Anything can sound right, especially when articulated by a pro, but doesn't always pass the smell test. As a Democrat, I want to think that my party can do no wrong; however, the harsh reality is that no one gets it right all the time.
Lately, several Democrats including presidential candidate Senator Obama have been advocating the idea of a windfall profits tax on oil companies. Sparked by the unprecedented quarterly profits reported by Exxon Mobil (XOM) the theory goes that oil companies that make a lot of money should give some back to the public or be taxed an additional amount to further subsidize the development of alternative sources of energy.
It sounds good and is gaining popularity with the general public. However, it smells to high heaven! Exxon Mobil (XOM), Chevron (CVX) and ConocoPhillips (COP) all compete with each other and several others like BP plc. (BP) Total (TOT) and Royal Dutch Shell (RDS.A). But that is only half the story. All compete as well with far larger competitors such as CNOOC (CEO) and PetroChina (PTR) which give the appearance of being public companies yet both are controlled by Beijing (China). Not to mention of course the 'supply side' state owned oil companies of oil producing countries where a number of them dwarf the collective muscle of all of the above.
The bottom line is that there is fierce global competition for resources. Instead of awarding a Congressional medal of honor to XOM, CVX and COP for holding their own in the battlefield, Senator Obama and others want to shoot our own soldiers in the back!
Success and Efficiency
Yes, the numbers are big and they will get even bigger. This is the nature of progress but this is not how you measure success and efficiency. For efficiency, use the net profit margin to see if there is enough competition. If the margin is way above norm, then there is inefficiency. If the number is too low, then our boys may need Washington's help to compete in the so called free market out there. At 10% to 13% net, our boys deserve a medal for holding their own.
On the success front, we are experiencing mixed results. Measured by the number of years of reserves that each company has, COP is barely holding its own taking into account the Venezuelan loss. CVX and XOM have seen better years. Reserve replacement is not keeping pace. Though there are several prospects on the horizon, we need to continue working with proven reserve figures and not change the method of calculation.
Houston, We Have a Problem
If you want to talk about hideous obscene profits and profit margins, then look no farther than Transocean (RIG). RIG just reported a whopping net double YOY (see earnings call transcript). Again, it's not the big number that matters! Though the net is over $1 billion it could be $10 billion and that would not be cause for concern. What does matter is that the $1B net earnings were achieved on $3.1B revenue. A net profit margin that exceeds 25% is astonishing for the drilling sector.
Pundits are likely to conclude that there is room here for a windfall tax and I would be inclined to agree. Obviously, there is not enough competition in the rig business. This is where Democrats and Republicans historically differ in opinion. The Republican approach is that the Government should stay out of free trade and let the market take its course. Eventually there will be more competition and margins will revert to the norm. Democrats will advocate that there is real danger of a monopoly type market evolving and intervention is needed. In order to assure that Joe six-pack doesn't get screwed at the pump a windfall tax should be imposed.
Having stated my political inclination, I trust that my Republican brethren will find the above fair and balanced. Normally I stick to analysis and don't write about politics, though at times the two are intertwined.
Hold the Horses
Without going into all the arguments whether or not windfall taxes work or exacerbate obscure market anomalies, a deeper understanding of the offshore drilling segment reveals that current margins are temporary at best.
Over the past five years there have been technological advances in offshore drilling, primarily related to underwater depth limitations. This has spurred a flurry of activity for a number of companies and countries. Too deep to be of use is now beginning to come online and is likely to continue over the next decade.
As with any new technological advancement, those that are at the forefront usually reap the benefits until the rest of the world catches up. In the drug industry, patents are used to assure a number of years of uninterrupted profits. In the military aerospace industry, secrecy and other measures insure years of continuous profits and supremacy. In the rig industry there are no such luxuries. Economy of scale is the only known method to ensure the foreseeable future.
Already, several competitors are appearing on the radar some backed by governments with deep pockets. India hasn't officially declared that it wants to be a major player in this segment as a stated State policy; however, both Chinese and Japanese companies are gaining traction. Transocean (RIG) is in the process of establishing itself as a world leader. Before we awaken to a new crude reality, let's not kill the horseman!
Disclosure: Numerous conflicts both long and short, pertains to personal, clients and associates, both direct and indirect. Example of indirect: long OMNI.