Busting the Myth About Oil Company Profits

Includes: BP, COP, CVX, RDS.A, XOM
by: Bob van der Valk
What can we do to stop commodity speculators from causing the rapid hike in gasoline prices? Arrest them, put them in jail, and try them before a jury before we hang them?
Early last week, President Obama started that ball rolling by telling U.S. Attorney General Eric Holder to stop oil market fraud. Holder promptly announced he was appointing a “working group” focused on rooting out the cases of fraud in the oil markets that might affect gasoline prices. This might work in any other business, but the petroleum industry is not going to be simple to control.
Later in the week Exxon Mobil (NYSE:XOM) reported first quarter profits went up a whopping 69% to $10.7 billion from the same quarter a year ago. This ignited a firestorm almost immediately, raising the ire of politicians and activists alike who accused the oil industry of profiteering while Americans pay nearly $4 a gallon for gasoline.
Instead of being good news, it was reported as bad news on the front page of major newspapers and became the lead off story on most TV and radio news broadcasts.
On the other hand Apple (NASDAQ:AAPL), which showed a 95% increase in net profits in its quarter, from $3 billion to $6 billion, had Steve Jobs proudly announce those results in his April 20, 2011 news conference.
No one screamed “off with their heads” about Apple’s profits, so why all the brouhaha about Exxon Mobil and the other oil company’s profits? Surely they are both stalwart organizations making the capitalistic system work for their shareholders, expecting to receive a fair return on monies invested in those companies. They should be allowed to make a profit with products everyone either wants or needs and you can charge for them according to what the market will bear.
Exxon Mobil sent out Ken Cohen, Vice President of Public and Government Affairs, to face skeptic reporters at a news conference on April 28, 2011. He launched a preemptive public relations strike to blunt expected criticism from politicians and the public about of seeing gasoline pump prices increase along with Exxon Mobil’s profits.
The following graph from the U.S. Energy Information Agency (EIA) shows the results of what happens to oil company profits when crude oil prices increase:
Click to enlarge
Ken Cohen wrote an article entitled: "Gas prices and industry earnings: A few things to think about", which can be read it in full on the Exxon Mobil Perspectives blog.
Exxon Mobil does not own the patents to the iPhone or iPad franchise but they have something even better by being the largest company in an oligopoly made of oil companies producing a product we cannot do without, fuel.
A few of the talking points used in Ken Cohen’s article need closer scrutiny and examination since they are now been repeated almost verbatim by pundits and analysts alike:
  • Point: We don’t own 95% of our station, and therefore we don’t set the price.
  • Counterpoint: The first part is correct; however the retail pricing manager for Exxon Mobil checks the spot market regularly during the day and makes wholesale pricing decisions dependent on the area of the country. The methods used by Exxon Mobil are rack and zone pricing giving them the ability charge whatever the market will bear. The competitive pricing data is gathered for them by third parties such as Oil Price Information Service and The Lundberg Survey. The latter is the most important one since Lundberg gathers Dealer Tank Wagon (DTW) prices for each locale in which ExxonMobil has retail operations. Rack pricing is used to set the wholesale prices for either branded or unbranded gasoline. The DTW prices are charged to those dealers that have branded supply contracts direct with Exxon Mobil. These are not the prices posted on the pumps at the station and are the most secretive part of gasoline retailing. Zone pricing, or a Temporary Voluntary Allowance (TVA) method of pricing, controls almost 85% of all the branded-contracted gasoline sold in the U.S. with the difference sold to unbranded non-contracted stations.
  • Point: Local stations are often owned by a businessman or businesswoman in your community, and they set their own prices based on local market conditions.
  • Counterpoint: The owner or dealer of a local station receives deliveries of gasoline with the new wholesale price set by the oil companies, and then adds a margin to the gallon of gasoline. They are contractually obligated with long term supply agreements to only buy from the “branded” supplier with whom they signed up.
  • Point: For every gallon of gasoline, diesel or finished products we manufactured and sold in the United States in the last three months of 2010, we earned a little more than 2 cents per gallon.
  • Counterpoint: Adding all the oil company profits together including their upstream, downstream and chemical divisions and then dividing that amount by the total gallons of fuel sold is somewhat misleading. Each one of those is separate profit centers and not the only products sold by the oil company. The following Energy Information Agency graphs shows the breakdown of the average price for a gallon of gasoline paid at the pump in March 2011:
  • Point: Crude oil is a commodity, and like all other commodities – such as corn, wheat or sugar – the price is determined by buyers and sellers in a global market.
  • Counterpoint: Exxon Mobil is one of five “super major" vertically integrated oil companies in the U.S. controlling the process of refining gasoline from the wellhead to the pump. Crude oil, the raw material from which gasoline is refined, is either purchased or obtained from company owned or controlled wells with prices set according to the gravity of the crude oil. Exxon Mobil utilizes the "Last In/First Out" method of accounting and the last price at which crude oil was obtained establishes the posted price for crude oil delivered to their refinery gates.
  • Point: Exxon Mobil owns less than 1% of the world’s oil reserves, and it produces less than 3% of the world’s daily oil supply.
  • Counterpoint: Exxon Mobil is the largest oil company in the world and when the elephant in the jungle trumpets, the market listens. The throughput of its refineries and percentage of market share have a big influence on the other oil companies’ reaction on how they in turn price their products.
  • Point: Last year, our total taxes and duties to the U.S. government topped $9.8 billion, which includes an income tax expense of $1.6 billion.
  • Counterpoint: This is a somewhat misleading statement since taxes and duties include tax credits allowed on payment to foreign governments. It is another subsidy, devised by the U.S. State Department in the 1950s, which allows U.S. based oil companies to reclassify the royalties they are charged by foreign governments as taxes. Those can then be deducted dollar-for-dollar from their domestic tax bill. That provision alone will cost the federal government $8.2 billion over the next decade, according to the Treasury Department. These are currently allowed to be reported as taxes paid to the U.S. government. The following opinion re-printed from the Harvard Law Review gives a more detailed explanation on how this works:
BP (NYSE:BP), Chevron (NYSE:CVX), ConocoPhillips (NYSE:COP) and Shell (NYSE:RDS.A), the other four super-major oil companies, said their profits rose in the first quarter because of soaring crude prices and other factors.
Members of Congress and President Obama used the record setting earnings reports to step up calls for the repeal of the $4 billion in annual depletion allowance tax breaks for oil producers. John Boehner (R-Ohio), Speaker of the House, first seemed to want to go along with eliminating this tax break only for the large oil companies, but then changed his mind.
Jeff Sheets, Chief Financial Officer of ConocoPhillips, said that while the industry's profits are higher, the margins are still slim compared to the amount of assets oil companies maintain, and profits haven't risen as fast as gasoline prices. “When critics focus only on the bottom-line number, they lose the scope of what's required to produce that profit," Sheets said.
The industry further argues that ending tax breaks would cut investment in new oil and natural gas projects, cost new jobs and decrease oil and natural gas production.
Senate Majority Leader Harry Reid (D-Nev.) said the Senate as early as next week could take up Obama's proposal to halt the tax breaks, and Obama said the $4 billion a year in oil subsidies would be spent on alternative energy investments.
Holding a commodity off the market and then selling it after the price goes up is only one form of speculation, and it’s not one that works very well in the oil market. Simply put when gasoline prices increase so do profits for the oil companies.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.