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Understanding Big Oil

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Understanding Big Oil's Profits

The United States suddenly lost 30% of its oil refining capacity when the epic hurricanes Katrina and Rita slammed the Gulf Coast in September 2005.1 The resulting shock to oil supplies caused gas prices to surge in the weeks following the crisis, and drivers throughout the country took a painful hit to their disposable incomes. So it's no wonder that American consumers and their elected officials were upset when the five largest oil companies reported record profits of almost $33 billion in the third quarter of 2005.2 Exxon Mobil Corp. alone earned a staggering $9.92 billion – among the largest quarterly profits in history.3

Congress called on U.S. oil executives to explain their good fortune at a joint hearing of the Senate Commerce and Energy Committee, which amounted to a basic economics lesson on the laws of supply and demand, and some late 20th century history to back it up. The oil executives urged the government not to implement price controls or a windfall profit tax, arguing that this could do more harm than good to the oil markets and consumers.

Despite the drain on consumer confidence and spending brought on by high gas prices, some experts believe that larger oil profits signal strength in the world economy and that market forces will correct the problem sooner if left to their own remedies.

Penalties for Profits?

Should the oil industry be punished for taking advantage of consumers in a time of crisis? The chairman of the Federal Trade Commission testified that higher prices were necessary to prevent panic buying and reduce demand, and also to induce suppliers to send more fuel to affected areas.4 Others have suggested that periods of higher oil prices encourage the general public to conserve fuel and purchase vehicles with better fuel efficiency. They also increase the motivation to research and pursue alternative fuel technologies. Reducing demand for oil over the long term should eventually have a stabilizing effect on prices.

Opponents of price controls and windfall profit taxes point out that the government tried such punitive measures to manage petroleum markets in the late 1970s and suffered dubious consequences. They contend that it resulted in less domestic production and took away the industry’s incentive to seek new deposits of oil. Oil shortages eventually led to further price increases, long gas lines, and even greater reliance on foreign oil.5 Once the penalties on U.S. companies were removed, supplies stabilized, and the real prices of oil and gas actually fell over the last 25 years – until Katrina’s shock to the system.6

While Big Oil’s profits may indeed be huge, so are their revenues at $379 billion for the quarter. An average profit margin of 8.7% does not really outshine other big-spending industries like technology or pharmaceuticals.7 It takes a lot of money to find and refine a gallon of gas, experts say; and in 16 of the last 20 years, the return on investment for oil companies has been below the average of the S&P industrials.8

No one needs to worry about Uncle Sam getting a fair share. From 1977 to 2004, the government collected $1.34 trillion in taxes on gas sales at the pumps. That number is more than double the $640 billion in oil company profits during the same period, and does not include corporate taxes paid on those profits.9

The good news is that higher oil prices and record oil company profits may well be a by-product of a flourishing economy in the United States and the increased demand created by rapidly growing economies in China, India, and elsewhere. The fact that the big five oil companies have close to $90 billion of cash on the books to spend on further oil exploration and other technological investment should bode well for the future.10 It’s just possible that the industry’s pursuit of profits could result in more reliable, affordable fuel supplies for consumers in America and around the world.

1) The Wall Street Journal, November 9, 2005
2,4,7) The Wall Street Journal, November 10, 2005
3) The Wall Street Journal, October 28, 2005
5, 8, 9) The Wall Street Journal, November 2, 2005
6) Investor’s Business Daily, November 10, 2005
10) The Wall Street Journal, October 25, 2005

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