Wednesday, October 21, 2009

Oil Profits and Energy Independence

Recently I have been hammered by people who are once again accusing “Big Oil” of making obscene profits and gouging customers. These accusations seem to be just a knee jerk reaction to gas pump prices fueled by various politicians who find Big Oil to be a Big Target. But efforts to explain the fluctuations in oil prices or even how business – any business – operates seems to fall on deaf ears; therefore I guess this is a lesson in elementary economics -- the law of supply and demand. Economics has laws that are as immutable as the laws of physics but for some reason the laws that govern our economy are rejected out of hand by glib politicians and those who can't look beyond the immediate impact to discover the force behind that impact.

Wealth and Taxes
It is always popular for a politician to demand that the rich pay more, that we should tax the rich. Ignoring that these politicians almost never describe who is rich, but lets just follow that reasoning to its conclusion, which is that higher taxes lead to lower revenues! How can that be? The reality is that taking money (capital) from the rich (the capitalists) and giving it to the poor means the rich have less money to invest. With less capital available businesses cannot expand and add new jobs and may actually have to contract and lay people off. With fewer jobs there are fewer people earning money and paying taxes and many may become non-tax paying or even consumers of tax dollars in the form of unemployment benefits. Once the rich have had their capital reduced through taxation they have less to invest and so their income goes down and the taxes they pay are reduced. If the government responds by raising taxes even higher then we enter a downward spiral leading to greater unemployment and reduced revenues and a declining standard of living. Once this spiral begins it is very difficult to reverse because politicians are allergic to the solution which is lowering taxes.

Revenues and Profits
The favorite target here seems to be big business but especially the oil companies who are accused of making obscene profits. Of course this accusation of obscene profits comes from politicians who are almost always lawyers with no experience whatsoever in business and the man-on-the-street who just sees the price of gas at the pump. All he knows is that the ignoramus he voted for is telling him the cost of gas is because of greedy oil moguls and not the taxes they put on the gas or the restrictions they have placed on the oil companies, or the distinctions between profit and revenues, those are ignored.

Yes the revenues of the oil companies are substantial but surely most people know that their annual salary is only a fraction of what they take home in their paycheck. So the annual salary is the revenue, the paycheck is income after tax, and the take home pay is the profit. This is very analogous to how business operates. Those so-called obscene profits are in reality the gross revenues. Once the taxes have been paid to the federal authorities, the state, and local governments (and in some cases foreign governments as well) the companies have their after tax revenue, then they must deduct their expenses, which include exploration, salaries, transportation, environmental costs, etc etc. The actual bottom line profits have historically been in the 10% to 12% range and this is over decades. Even though this information is readily available from the Federal Government the politicians don't want to acknowledge that because it might draw attention to their regulations and taxes that lie at the heart of the cost of gas at the pump.

Law of Supply and Demand
The complaint has been that oil companies are cutting back on production and the cost of gas is sure to rise because the oil companies are run by greedy businessmen who are out to gouge the consumer. In reality this is an example of "The Law of Unintended Consequences". Like all businesses the oil companies are governed by the law of supply and demand. The Department of Energy, the Environmentalists, the EPA, and of course all of the politicians have been pounding the drum and beating on GM to reduce gas consumption. Surprise!! This is actually working and the result has been that OPEC is wallowing in oil because the demand has gone down as refineries cut back their production as the demand for gas goes down. Is there cheering in the streets? Is GM up for any medals from the DOE? of course not -- the hue and cry is that the price of gas may (or is) go up. Well the taxes haven't been reduced, the restrictions on the oil refineries hasn't changed -- just the demand for a finished product. This is where mass production comes in -- the more units I produce the lower the cost per unit and as I reduce the number of units produced the cost per unit increases. So as the demand for gas declines the refineries cut back on production and as the volume decreases the cost per unit increases. These changes in volume and revenues do not fall to the bottom line because all of the parameters remain the same. So in effect the environmentalists have succeeded in reducing the demand for oil but were unprepared for the success of their program. The Law of Unintended Consequences strikes again as the demand goes down the price goes up.

Energy Independence
The cry has been that America should be Energy Independent and this is the mantra of most politicians because it is popular with the people. Although the DOE was created for the sole purpose of making America Energy Independent no one seems willing to point out how bloated this organization has become in spite of it total failure to achieve its objective.

Generally when this subject of energy independence comes up, it is interpreted to mean independence of imported crude oil and independence of OPEC. However it is the Federal Government that has prevented the development of proven reserves or offshore exploration while foreign governments are actively exploring the very areas the American companies are seeking to explore. So it is the Federal Government that is directly increasing our dependence on foreign oil by placing environmental restrictions and legislative roadblocks on the American companies that prevent these companies from actively adding to the domestic supply of oil.

But suppose the US stopped importing any oil what would happen? Certainly the price at the pump would decline since the price would be determined by the domestic market but the real impact would be on those countries that currently sell oil to the US. Canada and Mexico would be hurt but Venezuela would be devastated. If the US were to suddenly become oil independent it would have destabilizing impact on the world economy, so even if the US did have the ability to be oil independent this independence would have to be phased in.

But there is another dimension to the price of gasoline and that is the dollar. The American Dollar is the reserve currency of the world and the price of oil is tied to the dollar so as the value of the dollar declines the price per barrel goes up and this translates directly to a higher cost of gasoline. The value of the dollar is driven by many factors but not the least of which is the supply of dollars. As the supply increases the value declines so as the government continues to fund these huge stimulus packages and social programs by printing dollars, the value of those dollars decreases, which drives up the cost of everything including oil. If the government were to reduce the supply of money then the value of the dollar would rise and the price of oil would decline since a dollar would buy more.

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