Everyone needs a scapegoat right? Well currently, it seems as if the oil industry has become that for angry consumers bleeding from the wallet at the gas pumps. The question, though, is whether big oil is really just a scapegoat, or whether we really are looking at price gouging going on here.
In taking a look at this, I examined five companies from the oil group – ExxonMobil Corp (NYSE:XOM), Chevron Corp (NYSE:CVX), Occidental Petroleum Corp (NYSE:OXY), Western Refining Inc (NYSE:WNR) and Valero Energy Corp (NYSE:VLO). Of the group, we have two large-cap diversified oil companies in ExxonMobil and Chevron, two refiners in Western Refining and Valero, and one exploration and manufacturing player in Occidental.
I stayed away from the drillers and equipment providers here, mainly because I don’t see them as having a huge part in any price gouging that is/isn’t going on. Of course, investors in those companies still ought to pay very close attention to this issue because if the producers and sellers of oil take a hit, well that’s certainly going to filter down through to their equipment suppliers. So the exercise here is to look at the current controversy around the oil industry and figure out what is meant by “price gouging” and whether some tax on the oil industry’s “windfall profits” is necessary.
Now one of the biggest misconceptions here is that oil companies are simply making too much profit as an absolute measure. Headlines scream that Exxon is earning profits that are at the top of the list for all time corporate profits. This really means very little, Exxon is a huge company that does over $300B in revenue on an annual basis, and if you compare that to other large cap companies like Microsoft Corp (NASDAQ:MSFT), who does around $40B in revenue per year, or General Electric (NYSE:GE), who does around $150B in revenue per year, you have to figure that Exxon should come in at the top end of corporate profits. Saying that Exxon is making a huge absolute number on their profit line is really just the wrong way to look at this.
What you really need to do here is look at how much the companies are charging for the gas versus what they have to pay for it. A company’s gross margin is probably the best way to do this. Gross margin is simply gross profit as a percentage of total sales – and gross profit is equal to total sales minus the cost of the raw goods used to make them.
So if I’m an oil company and I buy a barrel of oil for $50 and resell that for $100 then my gross margin would be about 50%. If the price of that barrel of oil goes up to $70, then gross margin drops to 30% - alternatively, I could raise my price from $100 to $140 and keep my 50% margin. However, if I bump my price up to $200, my margin goes up to 65% and people might claim that I’m taking advantage of the situation and price gouging.
Unfortunately, using this logic on Exxon or Chevron to claim gouging doesn’t hold any water; in the last three to five years, both companies have seen declining gross margins, basically suggesting that they’re being hurt more than helped by the high oil prices.
On the other hand, a look at the other companies that I examined, Occidental, Western Refining and Valero, shows that all of these guys have had increases in their gross margins. So the question here becomes where exactly do we cross the line of price gouging and when does it become necessary to instate a tax on profits above a certain level.
My take on this is simply that there is no line, that we are operating under a capitalist system and we need to allow market forces to run their course. Of course, please note here that this blog is not about politics, it is about stocks and business, and so my take is geared towards what is most logical economically.
Let’s step back and go to that intro economics class that a lot of you may slept through at some point in your college career. The very first concept of economics is the idea of the relation between supply, demand and price. If supply remains constant and demand rises, price goes up; if demand moves the opposite way, price falls. If demand remains constant and supply goes up, prices fall; if supply moves the opposite way, prices rise. And if demand rises and supply falls, prices are going to go up in a big way.
This is what we’re seeing in the oil market today – demand is high as the two behemoths of China and India continue to chug through their industrial revolutions, not to mention the U.S. consuming as much oil as ever, and, at the same time, supply has been constricted in a number of ways, not least of which being the 50% drop in production in Iraq since the war and the continuing terrorist threats along the pipelines in Nigeria.
Good business practice means finding the right price so that you will sell the right amount of product for as much as possible. Economically speaking, it is a dangerous precedent to say what is and isn’t an acceptable level of profit for a company to have. If we say that Occidental, with a gross margin in the mid 60’s at the end of 2005, or Valero, with a gross margin of just under 13% for 2005, is charging too much for their product, then what does that mean for Microsoft, who has nearly an 85% gross margin, or Pixar (PIXR) with a 93% gross margin? Of course these are different types of businesses, but the point here is that it would be very arbitrary for the government to step in and decide what level of profit a any of these companies should have, and it will be a dark day for American business if this does happen.
The takeaway here on the investing front is that oil prices are not arbitrarily high, they are high for very good reasons and the oncoming summer season (when people do more traveling by car) is likely going to push them higher. While a certainly a risk, the probability of the government actually instating this profit tax is pretty unlikely.
Further, any of a number of possible things could happen in the meantime that could send prices higher; these include more attacks on Nigerian pipelines, Chavez doing something goofy with the oil down in Venezuela, more unrest in Iraq, a U.S. conflict with Iran, etc, etc. For investors, this means that oil companies should be able to continue to produce nice earnings and strong share price gains. It also means that those drillers and other oil industry capital equipment manufacturers that I mentioned above will see strong demand as more investment goes into finding and pumping new oil.
On top of that, it also bodes well for the companies out there working on products that circumvent the need for oil, and this would include solar players like SunTech Power Holdings Co Ltd (NYSE:STP), Evergreen Solar (ESLR) and SunPower (NASDAQ:SPWR), in addition to other alternative energy producers like Zoltek (NASDAQ:ZOLT).
In the area of oil capital equipment, Hydril Company (HYDL), is one that I see as particularly promising – they provide the connection and pressure control equipment for drilling oil in highly stressful environments such as deep ocean drilling. As oil companies continue to search high and low for new sources of oil, it is increasingly likely that they are going to start looking in places that are more difficult to drill.
And in the area of solar power, I still stand behind SunTech as the only profitable solar cell company on the U.S. exchanges (Q-Cells and Solarworld on the German exchanges are just as profitable as SunTech). While Evergreen and SunPower certainly have a lot of promise, I will take the company with current profits any day of the week.
As a disclaimer, I own shares of both Hydril and SunTech.