Busting the myth about oil company profits

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 US Attorney General Eric Holder to stop oil market fraud. Eric 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 ExxonMobil reported their 1st quarter profits went up a whopping 69 percent 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 of the TV and radio news broadcasts.

On the other hand Apple, which showed a 95% increase in net profits in their 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 ExxonMobil 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.

ExxonMobil sent out Ken Cohen, their 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 ExxonMobil’s profits.

The following graph from the US Energy Information Agency (EIA) shows the results of what happens to oil company profits when crude oil prices increase:

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 ExxonMobil Perspectives blog at http://bit.ly/j2qbkB

ExxonMobil 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 percent of our station, and therefore we don’t set the price.
Counterpoint: The first part is correct; however the retail pricing manager for ExxonMobil checks the spot market regularly during the day and makes wholesale pricing decisions dependent on the area of the country. The methods used by ExxonMobil 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 who have branded supply contracts direct with ExxonMobil. 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 US 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.

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: ExxonMobil is one of five “super major" vertically integrated oil companies in the US 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. ExxonMobil 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: ExxonMobil owns less than 1 percent of the world’s oil reserves, and it produces less than 3 percent of the world’s daily oil supply.
Counterpoint: ExxonMobil is the largest oil company in the world and when the elephant in the jungle trumpets, the market listens. The throughput of their 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 US 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 US State Department in the 1950s, which allows US 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 US Government. The following opinion re-printed from the Harvard Law Review gives a more detailed explanation on how this works:


BP, ChevronTexaco, ConocoPhillips and Shell, 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 earning reports to step up calls for the repeal of the $4 billion in annual depletion allowance tax breaks for oil producers. John Boehner, R-Oh, 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
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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 President 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 the profits at the oil companies.

B of A New Oil Price Target Suggests $4.25 Gasoline in the US by Memorial Day

While living in The Hague, Holland as a young boy I often wondered what was on the other side of that vast expanse of water known as the North Sea. How could I have known about the vast crude oil reserves lying underneath the angry waters of the North Sea and its eventual exploration by the countries surrounding it?

Economic zones in the North Sea

Brent geese would fly over my province of South Holland much like Canadian geese fly over Montana on their way south. I now live in Terry, Montana, which is a long distance from Holland and the North Sea, but the word "Brent" once again has once again become part of my every day vocabulary while discussing the reasons for the fuel price increases.

The word Brent was originally derived from the naming policy of Shell UK Exploration and Production, operating on behalf of ExxonMobil and Royal Dutch Shell, which names all of its fields after birds. In the case of their North Sea operations the field was called Brent Goose, which was later shortened by the market to Brent encompassing similar type crude oils being produced in the area.

Brent Crude, Brent Sweet Light Crude, Oseberg, Ekofisk, and Forties are all part of the Brent crude oil sourced from the North Sea and traded on the Intercontinental Exchange in London (ICE). The Brent crude oil marker is also known as Brent Blend, London Brent and Brent Petroleum and is used to price two thirds of the world's internationally traded crude oil supplies.

Why has the Brent crude oil benchmark price become so important to consumers of gasoline and diesel? The answer: It just recently replaced the New York Mercantile Exchange (Nymex) West Texas Intermediate (WTI) as the reference price for other “crude oil baskets” such as OPEC, Dubai, Russian and even Alaska North Slope crude oils.

The problem lies with the US Commodity Futures Trading Commission (CFTC) not having the power to regulate commodity transactions on the ICE. The big money is being moved into Brent and ICE thereby bypassing the Nymex and putting the WTI crude oil secondary to Brent. Even the Alaska North Slope crude oil posting is now tracking the Brent crude oil posting.

Bank of America Merrill Lynch recently increased its forecast for benchmark Brent crude for 2011 to $122 a barrel, and said that Brent could “briefly” surge above $140 a barrel in the second quarter of 2011. For WTI crude oil, the bank forecasted an average of $101 a barrel for this year, up from $87.

Bank of America also forecasted a 30 percent chance the price of Brent crude oil would reach $160 per barrel in 2011 with global demand for oil increasing and Libya supplying about 1 million barrels per day less than it did before the NATO coalition bombing started on March 19, 2011.

Each dollar differential in the price a barrel of crude oil represents 2.4 cents per gallon change for gasoline and diesel. When the price reaches the $140 level, it will add another 40 cent per gallon to today’s $3.856 per gallon national average price for unleaded gasoline per AAA Daily Fuel Gauge Report. That means $4.25 per gallon for regular gasoline by the end of May, which is right at the beginning of the summer driving season.

The average gasoline price in the US could reach $4.75 per gallon if the Brent crude oil reaches the predicted $160 a barrel sometime this year.

Crude oil prices now are determined not so much by supply and demand but by financial markets like the Nymex and ICE. Most oil is traded using derivative financial instruments that are not based on the physical exchange of crude oil (wet barrels in the trade) between seller and buyer. In the 1990's, physical transactions accounted for about 30 percent of oil traded, but they now number less than 1 percent of contracts traded on the various exchanges.

Crude oil prices soared to new highs in 2005 when U.S. pension funds were permitted to invest their members’ retirement monies in oil futures. The US Congress convened a special hearing in 2008 after prices soared to $147 a barrel for WTI crude oil to consider the influence that speculation has on crude oil prices. Analysts calculated for each $100 million pumped into the oil market the price per barrel was pushed up by 1.6 percent.

In effect, oil has become a speculative commodity whose price is determined by how investors anticipate its value will increase or decrease at a given point in the future.
No sooner had Bank of America Merrill Lynch given its “bullish” prediction than the commodities market rallied and the price of Brent oil surpassed $120 per barrel. Nonetheless, do analysts have at least some idea of an upper limit to prices?

The two dominant theories of the 1970's and 1980's held that oil prices were limited by the prices for alternative energy sources to crude oil or, by contrast, that the price ceiling was determined by the purchasing power of oil consumers who are also unable to reduce demand. This is just partly true today.

In the end, the main “energy resource” of the past 40 years was not oil but energy efficiency, and consumers’ ability to save money by reducing consumption and using alternative energy sources as prices increased.