Observations on Petroleum Industry Windfall Profits

(Posted 4/29/06) - Very few articles or public discussions about current petroleum industry windfall profits relate to free-market economics.

Read my views on the issue and see why the price of oil is a classic example of free-market operation.

Before looking at the petroleum industry I'd like to set the stage by creating an abstract for-profit publicly held business and examining its simple operation.

Company X is a typical corporate entity; it issues shares (stock) as well as debt instruments (bonds) to help finance major capital replacement and market initiatives.

Company X has a business plan that sets objectives which include sales and operational cost targets, and which analyzes opportunities (markets). Company X closely monitors what is generally referred to as its Gross Margin ratio. Simply put, it is the percentage of each dollar of revenue that exceeds operational costs (direct and overhead).

Company X strives to maintain or enhance its Gross Margin ratio, since this is an important measure of its efficiency relative to its peer companies. Investors will be looking at this (along with many other trend indicators and ratios relating inventory value, sales volume, accounts receivable, accounts payable, cash flow, cost of debt, etc).

Let us assume that Company X sells in a commodity market which also exhibits a relatively price-insensitive demand. Now introduce a situation in which Company X and all its direct competitors find that the cost of a major component of their product doubles in price. Company X realizes that demand will not diminish for the commodity (in the short run) and endeavors to maintain its Gross Margin efficiency, while also passing all cost increases on to its consumers. If it does this the consumer will absorb the additional costs, and continue to buy in a commodity market and at the same levels.

The question to ask now is, "Will Company X's Gross Profits increase in this scenario?" If company X and its direct competitors are passing on only their increased costs, the answer is of course "no." But, to maintain their Gross Margin ratio (and remember they are being measured by the market place on this value), Company X must also add an additional amount to their sales price. Not Clear? Here's a concrete example:

  • Initial Prod-Price --> $3
  • Cost of Goods Sold (CGS) --> $2
  • Gross Margin Ratio (1 - 2/3) --> 33%
  • Now increase CGS to $2.50
  • To maintain GMR of 33% the Prod-Price must be set at (1-2.50/X) = 33%, so X = $3.73

Notice that instead of just passing the half-dollar increase directly to the customer, an extra 23 cents was also added to maintain the gross margin ratio! Thus the Gross Profits in absolute terms will rise as the sales revenue rises, if Gross Margins are maintained by Company X (and its direct competitors).

This is basically the scenario for Big Oil. So lets talk about public policy versus free-market economics in that context.

As a commodity, no single oil distributor can afford to reduce their Gross Margin ratio becaue they'll be swamped with demand they cannot meet (limited product). Since all oil distributors are supply limited and they know that demand is pretty much price-insensitive in the short run they are highly motivated to just let things continue (after all their Gross Profits keep going up if they just maintain their Gross Margin ratio).

In many environments demand would fall or be deferred if the price of the product increased as dramatically as have petroleum products. So, in a sense George W Bush's statement that Americans are addicted to oil rings true. But blaming users of a staple-commodity for their predicament adds nothing of value. GW should be looking for ways to increase supply or reduce demand, not stating the obvious.

Let's look at the cartel of Big Oil. One has to ask, if ALL competitors were to reduce their Gross Margin targets exactly by the amount associated with a basis (fictitous market price), then consumers could be charged significantly less at the pumps, while Gross Profits stayed at pre-windfall levels. So, why isn't this being done?

Free-market economics says you don't price fix in any form. I believe the last president that tried a direct market price fixing (ceilings to control inflation) was Richard Nixon -- didn't work out well for him as I recall. Our federal government can pass laws that fix prices, or tax at the back end after the consumer has already paid through the nose. Neither has a good history of helping consumers in the short term.

My belief is that a near term solution is only possible through voluntary reductions of Gross Margins by the Big Oil cartel. They have the ability to meet and decide that they will unilaterally allow their margins to deteriorate to the extent that they pass costs directly to the consumer without also adding extra windfall amounts to prices to maintain current margin ratios. I could see an active president stepping in and leading a meeting of the Big Oil Execs to reach such an agreement. I don't think W is ever going to do it however.

To wrap up, you now understand the economics of what is happening. There is a possible solution, but our President will never push for it. I think we can all expect to see gas rise to around $5/gallon by 2007. Welcome to the free-market economy of the 21st century!