Ask the blogger

Another reader emails:

You just answered a reader question about oil prices, I hope you'll answer one about oil company profits, too.

My understanding is that oil companies buy crude oil from various places, refine it into gasoline, and sell that gasoline to stations around the country where we pump it into our cars. Recently, the cost of oil has skyrocketed, as have oil company profits. My understanding of the oil companies' defense of their profits when grilled by Congress
a while back was "It's not our fault that we're doing well: we don't control the cost of oil -- we can't help it that it's expensive, and when gas is expensive we make more money."

This seems exactly backwards to me: what kind of industry sees profits go up when its costs go up? Shouldn't expensive crude oil be terrible for an industry buying that oil and selling a derivative product to customers used to it being very cheap and lightly taxed?

If you answer this I might ask why so many economists want to get rid of the penny at the same time that businesses seem perfectly happy to buy them on their own accord.

Last question first: businesses like pennies because they believe that pricing something at $4.98 is psychologically different from pricing it at $5.00. Economists hate pennies because you shouldn't have a unit of exchange that can't buy anything. Pennies cost more to make than they are worth, and then waste valuable human time carrying and counting the things.

First question last: there are multiple oil industries. Not everyone extracts oil; those that don't are seeing their margins decline, just as you would expect. It is the companies that own oil fields which are posting high profits.

Comments

Megan,

Even if they got rid of pennies, they'd still price things in them--they'd simply round to the nearest nickle. You'll still buy things for $4.98, but in cash transactions the price will be rounded to $5.00.

Posted by Miser | May 9, 2008 1:58 PM

API used to have a helpful primer on gasoline prices, but it's gone off of their website. Some industrious reader might be able to find it, or its equivalent, with a few minutes' searching.

Megan makes a good point that is generally overlooked: not all "oil companies" have the same interests; similarly, not all "energy companies" have the same interests. In fact, energy companies fight eachother constantly; one set of circumstances profits Company A but hurts Company B. This is the sort of thing that we shouldn't have to come to Megan to learn; the MSM can and should be a little bit more informative on economic issues.

Just sayin'.

Posted by Ludwig | May 9, 2008 2:05 PM

Thats what bothers me about getting rid of the penny really--- while a penny in and off itself can't buy anything, getting rid of them while retaining the penny based amounts effectively injects irrational numbers into shopping. Me no like.

Posted by toxic | May 9, 2008 2:09 PM

Given the relative inelasticity of demand, couldn't hire crude prices also lead to higher profits? Perhaps not the enormous profits we're seeing... but a 10% profit margin (about what Exxon makes) gives you a lot more take home profit when the sale price has doubled, even if your cost has doubled as well.

Also, with something like 90% of the world's oil supply held by national entities, doesn't that sort of give the lie to the idea that there are companies that 'own' oil fields that are the ones with the huge profits?

Exxon has to buy more than half their oil, as does Chevron. Conoco buys about 75% of their oil. All of these companies seem to be doing well.

Posted by RMH | May 9, 2008 2:24 PM

People often forget that the US is the 3rd largest oil producer in the world. When oil is worth a lot, US oil companies make a lot of money.

Posted by Njorl | May 9, 2008 2:30 PM

Even if they got rid of pennies, they'd still price things in them--they'd simply round to the nearest nickle. You'll still buy things for $4.98, but in cash transactions the price will be rounded to $5.00.

Mostly because of different state sales taxes, though. Japan still has a one yen coin, but the vast majority of prices are priced so as to come out to an even multiple of 5 yen after the 5% consumption tax. (And the tax included prices are generally posted.)

Given the relative inelasticity of demand, couldn't hire crude prices also lead to higher profits? Perhaps not the enormous profits we're seeing... but a 10% profit margin (about what Exxon makes) gives you a lot more take home profit when the sale price has doubled, even if your cost has doubled as well.

No, because gasoline prices have not risen as fast as crude oil prices. The profit on a gallon of gas is smaller at every step from the refiner to the gas station, though much higher for most producers. See the DOE's Energy Information Administration website for details.

Posted by John Thacker | May 9, 2008 2:38 PM

"Also, with something like 90% of the world's oil supply held by national entities, doesn't that sort of give the lie to the idea that there are companies that 'own' oil fields that are the ones with the huge profits?"

That depends on how those nationally controlled fields are exploited. Saudi Arabia used to lease fields to companies for fixed payments and royalties, with the company getting what it could for the oil it extracted and footing the bill for development costs. I believe there are still some nationally owned oil fields thet work this way. If the lease is negotiated at a time of low prices, the company would profit more now than the country.

Posted by Njorl | May 9, 2008 2:38 PM

I believe there are still some nationally owned oil fields thet work this way. If the lease is negotiated at a time of low prices, the company would profit more now than the country.

And this is essentially the complaint with some of the US offshore oil fields. Oil exploration contracts signed with the Clinton Administration during a time of very low gas prices have very low royalty payments. There has been a movement in Congress and elsewhere to change the terms of these contracts with prices 5-10 times higher than when the contracts were signed. (The contracts failed to include a sliding scale if the price of oil went up.)

Posted by John Thacker | May 9, 2008 2:54 PM

Njorl, John,
Good points, thanks.

So oil companies, to a certain extent, do 'pump' their own oil, even if they may not own the fields they are pumping that oil from. Presumably, they're paying significantly less than $125 a barrel for it.

John - when you say the 'profit on a gallon of gas is smaller...', do you mean the actual profit, or the profit margin? If its the actual profit, how does one explain the success of a company like Conoco that has to buy 75% of its oil on the open market?

Also, it would seem that there must be massive stockpiles of crude involved with the large oil refiners. As I understand it, a barrel of crude can yield something like 20 gallons of gasoline and some other usable products. Estimating that the 'other stuff' yields half the market price of gasoline, you've got 30 gallons to sell. Even at $4 a gallon, that's only $120.

Looking at $125/barrel futures prices for oil - at what point in the future does the cost of that particular barrel move into the supply of gasoline?

Posted by RMH | May 9, 2008 2:55 PM

Thats what bothers me about getting rid of the penny really--- while a penny in and off itself can't buy anything, getting rid of them while retaining the penny based amounts effectively injects irrational numbers into shopping. Me no like.

Not irrational-- at least, I can't think of anything that would produce an irrational number in a typical transaction-- just cents that get rounded off, just like we do with fractional cents now. (Say you live someplace with 8.75% sales tax, and buy something marked $2.99. So the total would be $3.251625-- but you'd pay $3.25. Where's the merchant's 1.625 mills?)

When I was a kid, the US got by without any coins worth less than a nickel is worth now. In the 1940s, we didn't have any coins worth less than a modern dime. It doesn't really make sense to me that we need to have our currency become ever more finely-grained, even as cash transactions decline proportional to other sorts. I'd propose that we set some baseline year, and eliminate any coin worth less than half what the least valuable coin was worth in that year.

But I grant that that's unlikely to happen, due to sentiment. So we have pennies worth less than the never-minted mill coin would have been worth when it was proposed and rejected, and in a few decades (or less, if inflation gets worse) we'll have effective tenth-mills cluttering up pockets, jars, and desk drawers.

Posted by Mike S. | May 9, 2008 2:56 PM

It always astonishes me that liberals harp on this. Aren't they the ones always telling farmers of some sort to bury crops to boost their profits? How come when the supply vs demand mismatch comes from burying your own crops, it's easy to see how this will boost your profits. But when the mismatch comes from a steady increase in demand followed by a steady steadiness in supply, suddenly it requires a congressional investigation?

Posted by Josh | May 9, 2008 3:03 PM

John - when you say the 'profit on a gallon of gas is smaller...', do you mean the actual profit, or the profit margin?

Actual profit, according to the DOE, at least right now. March 06, average cost of a gallon of gasoline, $2.425, of which 21.7%, or 52.6 cents per gallon, was refining. Mar 07, $2.563, 23.7% refining, or 60.7 cents per gallon. But Mar 08, $3.244 but only 8.0%, or 26.0 cents per gallon refining payments. I agree that it's an unusual result, but that's how it is currently.

Meanwhile, crude oil has increased from a historically typical 50% of the retail cost of gas to 70%.

If its the actual profit, how does one explain the success of a company like Conoco that has to buy 75% of its oil on the open market?

The situation was different in 2007. 2008 has been odd so far.

Posted by John Thacker | May 9, 2008 3:13 PM

"Not everyone extracts oil; those that don't are seeing their margins decline, just as you would expect. It is the companies that own oil fields which are posting high profits."

To be more precise, most the companies that own or lease oil fields are posting high profits, as are the companies that lease them the equipment to extract the oil, and the companies that ship the oil. Companies that don't produce their own crude, but buy crude to refine it into gasoline aren't doing well.

Here's a handy picture to illustrate this: compare the stock performance over the last three months of Vaalco Energy (EGY), which explores for and extracts crude oil, and Frontier Oil Co. (FTO), which buys crude and refines it: FTO versus EGY.

Posted by Fred | May 9, 2008 3:19 PM

Tying the two topics together, anyone else notice that most retail gas prices have 9/10 of a cent at the end? Everyone accepts this even though there is no such thing as a 9/10 cent piece. Getting rid of the penny wouldn't be as big of a deal as people fear.

Posted by Nelson | May 9, 2008 3:28 PM

Nelson,

What happens when you actually buy your gas? The 9/10th of a cent gets rounded up to the next cent. Same principle would happen if you got rid of the penny, except that gas prices would get rounded up to the next nickel. So if a gallon of gas is, say, $3.52 and 9/10 of a cent today, you'd pay $3.53 for it. And you got rid of the penny, they'd charge you $3.55 for it.

Posted by Fred | May 9, 2008 3:38 PM

Megan makes a good point that is generally overlooked: not all "oil companies" have the same interests; similarly, not all "energy companies" have the same interests. In fact, energy companies fight eachother constantly;

No no no, I read the news regularly, and I'm pretty sure there's only one actual oil company. It's called Big Oil, and I think it's named after Mr. Big, the guy who also started Big Tobacco. Man, he must be rich.

Posted by Geoff | May 9, 2008 3:40 PM

If its the actual profit, how does one explain the success of a company like Conoco that has to buy 75% of its oil on the open market?

Oh, and for some reason diesel refining profits are up, though gasoline is not. That's actually a big source of Conoco's profits from 1Q2008.

Posted by John Thacker | May 9, 2008 3:55 PM

I've heard that if you buy gasoline in increments not divisible by 10 gallons, you need fractions of a penny in order to pay for the last gallon.

At any rate, I don't quite follow the idea that the penny is a problem for economists because it doesn't buy anything. What can you buy with a nickel or a dime these days?

Seems like the greatest value of a penny is that it allows a dollar to be subidvided into 100 parts and thus implicitly accommodates tax rates and surcharges denominated as percentages of a total. Albeit those are sometimes bonkered with fractions, too.

Posted by aMouseforallSeasons | May 9, 2008 4:41 PM

Seems like the greatest value of a penny is that it allows a dollar to be subidvided into 100 parts and thus implicitly accommodates tax rates and surcharges denominated as percentages of a total.

No more so than any other subdivision would, unless prices were required to be in whole-dollar amounts. Apply a percentage tax to a price like $5.99, and you're probably going to be rounding somewhere, whether it's to the nearest penny, nickel, or dime. A 3% tax makes that $6.1697, a 7% rate $6.4093, 10% $6.589.

So we currently call that $6.17, $6.41, and $6.59. We could as easily call it $6.15, $6.40, and $6.60. (Or, for that matter, $6.2, $6.4, and $6.6, given that a lifetime ago the same prices would have been 62 cents, 64 cents, and 66 cents, without anyone worrying about gaining or losing that last fraction.

(A penny used to be a tenth or more of a loaf of bread, and people apparently didn't demand anything smaller. Now it's generally less than a hundredth. At what point does it stop being worthwhile to have around? A thousandth? Less?)

Posted by Mike S. | May 9, 2008 4:57 PM

1) Pass a law requiring that prices be calculated out to the mill.

2) Require purchases to be charged to the mill for electronic funds purchases, checks, and other transactions where there's no currency-bounding.

3) Abolish the penny. Round to the nearest five cents for cash purchases (1-29 mills and 51-79 mills round down, 30-49 and 80-99 mills go up).

4) Switch the nickel to the Canadian composition. Yes, this end the convenient "one nickel is exactly five grams" relationship, but it eliminates the metal-higher-than-face-value problem.

5) Abolish the dollar bill. We have dollar coins.

Posted by Oildrilling Lunatic | May 9, 2008 5:11 PM

It's called Big Oil, and I think it's named after Mr. Big, the guy who also started Big Tobacco. Man, he must be rich.

He's the guy on the Monopoly cards - he has lots of money....

On another note, some divisions of oil companies get hammered as prices rise - chemical divisions. Most major oil companies have divisions that sell chemicals for plastics, etc. that do better when oil is cheap and economies are expanding. It's a way of using every last drop in a barrel and damping out the highs and lows of crude prices.

Posted by ech | May 9, 2008 5:13 PM

Er, 1-24 mills and 51-74 mills down, 25-49 mills and 75-99 mills up.

Posted by Oildrilling Lunatic | May 9, 2008 5:18 PM

I buy gumballs with pennies.

So...there!

Posted by Nessuno | May 9, 2008 5:27 PM

A penny used to be a tenth or more of a loaf of bread, and people apparently didn't demand anything smaller. Now it's generally less than a hundredth. At what point does it stop being worthwhile to have around? A thousandth? Less?

Never?

I would wager most folks in the US have more pressing things to worry about than whether or not to pull a John Wilkes Booth. Since the penny is neither a major help nor a major hindrance to transactions, especially now that even McDonalds accepts credit cards, it will probably be around until the very moment physical currency disappears entirely.

Even then, transactions will likely be denominated to the nearest hundredth of a cent, because humans like to do their figuring on fractions of ten. It would make more sense from a numeracy standpoint to do away with nickels and quarters. Unfortunately, the latter are intimately linked with legacy vending machines.

Posted by aMouseforallSeasons | May 9, 2008 5:29 PM

I have no idea what everyone's problem with pennies is. First, you can use credit cards almost everywhere these days (even at McDonald's), so you shouldn't have a need to touch a lot of pennies anyway. When I get pennies (or nickels or dimes) as change, I put them in my big red plastic "C" from Commerce Bank (the quarters I keep separate since I can use them for parking or laundry). When the "C" fills up, I go to Commerce's Penny Arcade and exchange it for cash. Not rocket science, and not a terrible burden in my life.

Posted by Fred | May 9, 2008 5:39 PM

Even then, transactions will likely be denominated to the nearest hundredth of a cent, because humans like to do their figuring on fractions of ten.

So abolish the penny and the nickel-- it's still all fractions of ten then, and the coinage is no less granular than it was for the first century and a half of the Republic.

Or don't. If keeping them in production (and annoying me with them in my change) is worth a few dozen million dollars a year, it's not the biggest or worst waste of money and effort the Federal government's ever been involved in. (If you asked people to vote on whether they'd spend a buck a year to keep the penny in production, I imagine the majority would say yes.)

But by the same token, it seems hard to justify on the basis of anything but sentiment. (Which, in a democracy, is as reasonable a basis as anything to legislate on.) It just doesn't seem likely that, over time, we develop an increasing need for ever-smaller stores of value.

But if people like them enough that Congress won't let the mint kill them-- and thus far, that seems to be the case-- well, that's pretty much how the system is supposed to work.

Posted by Mike S. | May 9, 2008 6:21 PM

New Zealand no longer has any coin smaller than 10 cents. Prices are denominated any old way and prices are rounded to 10 cents multiples (or not if the customer is paying by credit card or EFTPOS).

Posted by James K | May 10, 2008 1:07 AM

As with the previous string on supply, demand and "futures" prices - oil companies don't necessarily buy crude oil and sell refined products at the same time.

The could have bought or developed the oil years before, there is some choice (and constraint) as to how fast to pump/refine, and one can sell in the spot or futures market.

Not all oil companies are "vertically integrated" but to address the original question of how can a company make money when it's cost go up, everything depends on when and how much you paid for it (you main cost of production).

I own interests in several natural gas royalty trusts and when the price of nat-gas goes up the earnings I get go up only slowly, since the most recently pumped gas was sold forward at an agreed upon price. You don't get the spot price of a energy product for every unit you sell. There is a long production pipeline (no pun here) in the oil and gas business and both costs and sales prices for some portion of the business can be locked in years apart from one another.

Posted by Jozef | May 10, 2008 7:39 AM

Jozef,

Do you own any of this one, Tidelands Royalty Trust? What are your thoughts on the trajectory for NG prices over the next several months?

Posted by Fred | May 10, 2008 7:57 PM

No, Fred

I don't own Tidelands but will take a look

I hold HGT, PBT (oil and gas) and PBT (an outstanding performer on the oil side)

Posted by Jozef | May 11, 2008 7:23 AM

Both blades of the scissors cut. The increasing price of oil is largely driven by demand. Since in the short run it is difficult for competition to bring new supply to the party, anyone selling the goods for which demand is rising is going to experience large profits. Once those previously marginal wells get drilled (which won't happen if we have windfall taxes!) those profits will start to be erased.

So, if demand is rising for crude, extractors get big profits. If demand is rising for refined fuel, refiners get big profits. Or, if demanding is rising everywhere, everyone gets big profits.

Posted by NoneMoreBlack | May 11, 2008 8:06 AM

Jozef,

You've done great with PBT. I own BPT on the oil side. TIRTZ.OB gets about 15% of its royalties from oil, and the rest from nat gas.

Posted by Fred | May 11, 2008 6:26 PM