they have announced a further 1 year delay). Finally, while everyone seems to want more refining capacity, nobody seems to want a refinery in their community. This makes building a new refinery next to impossible. As Investor’s Business Daily recently asked Senator Chuck Schumer: “Just where in New York state would you like a new refinery to be built…?

However, the critics are correct on one point. Starting in the early 80’s, U.S. refining capacity did drop significantly, before beginning to climb back up in the 90’s. The reason for this is quite simple: There was far more refining capacity than was warranted by the demand. The result was that gasoline was $1.00 a gallon, and many oil companies were losing money. Many refineries shut down. Some oil companies went out of business. Property values in “oil towns” like Houston plummeted. Yet many view oil companies as if they are public utilities. But the majority are owned by shareholders, who expect a return on their investment. Billions of dollars of capital are risked in this business, and if the rewards are poor (or negative), the risks won’t be taken.

No industry can be expected to maintain high production levels in the face of poor or even negative margins. If milk producers make too much milk, prices fall and some producers go out of business. When that happens, supply is reduced and prices go up. The same is true for any other business. Yet people don’t accept this very well in the case of oil companies, because many have come to view cheap gas as an entitlement.

U.S. Senator Ron Wyden has spent quite a bit of time investigating these issues, and his view is probably typical with respect to the evolution of refining capacity:

The Oil Industry, Gas Supply and Refinery Capacity: More Than Meets the Eye

In this report, Senator Wyden presents a number of “smoking guns”, such as this internal Texaco document from 1996:

“As observed over the last few years and as projected well into the future, the most critical factor facing the refining industry on the West Coast is the surplus refining capacity, and the surplus gasoline production capacity. The same situation exists for the entire U.S. refining industry. Supply significantly exceeds demand year-round. This results in very poor refinery margins, and very poor refinery financial results. Significant events need to occur to assist in reducing supplies and/or increasing the demand for gasoline.”

Senator Wyden skipped right past the part about poor margins and poor financial results, and focused on the “smoking gun”, that either supplies needed to be reduced or demand for gasoline increased. He then gives a list of the refineries that have closed since the mid-90’s, apparently failing to connect these events with “poor refining margins.” Here are the refineries he lists that closed in 1995:

Indian Refining Lawrenceville, IL
Cyril Petrochemical Corp. Cyril, OK
Powerine Oil Co. Sante Fe Springs, CA
Sunland Refining Corp. Bakersfield, CA
Caribbean Petroleum Corp. San Juan, Puerto Rico

Do you recognize any of those names? Probably not, because most of the companies that shut down did so because they went out of business. Margins were too poor to remain in business for some. For others, it was failure to comply with environmental regulations (some of the closed refineries are now Superfund sites). Yet Senator Wyden presents a picture in which it was a systematic and cooperative effort between oil companies to reduce refining capacity – and that refinery capacity should have been maintained at any cost (as long as oil company shareholders are the ones to bear those costs). Somehow “the industry” is culpable for the closure of a number of marginal producers – many of whom went completely out of business. But it was years of poor returns in this cyclical business that drove down refining capacity.

Even in the past 10 years, refinery margins have turned negative on numerous occasions. The problem is that many people take a snapshot of the current view and believe this is normal. See the data that the IEA has accumulated (XLS download warning). Shall we expect that those who are calling for measures to be taken to address the current refinery margin situation will be calling for the government to extend a helping hand the next time margins go negative? Somehow, I doubt it. (Incidentally, for those who think oil companies have boosted their margins by raising prices, how do you explain the incredible variability from month to month? How do you explain negative margins?)

Paul Sankey, an analyst with Deutsche Bank, testified on May 15th before the Senate Committee on Energy and Natural Resources. He pointed out the long-term factors that have resulted in the refinery capacity we have today:

The reason for the massive recent run up in prices can be traced back to the last significant period of high prices, in the late 1970s, which forced lower gasoline demand, then more efficient cars, which led to excess refining capacity, which led to years of poor returns in refining (and cheap gasoline prices), which disincentivised investment in refining and encouraged demand, and which has ultimately led to today’s intense market tightness.

The bottom line on the refinery capacity issue is that yes, refining capacity has been reduced at times. And there were perfectly valid reasons that this happened. It is also true that capacity is short at the moment – if the objective is to maintain sub-$3 gasoline prices. But, reduced investment in refining capacity is indeed a key factor behind the current gasoline price spike. If some want to level the charge that refiners failed to accurately anticipate demand growth, then that charge is accurate. But like the rest of us, refiners don’t have crystal balls.

Are Oil Companies Purposely Withholding Supplies?

This charge has been repeated quite a bit lately. Oil companies are either accused of withholding supplies ala OPEC, or they are accused of stretching out their maintenance in order to keep supplies low. Let’s address that.

In a very tight market, events that take supply off of the market are likely to drive prices higher. In light of that, would it be a wise business practice if BP, for instance, purposely slowed down the maintenance at their Whiting, Indiana refinery that is partially closed due to a fire? Not a chance. When BP has supply off the market, it benefits everyone BUT BP. They are foregoing money every day they have that capacity offline. The refinery manager at Whiting will have part of his performance graded based on the financial returns of his refinery. The longer the supply is offline, the worse that grade will be.

Consider a couple of examples. Say that you operate a 200,000 barrel a day refinery. Margins are quite good right now – let’s say in your area they are $20 a barrel. So, when the refinery is running normally, you are grossing $4 million a day. Would it make good business sense to cut your capacity in half – to 100,000 barrels a day? While such action would probably cause the overall price of gasoline to rise, it is going to have a disproportionate effect on your refinery. If margins go up to $30 a barrel (although there is no way taking 100,000 barrels off the market would impact margins to that degree), you are still $1 million a day worse of than you were. You have given up $365 million a year in order to reduce your capacity. You would have made an incredibly stupid business decision. In fact, you would be much better off if you could boost capacity by 100,000 barrels a day. Sure, prices might slightly drop, but your overall profits will be higher, especially in such a tight market.

Furthermore, you don’t know if Shell down the street might be able to make up the production shortfall, pocketing the money that would have been made by your refinery. (Contrary to popular opinion, oil companies do not consult each other on such issues). You also don’t know if exporters from Europe will respond. If they respond by boosting exports to the U.S., now they are pocketing the money that your refinery is losing. In summary, this is not a rational way to conduct business – unless your margins are negative. You would be making a decision that will certainly cut the returns at your refinery, while not knowing how your competitors will respond to the supply shortfall.

For another example that many can relate to, consider that you wish to put your house on the market. Housing prices in your area have been outstanding, and you want to capitalize. However, you are afraid that by putting your house on the market, you may boost the supply in your area and cause prices to fall. So, you decide to be a charitable neighbor and keep your house off of the market in order to maintain prices for everyone else. You will sell some other time, even though the market may not be as good. If your primary objective is to capitalize on the good housing market, have you made a rational business decision? Of course not. The same is true regarding the charge that oil companies are deliberately prolonging maintenance. It just wouldn’t make good business sense in this market.

Are Refineries Breaking Down More Than Normal?

It certainly seems each week brings several new refinery outages. While refineries still have not reached pre-Hurricane Katrina production levels, most of the outages that you read about are the kinds of things that happen every year. Practically all refineries have one or more unplanned outages each year. Most years, when the market is amply supplied, these sorts of events don’t make the news. But this year, as we have seen, is very different.

As the afore-mentioned Paul Sankey testified:

The poor returns of the 1980s and 1990s have indirectly caused some additional external events that have played into the problems. The years of losing money caused companies to neglect refining investment, culminating in BP’s Texas City disaster. Texas City has now rightly caused other refiners to operate more cautiously – and so less capacity is available.

A second impact of years of reduced investment has been a lack of qualified engineering, procurement and construction staff. One vital issue here is that the tightness of US refining capacity at this time is not because companies are unwilling to invest in more capacity, it is that they are unable.

Refineries are complex. Heat is being added to flammable materials, and the entire chain of events depends on a steady supply of raw materials, equipment, and qualified people to keep things running smoothly. Equipment is going to break down. A refinery is much more complex than your car. Yet you would not be surprised if your 30-year old car had annual maintenance problems.

While this year’s outages may be somewhat above average, similar outages happen every year. The only difference is that most years there is enough spare capacity that the outages go unnoticed by the media.

The Impact of Environmental Regulations

Let me make it clear that I am in favor of the environmental regulations we have in place. They have made our air and water cleaner. But there is a price to be paid for those regulations, and consumers should understand that, as they are the ones who will ultimately bear those costs.

There are several things that can happen when a new regulation is implemented. First, new regulations may redirect capital that might have gone into expanding refining facilities. Second, they may increase the costs of producing the fuel. Third, additional processing, as in the case of ultra-low sulfur diesel (ULSD) and gasoline – can reduce the overall product yield. Fourth, and perhaps of greatest importance, additional equipment will increase the complexity of the refinery.

Those are the consequences. The more complex the refineries are, the more unreliable they are going to be. With each additional complexity that is added, there are more ways for them to break down. There is more danger as the inventory of hazardous materials increases. Politicians who are quick to point fingers should understand that they make their own contribution to supply shortages. If they are going to hold hearings on gas prices, they needn’t ponder “Gosh, I wonder why prices are going up?” Stricter environmental regulations – necessary as they may be – are one more piece of the puzzle. They have helped crimp supplies and add to costs.

Investor’s Business Daily recently touched on this:

Our refineries are doing more than ever, but their numbers are dwindling and no new ones are being built. The reason is not greed, but cost and regulations. From 1994 to 2003, the refining industry spent $47.4 billion, not to build new refineries, but to bring existing ones into compliance with ever new and stringent environmental rules. That’s where those allegedly excessive profits go.

I think most people are willing to pay higher prices for a cleaner environment, but it is important that they understand that this is a component of fuel prices.

The Ethanol Factor

It is a fact that ethanol only contains about 65% of the energy content of gasoline on a volumetric basis. Therefore, to displace the gross energy content of 1 gallon of gasoline requires 1/0.65, or 1.5 gallons of ethanol. What this means is that as ethanol is put into the gasoline pool, demand will go up simply because the pool now contains less energy. Is this enough to explain why motor gasoline demand (which includes blended ethanol) is at a record high?

In March of 2007, ethanol contributed 539 million gallons to the gasoline pool, according to the Renewable Fuels Association (RFA). This is almost 50% greater than the 365 million gallon ethanol demand in March of 2006. Gasoline demand in March, according to the Energy Information Administration, averaged 9.266 million barrels per day (up from 9.076 a year earlier). Total gasoline demand in March was then 9.266 million * 31 days * 42 gallons/bbl, or 12.06 billion gallons. The breakdown would have then been 11.52 billion gallons of gasoline and 0.54 billion gallons of ethanol. (Ethanol imports have been omitted as their impact would have been pretty small).

The energy content, however, of the 12.1 billion gallons would have been equivalent to 11.52 gallons of gasoline plus 0.54 billion gallons of ethanol * 0.65 (factoring the lower energy content), or 11.87 billion gallons of gasoline equivalent fuel. Therefore, our perceived gasoline demand is 1.9% (12.06/11.87) higher than it would be without ethanol in the pool.

In other words, part of the record high gasoline demand we are currently experiencing is due to the fact that ethanol is scaling up rapidly, and it is being counted in the finished motor gasoline pool. Even if demand was constant on a BTU basis, increasing the fraction of ethanol in the pool will increase the volume demand.

Conclusions

While the immediate cause of skyrocketing gas prices is a combination of record demand and low gasoline inventories in the U.S., several longer-term factors have contributed. Following years of poor returns and expensive new environmental regulations, investments into expanding existing refineries dried up. Many refineries closed their doors permanently, as a number of smaller producers went completely out of business in the 80’s and 90’s. The cumulative effect was that refining capacity fell starting in the early 80’s, but has recently been climbing back as margins have improved. Just as we were in an oversupply situation in the 80’s, we are now in an undersupply situation if the goal is to keep gasoline below $3.00/gallon. However, refining capacity has increased significantly in the past 10 years, and looks to continue this trend in the foreseeable future. But demand growth has remained robust in the face of higher prices, so an oversupply situation in which gasoline returns to $2/gal does not appear likely in the foreseeable future.

June 10, 2007 Posted by | energy policy, gas prices, oil refineries, price gouging, price manipulation, profit margins, refining | 6 Comments

Gasoline Prices Part II: Long-Term Factors

Introduction

In Part I, I discussed the short term factors that have resulted in the recent, rapid increase in the price of gasoline. But there are a number of underlying, long-term issues that have been major contributors. I will attempt to address them and answer a number of related questions, such as: Why have no new refineries been built in the past 30 years? Are U.S. refineries breaking down more than normal? Are oil companies purposely withholding supplies to keep prices high? Have environmental regulations played a role? Does the use of ethanol influence gasoline demand growth? The answers to some of these questions may surprise you.

Please note that my essays should not be confused with financial advice. Following Part I, I received a number of e-mails requesting financial advice. While there are often potential financial implications, I am not a financial planner. If you choose to make investment decisions based on what you read here, you are on your own.

Further note that it is not my contention that refiners are not benefiting from higher prices. They are. But my contention is that prices aren’t higher because they have increased margins. Margins have increased because prices are higher.

U.S. Refinery Capacity

The problem, I have read on many occasions, is that we aren’t building any new refineries, and that “limiting refinery capacity seems to make more money for oil companies than expanding it.” Claims like the following from the Foundation for Consumer and Taxpayer Rights – are quite common:

America’s big oil companies figured out long ago that they could make more money by making less gasoline. That’s why the industry hasn’t built a new refinery in 30 years. Since deregulation of the refinery business in 1982, oil consumption has increased 33% but oil companies have kept refining capacity near what it was 25 years ago. Why not? They know that the scarcer the product, the bigger the profit.

Even members of the Senate Committee on Energy and Natural Resources seem to believe this, with New Jersey Senator Robert Menendez recently commenting in a Senate hearing on gas prices:

Senator Menendez: Isn’t there a reality that we are paying for some industry decisions that actually reduced refining capacity in this country? I mean there was a time that we had greater refining capacity, and the industry reduced that refining capacity, and as a result of making that decision, consumers today find themselves with exactly the consequences that you have described in your testimony before.

There are elements of fact and elements of fiction in the preceding statements. So, what’s the scoop? Are oil companies cutting refinery capacity in order to boost profits?

In the past 10 years, refining capacity in the U.S. has increased by about 2 million barrels per day, which is equivalent to about 10 good-sized refineries. Capacity expansions equivalent to 8 more new refineries have been announced for the next 4 years (although some refiners have recently suggested that some expansions may be put on hold as a result of the stated goal of reducing gasoline consumption by 20% in 10 years – in order to avoid an oversupply situation). So while it is true that new refineries aren’t being built, it is certainly not true that capacity is stagnant. There are several reasons for expanding existing refineries as opposed to building new ones.

First, it is less expensive per barrel to expand an existing refinery than to build a new one. The estimates I have seen suggest that existing refineries can be expanded at 60% of the per barrel cost of building a new refinery. Second, the permitting process for building a new refinery is onerous. A group in Arizona has been trying to build a new refinery, and it took them 7 years just to get the permit. If they proceed and build the refinery, it will have taken 13 years from the time they started the process. (Even as I was working on this essay, they have announced a further 1 year delay). Finally, while everyone seems to want more refining capacity, nobody seems to want a refinery in their community. This makes building a new refinery next to impossible. As Investor’s Business Daily recently asked Senator Chuck Schumer: “Just where in New York state would you like a new refinery to be built…?

However, the critics are correct on one point. Starting in the early 80’s, U.S. refining capacity did drop significantly, before beginning to climb back up in the 90’s. The reason for this is quite simple: There was far more refining capacity than was warranted by the demand. The result was that gasoline was $1.00 a gallon, and many oil companies were losing money. Many refineries shut down. Some oil companies went out of business. Property values in “oil towns” like Houston plummeted. Yet many view oil companies as if they are public utilities. But the majority are owned by shareholders, who expect a return on their investment. Billions of dollars of capital are risked in this business, and if the rewards are poor (or negative), the risks won’t be taken.

No industry can be expected to maintain high production levels in the face of poor or even negative margins. If milk producers make too much milk, prices fall and some producers go out of business. When that happens, supply is reduced and prices go up. The same is true for any other business. Yet people don’t accept this very well in the case of oil companies, because many have come to view cheap gas as an entitlement.

U.S. Senator Ron Wyden has spent quite a bit of time investigating these issues, and his view is probably typical with respect to the evolution of refining capacity:

The Oil Industry, Gas Supply and Refinery Capacity: More Than Meets the Eye

In this report, Senator Wyden presents a number of “smoking guns”, such as this internal Texaco document from 1996:

“As observed over the last few years and as projected well into the future, the most critical factor facing the refining industry on the West Coast is the surplus refining capacity, and the surplus gasoline production capacity. The same situation exists for the entire U.S. refining industry. Supply significantly exceeds demand year-round. This results in very poor refinery margins, and very poor refinery financial results. Significant events need to occur to assist in reducing supplies and/or increasing the demand for gasoline.”

Senator Wyden skipped right past the part about poor margins and poor financial results, and focused on the “smoking gun”, that either supplies needed to be reduced or demand for gasoline increased. He then gives a list of the refineries that have closed since the mid-90’s, apparently failing to connect these events with “poor refining margins.” Here are the refineries he lists that closed in 1995:

Indian Refining Lawrenceville, IL
Cyril Petrochemical Corp. Cyril, OK
Powerine Oil Co. Sante Fe Springs, CA
Sunland Refining Corp. Bakersfield, CA
Caribbean Petroleum Corp. San Juan, Puerto Rico

Do you recognize any of those names? Probably not, because most of the companies that shut down did so because they went out of business. Margins were too poor to remain in business for some. For others, it was failure to comply with environmental regulations (some of the closed refineries are now Superfund sites). Yet Senator Wyden presents a picture in which it was a systematic and cooperative effort between oil companies to reduce refining capacity – and that refinery capacity should have been maintained at any cost (as long as oil company shareholders are the ones to bear those costs). Somehow “the industry” is culpable for the closure of a number of marginal producers – many of whom went completely out of business. But it was years of poor returns in this cyclical business that drove down refining capacity.

Even in the past 10 years, refinery margins have turned negative on numerous occasions. The problem is that many people take a snapshot of the current view and believe this is normal. See the data that the IEA has accumulated (XLS download warning). Shall we expect that those who are calling for measures to be taken to address the current refinery margin situation will be calling for the government to extend a helping hand the next time margins go negative? Somehow, I doubt it. (Incidentally, for those who think oil companies have boosted their margins by raising prices, how do you explain the incredible variability from month to month? How do you explain negative margins?)

Paul Sankey, an analyst with Deutsche Bank, testified on May 15th before the Senate Committee on Energy and Natural Resources. He pointed out the long-term factors that have resulted in the refinery capacity we have today:

The reason for the massive recent run up in prices can be traced back to the last significant period of high prices, in the late 1970s, which forced lower gasoline demand, then more efficient cars, which led to excess refining capacity, which led to years of poor returns in refining (and cheap gasoline prices), which disincentivised investment in refining and encouraged demand, and which has ultimately led to today’s intense market tightness.

The bottom line on the refinery capacity issue is that yes, refining capacity has been reduced at times. And there were perfectly valid reasons that this happened. It is also true that capacity is short at the moment – if the objective is to maintain sub-$3 gasoline prices. But, reduced investment in refining capacity is indeed a key factor behind the current gasoline price spike. If some want to level the charge that refiners failed to accurately anticipate demand growth, then that charge is accurate. But like the rest of us, refiners don’t have crystal balls.

Are Oil Companies Purposely Withholding Supplies?

This charge has been repeated quite a bit lately. Oil companies are either accused of withholding supplies ala OPEC, or they are accused of stretching out their maintenance in order to keep supplies low. Let’s address that.

In a very tight market, events that take supply off of the market are likely to drive prices higher. In light of that, would it be a wise business practice if BP, for instance, purposely slowed down the maintenance at their Whiting, Indiana refinery that is partially closed due to a fire? Not a chance. When BP has supply off the market, it benefits everyone BUT BP. They are foregoing money every day they have that capacity offline. The refinery manager at Whiting will have part of his performance graded based on the financial returns of his refinery. The longer the supply is offline, the worse that grade will be.

Consider a couple of examples. Say that you operate a 200,000 barrel a day refinery. Margins are quite good right now – let’s say in your area they are $20 a barrel. So, when the refinery is running normally, you are grossing $4 million a day. Would it make good business sense to cut your capacity in half – to 100,000 barrels a day? While such action would probably cause the overall price of gasoline to rise, it is going to have a disproportionate effect on your refinery. If margins go up to $30 a barrel (although there is no way taking 100,000 barrels off the market would impact margins to that degree), you are still $1 million a day worse of than you were. You have given up $365 million a year in order to reduce your capacity. You would have made an incredibly stupid business decision. In fact, you would be much better off if you could boost capacity by 100,000 barrels a day. Sure, prices might slightly drop, but your overall profits will be higher, especially in such a tight market.

Furthermore, you don’t know if Shell down the street might be able to make up the production shortfall, pocketing the money that would have been made by your refinery. (Contrary to popular opinion, oil companies do not consult each other on such issues). You also don’t know if exporters from Europe will respond. If they respond by boosting exports to the U.S., now they are pocketing the money that your refinery is losing. In summary, this is not a rational way to conduct business – unless your margins are negative. You would be making a decision that will certainly cut the returns at your refinery, while not knowing how your competitors will respond to the supply shortfall.

For another example that many can relate to, consider that you wish to put your house on the market. Housing prices in your area have been outstanding, and you want to capitalize. However, you are afraid that by putting your house on the market, you may boost the supply in your area and cause prices to fall. So, you decide to be a charitable neighbor and keep your house off of the market in order to maintain prices for everyone else. You will sell some other time, even though the market may not be as good. If your primary objective is to capitalize on the good housing market, have you made a rational business decision? Of course not. The same is true regarding the charge that oil companies are deliberately prolonging maintenance. It just wouldn’t make good business sense in this market.

Are Refineries Breaking Down More Than Normal?

It certainly seems each week brings several new refinery outages. While refineries still have not reached pre-Hurricane Katrina production levels, most of the outages that you read about are the kinds of things that happen every year. Practically all refineries have one or more unplanned outages each year. Most years, when the market is amply supplied, these sorts of events don’t make the news. But this year, as we have seen, is very different.

As the afore-mentioned Paul Sankey testified:

The poor returns of the 1980s and 1990s have indirectly caused some additional external events that have played into the problems. The years of losing money caused companies to neglect refining investment, culminating in BP’s Texas City disaster. Texas City has now rightly caused other refiners to operate more cautiously – and so less capacity is available.

A second impact of years of reduced investment has been a lack of qualified engineering, procurement and construction staff. One vital issue here is that the tightness of US refining capacity at this time is not because companies are unwilling to invest in more capacity, it is that they are unable.

Refineries are complex. Heat is being added to flammable materials, and the entire chain of events depends on a steady supply of raw materials, equipment, and qualified people to keep things running smoothly. Equipment is going to break down. A refinery is much more complex than your car. Yet you would not be surprised if your 30-year old car had annual maintenance problems.

While this year’s outages may be somewhat above average, similar outages happen every year. The only difference is that most years there is enough spare capacity that the outages go unnoticed by the media.

The Impact of Environmental Regulations

Let me make it clear that I am in favor of the environmental regulations we have in place. They have made our air and water cleaner. But there is a price to be paid for those regulations, and consumers should understand that, as they are the ones who will ultimately bear those costs.

There are several things that can happen when a new regulation is implemented. First, new regulations may redirect capital that might have gone into expanding refining facilities. Second, they may increase the costs of producing the fuel. Third, additional processing, as in the case of ultra-low sulfur diesel (ULSD) and gasoline – can reduce the overall product yield. Fourth, and perhaps of greatest importance, additional equipment will increase the complexity of the refinery.

Those are the consequences. The more complex the refineries are, the more unreliable they are going to be. With each additional complexity that is added, there are more ways for them to break down. There is more danger as the inventory of hazardous materials increases. Politicians who are quick to point fingers should understand that they make their own contribution to supply shortages. If they are going to hold hearings on gas prices, they needn’t ponder “Gosh, I wonder why prices are going up?” Stricter environmental regulations – necessary as they may be – are one more piece of the puzzle. They have helped crimp supplies and add to costs.

Investor’s Business Daily recently touched on this:

Our refineries are doing more than ever, but their numbers are dwindling and no new ones are being built. The reason is not greed, but cost and regulations. From 1994 to 2003, the refining industry spent $47.4 billion, not to build new refineries, but to bring existing ones into compliance with ever new and stringent environmental rules. That’s where those allegedly excessive profits go.

I think most people are willing to pay higher prices for a cleaner environment, but it is important that they understand that this is a component of fuel prices.

The Ethanol Factor

It is a fact that ethanol only contains about 65% of the energy content of gasoline on a volumetric basis. Therefore, to displace the gross energy content of 1 gallon of gasoline requires 1/0.65, or 1.5 gallons of ethanol. What this means is that as ethanol is put into the gasoline pool, demand will go up simply because the pool now contains less energy. Is this enough to explain why motor gasoline demand (which includes blended ethanol) is at a record high?

In March of 2007, ethanol contributed 539 million gallons to the gasoline pool, according to the Renewable Fuels Association (RFA). This is almost 50% greater than the 365 million gallon ethanol demand in March of 2006. Gasoline demand in March, according to the Energy Information Administration, averaged 9.266 million barrels per day (up from 9.076 a year earlier). Total gasoline demand in March was then 9.266 million * 31 days * 42 gallons/bbl, or 12.06 billion gallons. The breakdown would have then been 11.52 billion gallons of gasoline and 0.54 billion gallons of ethanol. (Ethanol imports have been omitted as their impact would have been pretty small).

The energy content, however, of the 12.1 billion gallons would have been equivalent to 11.52 gallons of gasoline plus 0.54 billion gallons of ethanol * 0.65 (factoring the lower energy content), or 11.87 billion gallons of gasoline equivalent fuel. Therefore, our perceived gasoline demand is 1.9% (12.06/11.87) higher than it would be without ethanol in the pool.

In other words, part of the record high gasoline demand we are currently experiencing is due to the fact that ethanol is scaling up rapidly, and it is being counted in the finished motor gasoline pool. Even if demand was constant on a BTU basis, increasing the fraction of ethanol in the pool will increase the volume demand.

Conclusions

While the immediate cause of skyrocketing gas prices is a combination of record demand and low gasoline inventories in the U.S., several longer-term factors have contributed. Following years of poor returns and expensive new environmental regulations, investments into expanding existing refineries dried up. Many refineries closed their doors permanently, as a number of smaller producers went completely out of business in the 80’s and 90’s. The cumulative effect was that refining capacity fell starting in the early 80’s, but has recently been climbing back as margins have improved. Just as we were in an oversupply situation in the 80’s, we are now in an undersupply situation if the goal is to keep gasoline below $3.00/gallon. However, refining capacity has increased significantly in the past 10 years, and looks to continue this trend in the foreseeable future. But demand growth has remained robust in the face of higher prices, so an oversupply situation in which gasoline returns to $2/gal does not appear likely in the foreseeable future.

June 10, 2007 Posted by | energy policy, gas prices, oil refineries, price gouging, price manipulation, profit margins, refining | 14 Comments

Record Prices = Record Profits?

So, I am running through some of my daily news searches – things like “gas prices”, “gas gouging”, “alternative energy”, etc. I ran across this gem:

Gas price gouging becomes even more obvious

It is basically just another ignorant screed from someone who apparently thinks oil companies can just raise and lower prices at a whim:

As long as no significant gasoline retailer breaks ranks and the price at the pump remains fairly constant from one street corner to the next within a region, there is no reason for any oil company not to raise prices. So they do.

An absolutely abysmal understanding of the issues. It is funny that people seem to understand that when the price of gold rises, gold mining companies make more money. And there doesn’t seem to be this widespread belief that the reason they are making more money is that they just decided to raise the price of gold. People understand that they can’t do this. But these same people seem to think that oil companies can just go out and raise prices when they want.

And then this:

Oil companies last fall did all they could to keep Republicans in the majority in Congress because no matter how high prices went during its reign, the GOP never did a thing to rein them in. No hearings questioning oil company executives about their pricing practices. No anti-gouging bills. Nothing.

Prices drop every fall, for reasons I have explained several times. Last year was no different, it just happened to be an election year so it gave the conspiracy theorists something to get worked up over.

As I worked my way through the article, I thought “Boy, this sounds just like the FTCR’s hysterics.” Then I reached the end:

“These figures show that gasoline prices are not about the price of oil, but about maximizing the already obscene profits of oil companies and their refiners,” said Judy Dugan, research director for the consumer advocate Foundation for Taxpayer and Consumer Rights.

LOL!

So, what is the connection between record gas prices and record profits? Absolutely yes, there is a connection. I expect oil companies to once again turn in huge profits (keeping in mind that the profit margins are in line with other industries) and there will be a new round of political grandstanding. Eventually congress is going to be pressured into passing some sort of legislation, but almost everything that will be politically palatable to them will make matters worse for consumers in the long run.

Right now the money is being made in the refining sector. When oil prices stay constant, and gas prices skyrocket, most of that is going to the refiner. Refining margins are certainly very healthy right now. But too many people – including most of the politicians – have their cause and effect backwards. High refining margins do not cause high gas prices. The high gas prices are not a result of the desire of the oil companies to make more profits. (They do desire to make more profits, but they can’t just raise gas prices as a result). The high profits are a result of the fact that gas prices have risen. (And of course some of those high profits are going to pay for things like compulsory ULSD and ULSG requirements, the phasing out of benzene, etc.)

Why have gas prices risen? Is it as the article above suggested – just companies raising prices with nobody breaking ranks? Anyone who takes a bit of time to watch the utilization numbers, imports, demand, and inventories will understand why price moves as it does. I know that takes a bit more effort, and that the lazy way out is to just argue – as Judy Dugan says like a broken record – that the price rise is “about maximizing the already obscene profits of oil companies and their refiners.” And it is obvious that many are ignorant of the basics and too lazy to do the research. The scary thing is that many (most?) of our political leaders fall into that same category.

A fundamental problem, which the Judy Dugans of the world never seem willing to address, is that Americans like to drive whenever and wherever they want. Now that the price of this habit is coming home to roost, they demand that politicians protect them so they don’t have to change their consumptive ways. Tell a European or an Australian about the pain of $3 gasoline and they will laugh in your face.

The best thing for all parties would be to come to terms with the fact that the days of cheap oil and gasoline are over. That era is finished. Start planning for the next one.

May 25, 2007 Posted by | FTCR, Judy Dugan, price gouging, profit margins, refining | 25 Comments

Record Prices = Record Profits?

So, I am running through some of my daily news searches – things like “gas prices”, “gas gouging”, “alternative energy”, etc. I ran across this gem:

Gas price gouging becomes even more obvious

It is basically just another ignorant screed from someone who apparently thinks oil companies can just raise and lower prices at a whim:

As long as no significant gasoline retailer breaks ranks and the price at the pump remains fairly constant from one street corner to the next within a region, there is no reason for any oil company not to raise prices. So they do.

An absolutely abysmal understanding of the issues. It is funny that people seem to understand that when the price of gold rises, gold mining companies make more money. And there doesn’t seem to be this widespread belief that the reason they are making more money is that they just decided to raise the price of gold. People understand that they can’t do this. But these same people seem to think that oil companies can just go out and raise prices when they want.

And then this:

Oil companies last fall did all they could to keep Republicans in the majority in Congress because no matter how high prices went during its reign, the GOP never did a thing to rein them in. No hearings questioning oil company executives about their pricing practices. No anti-gouging bills. Nothing.

Prices drop every fall, for reasons I have explained several times. Last year was no different, it just happened to be an election year so it gave the conspiracy theorists something to get worked up over.

As I worked my way through the article, I thought “Boy, this sounds just like the FTCR’s hysterics.” Then I reached the end:

“These figures show that gasoline prices are not about the price of oil, but about maximizing the already obscene profits of oil companies and their refiners,” said Judy Dugan, research director for the consumer advocate Foundation for Taxpayer and Consumer Rights.

LOL!

So, what is the connection between record gas prices and record profits? Absolutely yes, there is a connection. I expect oil companies to once again turn in huge profits (keeping in mind that the profit margins are in line with other industries) and there will be a new round of political grandstanding. Eventually congress is going to be pressured into passing some sort of legislation, but almost everything that will be politically palatable to them will make matters worse for consumers in the long run.

Right now the money is being made in the refining sector. When oil prices stay constant, and gas prices skyrocket, most of that is going to the refiner. Refining margins are certainly very healthy right now. But too many people – including most of the politicians – have their cause and effect backwards. High refining margins do not cause high gas prices. The high gas prices are not a result of the desire of the oil companies to make more profits. (They do desire to make more profits, but they can’t just raise gas prices as a result). The high profits are a result of the fact that gas prices have risen. (And of course some of those high profits are going to pay for things like compulsory ULSD and ULSG requirements, the phasing out of benzene, etc.)

Why have gas prices risen? Is it as the article above suggested – just companies raising prices with nobody breaking ranks? Anyone who takes a bit of time to watch the utilization numbers, imports, demand, and inventories will understand why price moves as it does. I know that takes a bit more effort, and that the lazy way out is to just argue – as Judy Dugan says like a broken record – that the price rise is “about maximizing the already obscene profits of oil companies and their refiners.” And it is obvious that many are ignorant of the basics and too lazy to do the research. The scary thing is that many (most?) of our political leaders fall into that same category.

A fundamental problem, which the Judy Dugans of the world never seem willing to address, is that Americans like to drive whenever and wherever they want. Now that the price of this habit is coming home to roost, they demand that politicians protect them so they don’t have to change their consumptive ways. Tell a European or an Australian about the pain of $3 gasoline and they will laugh in your face.

The best thing for all parties would be to come to terms with the fact that the days of cheap oil and gasoline are over. That era is finished. Start planning for the next one.

May 25, 2007 Posted by | FTCR, Judy Dugan, price gouging, profit margins, refining | 49 Comments

The Demagoguery Continues

I have been watching the news closely to see who would be the first politician to attempt to score political points as oil companies released profits this week. The prize was won by Nevada Senator Harry Reid:

Reid: The Republican Congress Puts Big Oil Before Working Families

Source: U.S. Newswire

WASHINGTON, July 27 /U.S. Newswire/ — The following release was issued today by the Senate Democratic Communications Center:

Once again, Big Oil is reporting stunning profits as Americans pay skyrocketing prices for gas. With ExxonMobil today reporting $10 billion in second quarter profits, the second largest quarterly profit ever recorded by a publicly traded U.S. company and only the latest of the sky-high profits reported by Big Oil this week, Senate Democratic Leader Harry Reid issued the following statement. A breakdown of current oil company profits is attached below.

“Americans are paying near-record gas prices, oil companies are reaping billions in profits, but the response from the Oil Men in the White House and the Republicans in Congress has been billions for Big Oil and a backhand to the American people. It would be shocking in normal times, but it is standard procedure for Republicans in Washington.

“It is time for a change from the Bush/Cheney energy plan that put Big Oil’s interests ahead of working families. For five years, this Republican Congress has failed to adopt a forward- thinking plan to deliver affordable and clean energy, and it is time for a new direction. Democrats have offered the Clean EDGE Act. It is the comprehensive legislation needed to address the current energy crisis, and the right way to help the American people.”

First, I hate to break it to Senator Reid, but “Big Oil” is composed primarily of “working families”. It is not a bunch of fat cats sitting around in a conference room smoking cigars and counting their money. It is made up of hard working women and men that span all backgrounds. The shareholders of “Big Oil” – the true owners – span the gamut from the proverbial widows and orphans to retirees with money invested through mutual funds to those “working families” Reid is trying to protect. When you complain about “Big Oil”, these are the people you complain about. So don’t paint with such a broad brush.

Second, I don’t know if Reid actually understands the difference in a profit and a profit margin, and I don’t know if he wants to understand the difference. I think a big part of the problem is that too many people don’t understand the difference. Take this blurb from a Cincinnati Post article:

Profits Surge at ConocoPhillips

Source: Cincinnati Post

Publication date: 2006-07-27

HOUSTON — ConocoPhillips pumped more oil and gas and commanded sharply higher prices for its energy in the second quarter, boosting profits by nearly two thirds to more than $5 billion.

Its acquisition of Burlington Resources in March appears to have paid off, too, accounting for more than a quarter of the earnings growth in its exploration and production business.

ConocoPhillips, which announced its results Wednesday, far surpassed Wall Street’s expectations and its shares climbed close to 2 percent. The nation’s third-largest oil company earned $5.18 billion in the April-June quarter — a 65 percent increase from the $3.14 billion profit during the same period a year earlier.

Revenue only rose 12.6 percent, to $47.1 billion, highlighting how staggeringly high profit margins for oil, gasoline and other fuels accounted for the bulk of ConocoPhillips’ bonanza.

“Staggeringly high profit margins”? Here someone has once again confused “profit” and “profit margin”. The profit margin was $5.18 billion/$47.1 billion, or 11%. That doesn’t seem “staggeringly high” to me. The oil majors are gigantic companies. Their profits are gigantic, because they move gigantic quantities of product.

However, the public really sees two things: Their gas prices are at record highs, and oil company profits are at record highs. Are the two related? Of course they are. But gas prices are not at record highs because oil companies have just now decided to gouge because there is a Republican administration in the White House. Gas prices are high because supplies are extremely tight. I don’t believe this situation would have been much different if someone else was in the White House, unless they were willing to commit to a major overhaul of energy policy. Actually, gas prices would probably have been a bit lower with the Democrats in, because our incursion into Iraq took a lot of oil off the market and tightened supplies up. But that’s a road I won’t go down right now.

The core problem, which neither Republicans nor Democrats seem willing to confront, is that gas demand is too high. Unless the demand issue is addressed, gas prices will remain high, and escalate higher as demand continues to outstrip supplies.

July 28, 2006 Posted by | oil companies, politics, profit margins | 3 Comments

The Demagoguery Continues

I have been watching the news closely to see who would be the first politician to attempt to score political points as oil companies released profits this week. The prize was won by Nevada Senator Harry Reid:

Reid: The Republican Congress Puts Big Oil Before Working Families

Source: U.S. Newswire

WASHINGTON, July 27 /U.S. Newswire/ — The following release was issued today by the Senate Democratic Communications Center:

Once again, Big Oil is reporting stunning profits as Americans pay skyrocketing prices for gas. With ExxonMobil today reporting $10 billion in second quarter profits, the second largest quarterly profit ever recorded by a publicly traded U.S. company and only the latest of the sky-high profits reported by Big Oil this week, Senate Democratic Leader Harry Reid issued the following statement. A breakdown of current oil company profits is attached below.

“Americans are paying near-record gas prices, oil companies are reaping billions in profits, but the response from the Oil Men in the White House and the Republicans in Congress has been billions for Big Oil and a backhand to the American people. It would be shocking in normal times, but it is standard procedure for Republicans in Washington.

“It is time for a change from the Bush/Cheney energy plan that put Big Oil’s interests ahead of working families. For five years, this Republican Congress has failed to adopt a forward- thinking plan to deliver affordable and clean energy, and it is time for a new direction. Democrats have offered the Clean EDGE Act. It is the comprehensive legislation needed to address the current energy crisis, and the right way to help the American people.”

First, I hate to break it to Senator Reid, but “Big Oil” is composed primarily of “working families”. It is not a bunch of fat cats sitting around in a conference room smoking cigars and counting their money. It is made up of hard working women and men that span all backgrounds. The shareholders of “Big Oil” – the true owners – span the gamut from the proverbial widows and orphans to retirees with money invested through mutual funds to those “working families” Reid is trying to protect. When you complain about “Big Oil”, these are the people you complain about. So don’t paint with such a broad brush.

Second, I don’t know if Reid actually understands the difference in a profit and a profit margin, and I don’t know if he wants to understand the difference. I think a big part of the problem is that too many people don’t understand the difference. Take this blurb from a Cincinnati Post article:

Profits Surge at ConocoPhillips

Source: Cincinnati Post

Publication date: 2006-07-27

HOUSTON — ConocoPhillips pumped more oil and gas and commanded sharply higher prices for its energy in the second quarter, boosting profits by nearly two thirds to more than $5 billion.

Its acquisition of Burlington Resources in March appears to have paid off, too, accounting for more than a quarter of the earnings growth in its exploration and production business.

ConocoPhillips, which announced its results Wednesday, far surpassed Wall Street’s expectations and its shares climbed close to 2 percent. The nation’s third-largest oil company earned $5.18 billion in the April-June quarter — a 65 percent increase from the $3.14 billion profit during the same period a year earlier.

Revenue only rose 12.6 percent, to $47.1 billion, highlighting how staggeringly high profit margins for oil, gasoline and other fuels accounted for the bulk of ConocoPhillips’ bonanza.

“Staggeringly high profit margins”? Here someone has once again confused “profit” and “profit margin”. The profit margin was $5.18 billion/$47.1 billion, or 11%. That doesn’t seem “staggeringly high” to me. The oil majors are gigantic companies. Their profits are gigantic, because they move gigantic quantities of product.

However, the public really sees two things: Their gas prices are at record highs, and oil company profits are at record highs. Are the two related? Of course they are. But gas prices are not at record highs because oil companies have just now decided to gouge because there is a Republican administration in the White House. Gas prices are high because supplies are extremely tight. I don’t believe this situation would have been much different if someone else was in the White House, unless they were willing to commit to a major overhaul of energy policy. Actually, gas prices would probably have been a bit lower with the Democrats in, because our incursion into Iraq took a lot of oil off the market and tightened supplies up. But that’s a road I won’t go down right now.

The core problem, which neither Republicans nor Democrats seem willing to confront, is that gas demand is too high. Unless the demand issue is addressed, gas prices will remain high, and escalate higher as demand continues to outstrip supplies.

July 28, 2006 Posted by | oil companies, politics, profit margins | 6 Comments

Debunking the Debunkers

There are a few things I have learned over the years regarding the relationship between the public and oil companies. The public seems to have an especially strong distaste for oil companies, and especially Big Oil. They don’t seem to care that the profit margins are much higher at Microsoft or Citibank, because they don’t have to shell out money directly to them on a regular basis. If they are paying higher prices than they think they should be, and oil company earnings are good, then they think they must be getting ripped off.

This mentality is pervasive, despite the fact that finding, extracting, and refining oil is risky, both physically and financially, and requires huge sums of capital. When is the last time someone was seriously injured programming software? Does it require a multibillion dollar capital investment to sign someone up for a credit card at 18% interest? But, I bet if you polled the public, a substantial portion would say they don’t care if oil companies make any money at all. They just want their cheap gas. Of course politicians know this and they pander to their constituents, promising to punish oil companies and to bring prices back down.

Oil Industry “Windfall”
Source: Facts on Fuel

To be fair, not everyone is complaining. From CNNMoney.com:

First the oil companies scour the freaking globe, going to the most gosh-forsaken dangerous places on earth to find the stuff. Then they pump it. Then they ship the stuff in huge, complicated ships halfway across the world. Then in giant, expensive plants they refine the stuff through amazingly complicated processes and turn in into gasoline. Then they distribute it to rural Nebraska and Vermont and all over the USA. The price is less than a gallon of bottled water, and it’s gone up less than inflation, and we take it for granted and we’ve squandered it with our Suburbans and Tahoes and Navigators. (1)

That brings me to a new report from Consumers Union , a non-profit publisher of Consumer Reports, explaining how you are being ripped off by oil companies. The report is “Debunking Oil Company Myths and Deception: The $100 Billion Consumer Rip-Off” (2). The report gets into some areas not addressed in an earlier attack piece by FTCR, which I previously addressed. Therefore, it is worth a bit of time to address the allegations made by Consumers Union. I will hit the highlights, most of which are contained in a news release here.

Addressing Some Claims

Claim 1: The U.S. oil industry made $100 billion in windfall profits since the late 1990s, largely by eliminating refining capacity that paved the way to drive up prices at the pump.

Fact: The oil industry is cyclical, and is not always as profitable as it is now. So, what is the baseline for defining a windfall profit? Should it be based on a time in which the industry was at the bottom of the cycle? Refineries are shut down when they are not profitable – not to restrict capacity. If there is a refinery that is not providing a very good return, or is even a money loser, why should I be expected to continue running it? Would you run your business this way?

Consider this “windfall” analogy. Millions of homeowners are sitting on a huge amount of appreciation in their homes. What did they do to earn this windfall? Nothing, other than being in the right place when the market was appreciating. I am sure the person buying one of these houses doesn’t want to pay that much for it. But, what are their options? All of the other houses are also sitting on windfalls and are also “too much”. Consider the person in California who bought a house for $170,000 that is now worth $750,000. That is a serious windfall. Shall we cap how much they can sell their house for? After all, that price isn’t really “fair” to new homeowners. Shall we impose a steep windfall profits tax for all houses that have a certain level of capital gains, and then use that to help those who want to move into that neighborhood? Sure, they will have to pay capital gains taxes, just like oil companies pay taxes on their earnings. But why not an additional penalty, since they really did nothing to earn their windfall? The market just gave it to them.

Claim 2: Consumers are trapped between a small group of powerful, non-competing oil companies out to maximize profits and weak governmental authorities who consistently fail to strengthen or enforce the law.

Fact: The oil companies are certainly out to maximize profits. That’s what companies are supposed to do. But non-competing? How’s that? ExxonMobil, the largest company in the United States, controls 3% of the world’s oil supply and 8% of the nation’s service stations. How exactly is it that oil companies aren’t competing? No company can dictate price, because they don’t control enough of the market to do so. Oil companies have been investigated countless times for collusion, and they have always been vindicated. In order to be “non-competing”, a company either has to control the market or be in collusion. Unless Consumers Union can show either of these to be the case, they should retract this claim.

Claim 3: On Wall Street they point to their soaring return on equity and cash flow as proof of their huge profitability, while on Main Street they point to profit as a percentage of sales and ignore cash flow to claim less than stellar results.

Fact: The reason oil companies point to their profit on sales is that it is a commonly reported metric for many different industries. It allows the public to see just where Big Oil fits among other industries. The return on capital employed (ROCE) metric is often criticized as proof that the profitability of Big Oil is “too high”. What ROCE means is basically the return on your assets. That is a perfectly acceptable measure of a company’s profitability, but if you want to criticize it for being too high, you must again look at other industries. What is the ROCE for software companies? Banks? Pharmaceuticals? Since these industries don’t require a lot of capital, as is the case with oil companies, their ROCE is going to be much, much higher than that for oil companies. What ROCE does is allow one oil company to compare itself to another. Using ROCE to claim that oil companies are too profitable is meaningless unless we use the same metric to compare other industries and see where Big Oil fits into the overall picture.

Irony

I thought one theme in the report was particularly ironic. On the one hand, they admit that earnings were much lower just a few years ago. ExxonMobil, for instance, had profits of $11 billion in 2002, which was less than 6% profit on sales. Yet they complain the oil companies have underinvested in recent years in new refining capacity. So, let me pose a question for the good people at Consumers Union: Do you think it’s possible that underinvestment was due to lower profits just a few years ago? Profits drive investments. When you are making good profits, you tend to make more investments back into the business. When profits aren’t all that great, you don’t have as much money to invest in the business. Yet the supreme irony is that when profits are good, so more investments can be made back into the business, you complain about the windfall!

What are companies doing now that earnings are good? ConocoPhillips invested 141% of their first quarter earnings back into the business. ExxonMobil invested more than 50% of their earnings back into the business. Chevron’s earnings were $4 billion, and their exploration and production budget for the first quarter was $3 billion. This can be done when earnings are good. The reason this level of investment did not occur 5 years ago is that the earnings were insufficient to support that level of investment.

References

1. “Defending Big Oil and buying some stock”, CNNMoney.com, April 27, 2006
2. “Debunking Oil Company Myths and Deception: The $100 Billion Consumer Rip-Off”, Consumers Union , May 3, 2006.

May 5, 2006 Posted by | FTCR, oil companies, price gouging, profit margins | 20 Comments

Debunking the Debunkers

There are a few things I have learned over the years regarding the relationship between the public and oil companies. The public seems to have an especially strong distaste for oil companies, and especially Big Oil. They don’t seem to care that the profit margins are much higher at Microsoft or Citibank, because they don’t have to shell out money directly to them on a regular basis. If they are paying higher prices than they think they should be, and oil company earnings are good, then they think they must be getting ripped off.

This mentality is pervasive, despite the fact that finding, extracting, and refining oil is risky, both physically and financially, and requires huge sums of capital. When is the last time someone was seriously injured programming software? Does it require a multibillion dollar capital investment to sign someone up for a credit card at 18% interest? But, I bet if you polled the public, a substantial portion would say they don’t care if oil companies make any money at all. They just want their cheap gas. Of course politicians know this and they pander to their constituents, promising to punish oil companies and to bring prices back down.

Oil Industry “Windfall”
Source: Facts on Fuel

To be fair, not everyone is complaining. From CNNMoney.com:

First the oil companies scour the freaking globe, going to the most gosh-forsaken dangerous places on earth to find the stuff. Then they pump it. Then they ship the stuff in huge, complicated ships halfway across the world. Then in giant, expensive plants they refine the stuff through amazingly complicated processes and turn in into gasoline. Then they distribute it to rural Nebraska and Vermont and all over the USA. The price is less than a gallon of bottled water, and it’s gone up less than inflation, and we take it for granted and we’ve squandered it with our Suburbans and Tahoes and Navigators. (1)

That brings me to a new report from Consumers Union , a non-profit publisher of Consumer Reports, explaining how you are being ripped off by oil companies. The report is “Debunking Oil Company Myths and Deception: The $100 Billion Consumer Rip-Off” (2). The report gets into some areas not addressed in an earlier attack piece by FTCR, which I previously addressed. Therefore, it is worth a bit of time to address the allegations made by Consumers Union. I will hit the highlights, most of which are contained in a news release here.

Addressing Some Claims

Claim 1: The U.S. oil industry made $100 billion in windfall profits since the late 1990s, largely by eliminating refining capacity that paved the way to drive up prices at the pump.

Fact: The oil industry is cyclical, and is not always as profitable as it is now. So, what is the baseline for defining a windfall profit? Should it be based on a time in which the industry was at the bottom of the cycle? Refineries are shut down when they are not profitable – not to restrict capacity. If there is a refinery that is not providing a very good return, or is even a money loser, why should I be expected to continue running it? Would you run your business this way?

Consider this “windfall” analogy. Millions of homeowners are sitting on a huge amount of appreciation in their homes. What did they do to earn this windfall? Nothing, other than being in the right place when the market was appreciating. I am sure the person buying one of these houses doesn’t want to pay that much for it. But, what are their options? All of the other houses are also sitting on windfalls and are also “too much”. Consider the person in California who bought a house for $170,000 that is now worth $750,000. That is a serious windfall. Shall we cap how much they can sell their house for? After all, that price isn’t really “fair” to new homeowners. Shall we impose a steep windfall profits tax for all houses that have a certain level of capital gains, and then use that to help those who want to move into that neighborhood? Sure, they will have to pay capital gains taxes, just like oil companies pay taxes on their earnings. But why not an additional penalty, since they really did nothing to earn their windfall? The market just gave it to them.

Claim 2: Consumers are trapped between a small group of powerful, non-competing oil companies out to maximize profits and weak governmental authorities who consistently fail to strengthen or enforce the law.

Fact: The oil companies are certainly out to maximize profits. That’s what companies are supposed to do. But non-competing? How’s that? ExxonMobil, the largest company in the United States, controls 3% of the world’s oil supply and 8% of the nation’s service stations. How exactly is it that oil companies aren’t competing? No company can dictate price, because they don’t control enough of the market to do so. Oil companies have been investigated countless times for collusion, and they have always been vindicated. In order to be “non-competing”, a company either has to control the market or be in collusion. Unless Consumers Union can show either of these to be the case, they should retract this claim.

Claim 3: On Wall Street they point to their soaring return on equity and cash flow as proof of their huge profitability, while on Main Street they point to profit as a percentage of sales and ignore cash flow to claim less than stellar results.

Fact: The reason oil companies point to their profit on sales is that it is a commonly reported metric for many different industries. It allows the public to see just where Big Oil fits among other industries. The return on capital employed (ROCE) metric is often criticized as proof that the profitability of Big Oil is “too high”. What ROCE means is basically the return on your assets. That is a perfectly acceptable measure of a company’s profitability, but if you want to criticize it for being too high, you must again look at other industries. What is the ROCE for software companies? Banks? Pharmaceuticals? Since these industries don’t require a lot of capital, as is the case with oil companies, their ROCE is going to be much, much higher than that for oil companies. What ROCE does is allow one oil company to compare itself to another. Using ROCE to claim that oil companies are too profitable is meaningless unless we use the same metric to compare other industries and see where Big Oil fits into the overall picture.

Irony

I thought one theme in the report was particularly ironic. On the one hand, they admit that earnings were much lower just a few years ago. ExxonMobil, for instance, had profits of $11 billion in 2002, which was less than 6% profit on sales. Yet they complain the oil companies have underinvested in recent years in new refining capacity. So, let me pose a question for the good people at Consumers Union: Do you think it’s possible that underinvestment was due to lower profits just a few years ago? Profits drive investments. When you are making good profits, you tend to make more investments back into the business. When profits aren’t all that great, you don’t have as much money to invest in the business. Yet the supreme irony is that when profits are good, so more investments can be made back into the business, you complain about the windfall!

What are companies doing now that earnings are good? ConocoPhillips invested 141% of their first quarter earnings back into the business. ExxonMobil invested more than 50% of their earnings back into the business. Chevron’s earnings were $4 billion, and their exploration and production budget for the first quarter was $3 billion. This can be done when earnings are good. The reason this level of investment did not occur 5 years ago is that the earnings were insufficient to support that level of investment.

References

1. “Defending Big Oil and buying some stock”, CNNMoney.com, April 27, 2006
2. “Debunking Oil Company Myths and Deception: The $100 Billion Consumer Rip-Off”, Consumers Union , May 3, 2006.

May 5, 2006 Posted by | FTCR, oil companies, price gouging, profit margins | Comments Off on Debunking the Debunkers

Debunking the Debunkers

There are a few things I have learned over the years regarding the relationship between the public and oil companies. The public seems to have an especially strong distaste for oil companies, and especially Big Oil. They don’t seem to care that the profit margins are much higher at Microsoft or Citibank, because they don’t have to shell out money directly to them on a regular basis. If they are paying higher prices than they think they should be, and oil company earnings are good, then they think they must be getting ripped off.

This mentality is pervasive, despite the fact that finding, extracting, and refining oil is risky, both physically and financially, and requires huge sums of capital. When is the last time someone was seriously injured programming software? Does it require a multibillion dollar capital investment to sign someone up for a credit card at 18% interest? But, I bet if you polled the public, a substantial portion would say they don’t care if oil companies make any money at all. They just want their cheap gas. Of course politicians know this and they pander to their constituents, promising to punish oil companies and to bring prices back down.

Oil Industry “Windfall”
Source: Facts on Fuel

To be fair, not everyone is complaining. From CNNMoney.com:

First the oil companies scour the freaking globe, going to the most gosh-forsaken dangerous places on earth to find the stuff. Then they pump it. Then they ship the stuff in huge, complicated ships halfway across the world. Then in giant, expensive plants they refine the stuff through amazingly complicated processes and turn in into gasoline. Then they distribute it to rural Nebraska and Vermont and all over the USA. The price is less than a gallon of bottled water, and it’s gone up less than inflation, and we take it for granted and we’ve squandered it with our Suburbans and Tahoes and Navigators. (1)

That brings me to a new report from Consumers Union , a non-profit publisher of Consumer Reports, explaining how you are being ripped off by oil companies. The report is “Debunking Oil Company Myths and Deception: The $100 Billion Consumer Rip-Off” (2). The report gets into some areas not addressed in an earlier attack piece by FTCR, which I previously addressed. Therefore, it is worth a bit of time to address the allegations made by Consumers Union. I will hit the highlights, most of which are contained in a news release here.

Addressing Some Claims

Claim 1: The U.S. oil industry made $100 billion in windfall profits since the late 1990s, largely by eliminating refining capacity that paved the way to drive up prices at the pump.

Fact: The oil industry is cyclical, and is not always as profitable as it is now. So, what is the baseline for defining a windfall profit? Should it be based on a time in which the industry was at the bottom of the cycle? Refineries are shut down when they are not profitable – not to restrict capacity. If there is a refinery that is not providing a very good return, or is even a money loser, why should I be expected to continue running it? Would you run your business this way?

Consider this “windfall” analogy. Millions of homeowners are sitting on a huge amount of appreciation in their homes. What did they do to earn this windfall? Nothing, other than being in the right place when the market was appreciating. I am sure the person buying one of these houses doesn’t want to pay that much for it. But, what are their options? All of the other houses are also sitting on windfalls and are also “too much”. Consider the person in California who bought a house for $170,000 that is now worth $750,000. That is a serious windfall. Shall we cap how much they can sell their house for? After all, that price isn’t really “fair” to new homeowners. Shall we impose a steep windfall profits tax for all houses that have a certain level of capital gains, and then use that to help those who want to move into that neighborhood? Sure, they will have to pay capital gains taxes, just like oil companies pay taxes on their earnings. But why not an additional penalty, since they really did nothing to earn their windfall? The market just gave it to them.

Claim 2: Consumers are trapped between a small group of powerful, non-competing oil companies out to maximize profits and weak governmental authorities who consistently fail to strengthen or enforce the law.

Fact: The oil companies are certainly out to maximize profits. That’s what companies are supposed to do. But non-competing? How’s that? ExxonMobil, the largest company in the United States, controls 3% of the world’s oil supply and 8% of the nation’s service stations. How exactly is it that oil companies aren’t competing? No company can dictate price, because they don’t control enough of the market to do so. Oil companies have been investigated countless times for collusion, and they have always been vindicated. In order to be “non-competing”, a company either has to control the market or be in collusion. Unless Consumers Union can show either of these to be the case, they should retract this claim.

Claim 3: On Wall Street they point to their soaring return on equity and cash flow as proof of their huge profitability, while on Main Street they point to profit as a percentage of sales and ignore cash flow to claim less than stellar results.

Fact: The reason oil companies point to their profit on sales is that it is a commonly reported metric for many different industries. It allows the public to see just where Big Oil fits among other industries. The return on capital employed (ROCE) metric is often criticized as proof that the profitability of Big Oil is “too high”. What ROCE means is basically the return on your assets. That is a perfectly acceptable measure of a company’s profitability, but if you want to criticize it for being too high, you must again look at other industries. What is the ROCE for software companies? Banks? Pharmaceuticals? Since these industries don’t require a lot of capital, as is the case with oil companies, their ROCE is going to be much, much higher than that for oil companies. What ROCE does is allow one oil company to compare itself to another. Using ROCE to claim that oil companies are too profitable is meaningless unless we use the same metric to compare other industries and see where Big Oil fits into the overall picture.

Irony

I thought one theme in the report was particularly ironic. On the one hand, they admit that earnings were much lower just a few years ago. ExxonMobil, for instance, had profits of $11 billion in 2002, which was less than 6% profit on sales. Yet they complain the oil companies have underinvested in recent years in new refining capacity. So, let me pose a question for the good people at Consumers Union: Do you think it’s possible that underinvestment was due to lower profits just a few years ago? Profits drive investments. When you are making good profits, you tend to make more investments back into the business. When profits aren’t all that great, you don’t have as much money to invest in the business. Yet the supreme irony is that when profits are good, so more investments can be made back into the business, you complain about the windfall!

What are companies doing now that earnings are good? ConocoPhillips invested 141% of their first quarter earnings back into the business. ExxonMobil invested more than 50% of their earnings back into the business. Chevron’s earnings were $4 billion, and their exploration and production budget for the first quarter was $3 billion. This can be done when earnings are good. The reason this level of investment did not occur 5 years ago is that the earnings were insufficient to support that level of investment.

References

1. “Defending Big Oil and buying some stock”, CNNMoney.com, April 27, 2006
2. “Debunking Oil Company Myths and Deception: The $100 Billion Consumer Rip-Off”, Consumers Union , May 3, 2006.

May 5, 2006 Posted by | FTCR, oil companies, price gouging, profit margins | 10 Comments

I’m Being Gouged!

Where’s the Outrage?

They reported profits today of $2.89 billion in the first quarter on revenues of $10.9 billion. Their profit margin on sales was 26.5%! I was expecting outrage. Yet I haven’t heard anyone call for their tax records, to make sure they “aren’t taking a taking a speed pass by the tax man”. (1) I haven’t heard anyone propose legislation to cap their profits. I haven’t heard anyone propose that their CEO be called to Capitol Hill to defend his company’s profits. Why not? Because we are talking about Microsoft, and the rules seem to apply differently when we are talking about “optional” purchases like software instead of “mandatory” purchases like gasoline. (Of course software permeates every facet of our society, so you just think you can avoid contributing to Microsoft’s profits).

On the other hand, Exxon Mobil today reported profits of $8.4 billion on sales of $88.98 billion. Their profit margin on sales was 9.4%. The public is outraged. The media is reporting the story with highly inflammatory sound bites. The politicians are in a tizzy, groping for some answer to these outrageous profits. Subpoenas are being issued. Legislation is being prepared.

So, here are some questions. Who is more profitable: Microsoft, with a 26.5% profit margin, or Exxon Mobil, with a 9.4% profit margin? Which seems like a more lucrative investment? If you had $1000 to invest, which do you think would give you a better return?

Priceless Commentary

A tip of the hat to Gristmill, where I ran across the following link. This is a great article showing what we are up against with politicians on both sides:

Lawmakers talk gas, drive away in SUVs

A lot of lawmakers are driving a block in their gas guzzlers to hold press conferences to rail against gas prices. The lawmakers’ parking lots are full of gas guzzlers. This is a priceless commentary on why real solutions aren’t being offered.

Editorial Coverage

I want to comment on a couple of editorials I read today. Believe me, I am almost finished beating this dead horse for a while, and I have some alternative energy articles coming up. But these editorials struck me as particularly timely.

The first is from The Paducah Sun:

Apr. 27–The recent spike in demagoguery over rising gasoline prices probably will have little impact beyond wasting political energy in Washington.

But it’s possible that Congress will foolishly repeat past mistakes such as imposing price controls on oil or a windfall profits tax on the oil companies. If the populist table-thumping about the darned ol’ big oil companies turns into legislative action that interferes with the workings of the market, motorists will likely see $4 per gallon gas — if they’re able to find any gas in the midst of artificially created shortages. (2)

As big a mistake as I think it will be, I believe the politicians, in their desperation to save their skins, will make some very short-sighted choices here that will cause big problems down the road.

No evidence exists to substantiate claims of a conspiracy to manipulate prices by the oil companies or retailers who sell gasoline. Over the past 25 years, the federal government has conducted a number of investigations of suspected gouging by the oil companies, but none of those probes uncovered widespread illegal manipulation of prices.

The fact is, oil is not an especially profitable industry. Jerry Taylor and Peter Van Doren of the Cato Institute point out that profit margins for the major oil companies in 2005 averaged about 8.8 cents on every dollar of sales. Yahoo and Apple enjoyed profit margins of 45 percent and 22 percent, respectively, but no one is calling for legislation to reign in the profits of the computer industry.

Is this really that difficult to understand? I guess that the public just requires an enemy, and Big Oil fits the bill. If we focus our anger on Big Oil, perhaps we won’t focus it on the politicians by throwing them out of office.

Many factors have contributed to the sharp rise in the price of crude oil. An analysis by a writer for the Knight Ridder newspapers noted the following: growing global demand for oil, spurred by economic expansion in India and China; a contraction in the supply related to political unrest in several oil-producing nations — most notably, Nigeria and Venezuela — as well as reduced production in the Gulf of Mexico caused by Hurricanes Katrina and Rita; and market jitters sparked by worries about a possible confrontation between Western nations and Iran, the world’s fourth-largest oil producer, over the Islamic country’s nuclear program.

Supply and demand, sprinkled with a dab of fear. Just like I have been saying.

A fear is that Congress will respond to public complaints about gas prices with ill-conceived legislation aimed at controlling the oil market. In the past Congress has tried price controls and a windfall profits tax, with unfortunate results. This kind of interference in the market invariably leads to decreased supply and higher prices as oil companies respond to the politically contrived disincentives for production.

But who’s worried about a little gas shortage, when reelection is at stake?

From the Appeal Democrat:

Apr. 27–April 27, 2006 – If only automobiles could run on hot air from politicians bloviating about high gasoline prices. Then we might have something.

President Bush is the latest to jump on a bandwagon overcrowded with the likes of Chuck Schumer, Nancy Pelosi, Bill Frist, Dennis Hastert, Arlen Specter, Dianne Feinstein and Arnold Schwarzenegger, announcing a probe into possible “price gouging” by oil companies and ordering a temporary halt to deposits in the Strategic Petroleum Reserve. (3)

I wish both sides would stop pointing fingers at each other. This situation is so much worse because it is an election year. Getting the parties to work together to address the long term issues is probably hopeless. We’re in serious trouble if we can’t get a plan in place well in advance of Peak Oil. We may already be too late for that.

Oil companies would no doubt love to dictate and manipulate the prices of oil and gasoline if they could. But none has the market power to do so. The current price of oil, at something more than $70 a barrel, up about 20 percent since January, is the result of high demand due to a number of factors, including conversion to ethanol from MTBE, as well as economic growth, mainly in the United States and China, along with political uncertainty in oil-producing countries like Venezuela, Iraq and Iran. Oil companies benefit from these high prices, but the prices are determined by supply and demand.

One thing I have realized lately is that very few people in the country actually understand how markets work. They seem to think that oil companies look at production costs, and say “Let’s charge $3.00; that should cover costs and provide a nice profit.” It just doesn’t work like that.

If Congress were serious about reducing gasoline prices, it would start by repealing the energy bill it passed last year, especially the ethanol mandate. Ethanol is difficult to store and ship outside the Midwest, and corn farmers cannot yet supply the amounts mandated. So the price has risen from $1.45 a gallon to $2.77.

They obviously hate the environment. 🙂

Coming Attractions

A comment left by a visitor sparked an interest in doing some research on biomass to liquids (BTL). I am going to devote an upcoming essay to a review of gas to liquids (GTL), coal to liquids (CTL), and BTL. These technologies have the potential to offset some of our usage of petroleum, but the capital costs are very high, and 2 of the 3 still rely on non-renewable energy. I will also discuss the “L” portion that is common between the technologies: The Fischer-Tropsch reaction and why it is very important.

References

1. This was Sen. Charles Grassley’s reasoning for requesting tax records of all the major oil companies.
2. “Gasbags”, The Paducah Sun , April 27, 2006.
3. “Big Oil doesn’t cause high prices at the gas pump”, Appeal Democrat , April 27, 2006.

April 27, 2006 Posted by | politics, price gouging, profit margins | 18 Comments