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By Robert Rapier on May 4, 2006 with no responses

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.