Let’s Talk Oil Economics!

OK, so no one appears to want to discuss religion, so let’s discuss oil and gasoline prices.   That seems to be a popular topic of late.

It seems everyone is upset about the price at the pump, and is looking for someplace to aim their frustration.  Two popular targets for blame are the government and big oil.  In the interest of total transparency, I am an employee of a major oil company, but I don’t have any “inside knowledge” to share.  Instead, I hope to help readers understand a few things about crude the oil industry, so that maybe there can be a little less anger in the world.  If you’re of the mindset that big oil is nothing more than a bunch of rich guys chomping big cigars and scheming how they can screw you out of more money, hopefully you know me well enough to know that stereotype is not accurate.  If you’re convinced I’m one of those rich guys, you might as well quit reading now, because nothing I’m going to say is going to convince you otherwise.

In the interest of brevity, I’m not going to try to cover all the details of the very complex economics that determine oil and gas prices.  A good source to understand that is the US Energy Information Administration website.  It’s full of all sorts of educational material and statistics about what’s going on in the world energy markets.  If you’re convinced that you can’t believe anything you read there because it’s a government agency, then tighten your tinfoil hat and surf on, because nothing I’m going to say is going to sway you.  If you’re still here, then here is a specific page on that site than can help you understand the basics of the market.

What I specifically want to talk about today is some recent rants I’ve seen on the internet, and heard from politicians, talk show hosts, and generally frustrated consumers about the “obscene” profits earned by oil companies.   The media, politicians, and anyone else that wants to work the public into a frenzy loves to talk about “big oil” profits.  The numbers are astounding–no argument there.  Let’s take Exxon’s annual Consolidated Statement of Income for 2011, where they reported an income of $486 billion.  That’s obscene, right?!  No company should make that much money!  We should revolt!

But keep reading on that same report.   To generate that obscene amount of income, they spent–$413 billion.  Then, they paid income taxes–$31 billion.  When you subtract that from their income–the number that’s thrown around to get us all lathered up, you get to an actual earning of $42 billion.  I’m sure we’d all like to try to suffer along on such a paltry sum.  It’s still a huge number, that can easily frustrate us at the pump.  That’s a lot of money!  But stop to think about it a minute–they invested $413 billion to earn that $42 billion.  That “b” word makes this all unfathomable, so let’s get the numbers into normal consumer terms, by just dropping the “billion”.  They invested $413 to earn $42.  Hey, that’s still a 10.2% return on investment-none of us can earn that in our money market fund or CD at the bank, right?  Let’s hate ’em.

Not so fast.  Let’s pick a company that everybody loves… how about Apple?  Apple’s most recent annual report runs through 3Q 2011; close enough for our purposes.  How much income did Apple earn in their most recent reporting year?  Only $108 billion.  Nothing close to Exxon.  But let’s look do the same analysis:

  • Expenses (I’m including Cost of Sales in this numbers for you financial gurus): $74 billion
  • Income taxes:  $8 billion
  • Earnings:  $26 billion

There’s that “b” word again.  In normal human terms:  They spent $74 to earn $26.  Poor Apple, they only made–wait–they only made 35% return on their investment.  35%!  That’s highway robbery!  The only people I ever heard of who could collect 35% on their money were loan sharks!

OK, one more just to be fair.  Everybody knows that computer companies rip us off.  Let’s go for something everybody likes-food.  How about a nice, friendly, likeable company:  Nestle.  Purveyors of Gerber Baby Food, and my personal favorite, Nestle Toll House Morsels, aka chocolate chips, aka the perfect snack food!  Data from their 2011 Income Statement:

  • Sales:  $83.6 billion
  • Expenses:  $71.1 billion
  • Income taxes:   $3.1 billion
  • Earnings:  $9.8 billion (there’s some other things in their report that I’ve left out, but this is their earnings)
  • 13.7% return on investment

So, what’s my point?  Don’t get sucked in by the big numbers the media throws around.  Sure, the super majors earn huge profit numbers, but they spend huge amounts of money to do it.  And they have to, because it takes a lot of money, and a lot of risk, to drill for oil.  When things go wrong, they go bad wrong–as we’ve seen in recent history.  If they don’t have the opportunity to earn a decent return on their investment, why would they spend the money?  As seen above, 10% isn’t a huge return, compared to many other industries that we don’t vilify.  And it is hard work, done in extremely inhospitable places all around the world.  And where do those billions in earnings go?  To their shareholders.  If you own a mutual fund, 401k, or are part of a private pension plan, you’re very likely one of those shareholders.  Federal Government Thrift Savings Plan?  Yeah, you too.

Why are pump prices so high?  Well, it’s complicated.  Is it big oil’s fault?  Not really.  Should we hate ’em?  I submit that if you look at it rationally, your answer will be “no.”  If you need someone to be mad at because you don’t like your gas bill, and you want a simple world to live in where someone else is to blame for all your “problems,” sure, go ahead.  Hate “big oil.”

Somebody pass me a cigar…

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