How Much Profit Is Too Much?

Lynne Kiesling

Last week’s quarterly earnings announcements made for a lot of wailing and tooth-gnashing about the profits of oil companies. I was too buried in other things to opine, but others said smart and useful things. Take, for example, this question from Russ Roberts to those who want to impose a windfall profits tax on oil companies:

… if they lower prices when profits are high, are you willing to make a charitable contribution to oil company stockholders when profits are low or negative?

Russ is right when he says that the true economic illiteracy is not the asymmetry of wanting to take their profits but not subsidize their losses. The true economic illiteracy comes in the lack of understanding of what prices do, where they come from, and how they work to induce optimal decisions on both sides of a transaction over time.

Then there was Jim Glassman’s interview with Dan Yergin at Tech Central Station. They touch on several interesting and important energy topics, including the windfall profits one:

What a windfall profits tax does is introduce a lot of distortions. It reduces investment, it increases a sense of political risk and it doesn’t achieve the goal that is intended, if it is to facilitate investment in new sources. It obviously responds to a political demand, but it has the opposite effect of increasing supply. It really will lead to decreased supply, not only here, but it will be something that will have an impact around the world. And this is a time when you want to increase and encourage investment, not provide disincentives to investment. …

I think that there are two things that we can do as we are heading into the winter that would be significant. The first thing is that we really ought to make sure that people really have the information and the knowledge about the minor changes in behavior that they can make that will not only save them money but in a total sense would reduce natural gas prices and take the pressure off. If all of us this winter reduced our thermostats by two degrees, homeowners, commercial establishments, we would save more natural gas than has been lost because of Hurricane Katrina.

The other thing we ought to do is not wait until a cold winter, if we do have a cold winter, and address now how to build flexibility into some of these environmental regulations so that for instance, in an area where a utility is only allowed to burn oil four days a months, perhaps in January if there is really pressure on prices they can burn oil eight days a month and reduce their consumption of natural gas. And there is no shortage of residual fuel oil, the type of oil that does get burned in utilities, so it wouldn’t add to the price pressure on oil but it would take pressure off natural gas.

Demand response and adaptable environmental regulations … yes, that’s the litany here at KP.

Then at Catallarchy, David Masten delivers the goods by calculating Exxon-Mobil’s profit margin, which was 9.85% for the third quarter. Healthy, but not outrageous.

From the Fortune Global 500 data, financial services company Bank of America is getting margins of 22.3%, General Electric had 11%, and Proctor & Gamble comes in with 12.61%. Big Pharma does quite well with Pfizer at 21.5%.

Note that the margin data are consistent with the higher costs that oil companies face due to cleanup and restarting Gulf resources taken offline due to hurricanes.

Finally, today Russ Roberts gave a commentary on NPR about the role of high profits:

Thereís another benefit of high prices. They encourage greedy oil companies to pull oil out of the ground that isnít worth pulling out of the ground when prices are low.

Getting oil out of the ground and into your car in the form of gasoline is an extremely expensive and unpredictable process. ExxonMobil spent almost $15 billion last year on equipment to find new oil and make refineries more productive.

As consumers, we want oil companies to take risks and spend money searching for new supplies. Profits are the reward for risk-taking and investment. Take away profits when they’re high and oil companies will take fewer risks and invest less. That means less energy in the future.

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29 thoughts on “How Much Profit Is Too Much?

  1. Isn’t it a little late to complain about market distortions in the oil industry? The oil depletion allowance, the Interstate Highway Act, and zoning regulations that encouraged suburban sprawl didn’t distort the market?

  2. High prices and excessive risk can also point to the market failure. What would need to be addressed is average long term profits to compare to other industries. It is possible that a futures/hedge market at the individual retail level might provide stability in both profits and prices that is not present in an overwhelmingly spot market. Also high prices may distort incentives by causing drug companies to only research “blockbuster” drugs or to induce oil companies into wasting money on rent-seeking behavior.

  3. Dave,

    The fact that government, at all levels, has taken actions which distorted the oil market (and most other markets) is not an argument for continuing and/or expanding the distortions. The fact that the government distortions of markets have frequently operated at cross purposes to each other is also not an argument for continuing or expanding the conflicts.

    The list of distortions you provide above is a very short list of the government actions which have distorted the oil market; and, each of these actions was taken for reasons other than distorting the oil market in a specific way.

    A windfall profits tax would not return “excess profits” to those who were the “victims” of the “price gouging”. They would instead provide additional revenues to government, which could (would?) be used to distort other markets.

    The expanding economy has already provided a “windfall tax profit” to government at all levels. Perhaps we should again encourage the government to take actions which would return this windfall to the taxpayers. (I will not hold my breath in anticipation of this result.)

  4. akatsuki,

    In the absence of government “distortion” of the markets, markets set prices and those prices influence behaviors by all market participants. When government acts to distort markets, absent price controls, the markets set different prices than would have been the case without the government action. These different prices ultimately change the future structure and operation of the markets. When government imposes price controls, all bets are off; and, arguably, markets cease to be markets in the real sense.

    Government efforts to “punish” US companies for “excess profits” will encourage US companies to move their headquarters overseas, to countries which do not impose such punishments.

    Price controls are unworkable in a world market, particularly a market in shortage, because product will follow price and create shortage in the controlled market.

    You also raise the issue of “high prices” (relative to what?) in the drug market. I would suggest you should be far more concerned about low, “controlled” prices in the drug market and the impacts that situation would (will?) have on the development of new drugs, “blockbuster” or not. For example, why would the major drug companies continue spending billions on research into HIV / AIDS drugs, if the successful drugs must then be sold at low, controlled prices; or, lose patent protection to generic drug manufacturers which are are willing to produce and market untested and ineffective combination drugs. (UN in Africa)

    One could argue about the Law of Unintended Consequences. However, some consequences, while they may be unintended, are certainly predictable. Government, too frequently, begins “vast programs with half-vast ideas”. The results, too frequently, may be unintended but are still predictable.

  5. akatsuki,

    In the absence of government “distortion” of the markets, markets set prices and those prices influence behaviors by all market participants. When government acts to distort markets, absent price controls, the markets set different prices than would have been the case without the government action. These different prices ultimately change the future structure and operation of the markets. When government imposes price controls, all bets are off; and, arguably, markets cease to be markets in the real sense.

    Government efforts to “punish” US companies for “excess profits” will encourage US companies to move their headquarters overseas, to countries which do not impose such punishments.

    Price controls are unworkable in a world market, particularly a market in shortage, because product will follow price and create shortage in the controlled market.

    You also raise the issue of “high prices” (relative to what?) in the drug market. I would suggest you should be far more concerned about low, “controlled” prices in the drug market and the impacts that situation would (will?) have on the development of new drugs, “blockbuster” or not. For example, why would the major drug companies continue spending billions on research into HIV / AIDS drugs, if the successful drugs must then be sold at low, controlled prices; or, lose patent protection to generic drug manufacturers which are are willing to produce and market untested and ineffective combination drugs. (UN in Africa)

    One could argue about the Law of Unintended Consequences. However, some consequences, while they may be unintended, are certainly predictable. Government, too frequently, begins “vast programs with half-vast ideas”. The results, too frequently, may be unintended but are still predictable.

  6. Also seldom mentioned is that simple cost-plus pricing leads to higher profits when the cost of raw materials rises.

    Say a company prices it products based on a simple formula of cost plus 10%. If a unit of product cost $1 to make it sells it for $1.10 and makes a 10 cent profit. If the price goes up to $2 a unit it sells it for $2.20 and makes a profit 20 cents, double the profit they got at a lower price.

    Actual markets are much more complex than that but in industries where raw material prices fluctuate a lot, cost-plus pricing plays a significant role.

  7. It’s not just cost-plus pricing that is at issue here- it is the fact that profit reports lag current production, so that a a FIFO-LIFO accounting differential in a time of rapid raw materials fluctuation and significant market perturbations can completely screw up the equation.

    If Congress took away the oil production company’s cash flow at the exact time that there is a shortage and the costs are rising due to increased well-head demand, all they are doing is FORCING prices to go higher if they want there to be any production. If a company is reporting historical profits, but right now on a LIFO pricing model has to buy raw materials at a premium, how is a tax increase going to make prices moderate?

    Is there a single member of the Senate who has ever been near a factory?

  8. Redman:

    Sounds to me like Mobil made a pretty good move, since just 6 or 7 years later in 1986 oil was bumping down toward $10 barrel. What the world needed in the late 70s wasn’t more oil, but fewer dollars chasing the oil. I’m not sure that’s exactly the case now.

  9. The oil companies like any other company will try to maximize its ROI, period. And that is as it should be. Monkey Ward may not seem like a rational acquisition but time will tell. If Exxon can’t run a department store it will sell it off at a loss to someone who thinks he can, who may also be wrong… maybe departments stores are obsolete, hey, who knows? These decisions are made by the people risking their money in the market or their delegates. The only “excess profit” is one that cannot survive competition.

  10. Ed Reid:

    You wrote

    he fact that government, at all levels, has taken actions which distorted the oil market (and most other markets) is not an argument for continuing and/or expanding the distortions. The fact that the government distortions of markets have frequently operated at cross purposes to each other is also not an argument for continuing or expanding the conflicts.

    I’m neither for nor against excess profits taxeson the oil companies. I don’t know enough. I’m just pointing out that in an already-distorted market that a tax would create market distortions is irrelevant. As I see it the proper questions are:

    Would the distortion move the state of things closer to or farther away from a natural market? (in my view closer is better)
    Would society be better or worse off as a result of the tax?

    I don’t know the answer to the first question but I suspect the answer to the second question is “Worse off” and, consequently, I’m inclined to opposed excess profits taxes generally.

    But complaining about market distortions in an already-distorted (in the oil companies’ favor) market is a red herring.

  11. Nobody explains how gasoline prices get set.

    The guy at the tank farm notices that the inventory level is falling. People are buying gas faster than he can get it in, say from some blockage in supply but it doesn’t matter.

    So he raises the price TO SLOW THE OUTFLOW, matching incoming to outgoing rates.

    The price rises at the pump. The consumption has to fall to match the available supply, but what price will achieve this?

    Consumers are now bidding against each other, not against the cost of oil. Consumers set the price at this point.

    The price of gasoline is “inelastic,” meaning that you need the gasoline and you’ll buy it at any price. You’ve got to have the gasoline. Demand does not change with price.

    Well, not quite. Inelastic demand means that consumption declines accompanied by shouting, screaming and yelling, and demands for revenge.

    This is the mark of a success of the market, not a failure. Demand, even inelastic demand, responds to price! Inelastic demand has been elasticized!

    But you can still get all the gasoline you want! There are no lines (except in Florida, which has consumer-protecting anti-price-gouging laws, and the predicted day-long lines as a result).

    Another effect, besides distributing a scarce supply among consumers according to their desires at the new price, is windfall profits to whoever owns the gasoline at low cost, namely the oil companies. This is not a problem. It is the scapegoat chosen in the yelling. If the price were not that high, producing that profit, there would be lines all day at the gas pump rationing the gasoline instead. Price or lines, your choice.

    Any politician who trades on this deserves to be thrown out. They do in fact know better.

    AND

    Did you know that consumers profit too at the high prices?

    In every voluntary transaction, both sides come out ahead. That’s why the transaction happens. Ones where one side loses do not take place.

    So the consumers value the gasoline they get more than the price they pay, even at the higher price. They turn a profit. Where are the calls to confiscate this profit?

    The transactions that don’t occur, of course, are the ones that were lost in order to match supply to demand, namely the least profitable ones. Supply matches demand because this happens.

    MORE BROADLY

    You want economic activity, not to keep peopole off the streets, but because every voluntary transaction profits both sides of the transaction. The standard of living of both sides has gone up with each trade. The more transactions, the higher the standard of living. That’s the entire trick of a free market.

    It is not a problem that one side benefits so long as the other does too. That in fact happens even here.

  12. Nobody explains how gasoline prices get set.

    The guy at the tank farm notices that the inventory level is falling. People are buying gas faster than he can get it in, say from some blockage in supply but it doesn’t matter.

    So he raises the price TO SLOW THE OUTFLOW, matching incoming to outgoing rates.

    The price rises at the pump. The consumption has to fall to match the available supply, but what price will achieve this?

    Consumers are now bidding against each other, not against the cost of oil. Consumers set the price at this point.

    The price of gasoline is “inelastic,” meaning that you need the gasoline and you’ll buy it at any price. You’ve got to have the gasoline. Demand does not change with price.

    Well, not quite. Inelastic demand means that consumption declines accompanied by shouting, screaming and yelling, and demands for revenge.

    This is the mark of a success of the market, not a failure. Demand, even inelastic demand, responds to price! Inelastic demand has been elasticized!

    But you can still get all the gasoline you want! There are no lines (except in Florida, which has consumer-protecting anti-price-gouging laws, and the predicted day-long lines as a result).

    Another effect, besides distributing a scarce supply among consumers according to their desires at the new price, is windfall profits to whoever owns the gasoline at low cost, namely the oil companies. This is not a problem. It is the scapegoat chosen in the yelling. If the price were not that high, producing that profit, there would be lines all day at the gas pump rationing the gasoline instead. Price or lines, your choice.

    Any politician who trades on this deserves to be thrown out. They do in fact know better.

    AND

    Did you know that consumers profit too at the high prices?

    In every voluntary transaction, both sides come out ahead. That’s why the transaction happens. Ones where one side loses do not take place.

    So the consumers value the gasoline they get more than the price they pay, even at the higher price. They turn a profit. Where are the calls to confiscate this profit?

    The transactions that don’t occur, of course, are the ones that were lost in order to match supply to demand, namely the least profitable ones. Supply matches demand because this happens.

    MORE BROADLY

    You want economic activity, not to keep peopole off the streets, but because every voluntary transaction profits both sides of the transaction. The standard of living of both sides has gone up with each trade. The more transactions, the higher the standard of living. That’s the entire trick of a free market.

    It is not a problem that one side benefits so long as the other does too. That in fact happens even here.

  13. If governments (local, state, federal) had greater “profits” from increasing gasoline prices (as a percentage of sales) than (those big, bad, greedy) energy companies (they did!), does that mean they are more evil than those (big, bad, greedy) energy companies? And what should we do about this? (windfall tax refunds! methinks :-)

  14. Redman – who is to say what they “ought” to do with their profits. It’s quite possible that Mobil (or whoever it was) believed that they could acheive higher margins by purchasing Montgomery Ward. It is ultimately the shareholders’ responsibility to evaluate the merit of that sort of decision, just because you sell oil today doesn’t mean you’re obligated to sell oil for eternity.

  15. We are not seeing the big profits yet since a lot of oil and almost all natural gas are sold on contract, usually a year in advance. So the big profits, particularly for the natural gas companies will be next year.

    Every oil field has 2 numbers that are used to evaluate the profitability of the field, the cash flow number and the capital number. The cash flow number is how much the oil must be sold for to cover the current expenses for the well and the capital number is how much the oil must be sold for to cover the current expenses and the capital expenses for drilling the well. Since oil drilling is capital intensive, the capital number can be twice as high as the cash flow number. When the price of oil goes below the capital number for a field, no more wells are drilled. When the price goes below the cash number, the pumps are shut down and every one goes home (overly simplistic but good enough for this example). Every dollar that oil goes above the capital number goes straight to the bottomed line, pure profit

    For almost 20 years, oil companies have been building their business around $25 a barrel oil so capital numbers around $20 a barrel with cash flow numbers around $10 to $15 a barrel. Oil companies will spend their new found money on drilling new fields IF THEY THINK THE PRICE OF OIL WILL STAY HIGH. Oil fields are long term investments. You are not going to exploit a field with a capital number at $35 a barrel if you think oil will go back to $25.

    Higher taxes will just move both numbers higher. Politicians making noise about driving the the price of oil down just means the oil compaines will be less likely to open up new fields (there is very little for anyone to do with exploration. there are very few places in the world left that have not been explored for oil. all of the ones left are damn expensive places to drill). Look for the oil companies to spend their money buying other oil companies, the ones with proven reserves. Consolidation is the order of the day until we see how long the high prices will last.

  16. We are not seeing the big profits yet since a lot of oil and almost all natural gas are sold on contract, usually a year in advance. So the big profits, particularly for the natural gas companies will be next year.

    Every oil field has 2 numbers that are used to evaluate the profitability of the field, the cash flow number and the capital number. The cash flow number is how much the oil must be sold for to cover the current expenses for the well and the capital number is how much the oil must be sold for to cover the current expenses and the capital expenses for drilling the well. Since oil drilling is capital intensive, the capital number can be twice as high as the cash flow number. When the price of oil goes below the capital number for a field, no more wells are drilled. When the price goes below the cash number, the pumps are shut down and every one goes home (overly simplistic but good enough for this example). Every dollar that oil goes above the capital number goes straight to the bottomed line, pure profit

    For almost 20 years, oil companies have been building their business around $25 a barrel oil so capital numbers around $20 a barrel with cash flow numbers around $10 to $15 a barrel. Oil companies will spend their new found money on drilling new fields IF THEY THINK THE PRICE OF OIL WILL STAY HIGH. Oil fields are long term investments. You are not going to exploit a field with a capital number at $35 a barrel if you think oil will go back to $25.

    Higher taxes will just move both numbers higher. Politicians making noise about driving the the price of oil down just means the oil compaines will be less likely to open up new fields (there is very little for anyone to do with exploration. there are very few places in the world left that have not been explored for oil. all of the ones left are damn expensive places to drill). Look for the oil companies to spend their money buying other oil companies, the ones with proven reserves. Consolidation is the order of the day until we see how long the high prices will last.

  17. Y’know, the major oil companies are publically traded, and if a person thought that oil was going sky high, that person could have bought oil company stock and raked in the dividen bucks. Did y’all complaining about high gas prices stock up on Exon-Mobil stock 5, or 3, or even last year? I don’t think you did.

    I know another fellow who is saying “gas will never go below 3 dollars a gallon.” This guy thinks high gas prices will make the public demand greater investment in trains, leaving aside that Amtrak fuel efficiency is currently at the SUV level and is hurt equally by high gas prices. I gotta ask these gloom-and-doom people, “are you buying stock in oil companies” because if you did, you really believe in 60 dollar plus oil — the oil companies certainly don’t — they are basing their investment strategies on 25-30 dollar oil because they don’t believe high oil prices will last.

    Oil stocks are high right now, but not as high as they could be if people really believed in high oil prices. C’mon all of you gloomy liberals — if you really believed your gloom, you would be hedging your gas and heating fuel purchases with purchases of oil company stock. Are you chicken about investing your money? Do you not in your heart believe the stuff you are telling people? Then you don’t have standing to complain about those “windfall profits.”

  18. Redman,

    It may be true that Mobil purchased Montgomery Ward. The question one might ask then is why if oil is so profitable they did so? It might be connected to the fact that profits down the road are unpredictable, and a significant factor there is the fear of government limiting the future profits from oil exploration and refining. I would say your example points to exactly what is wrong with such anti-market behavior.

  19. Er, didn’t taxprof note that since 1977 the government has taken in twice as much as the gross domestic profit of the oil companies in gasoline taxes? So who, exactly, is getting the windfall? I’m waiting for a “windfall gasoline tax rebate” from New York and the Feds, but it wasn’t in my mailbox today.

  20. Paul,

    Well, I don’t consider myself a liberal but I have bet everything on energy. I did it 3 years ago, 95% of everything I had to invest, mostly 401k money. It has gone pretty well, if you consider over 500% return doing pretty well.

    Cheap oil is done, do the math, it is all about China. Do you think China will raise its standard of living? A rise in standard of living equals a rise in energy consumption. One person in the US consumes over 20 barrels of oil a year, in Europe, 15 barrels a year, in China, 1.5 barrels a year. For the Chinese to double their stand of living, which would still be 1/5 the standard of living in Europe, they will need an additional 5 million barrels of oil A DAY. That is 1/2 the daily production of Saudi Arabia. And we have not even talked about India.

    I know that China will burn coal when oil gets too high but as soon as oil gets cheap, China will switch back to oil. I also know that there will be other forms of energy developed, solar, nuclear, but only if oil stays high. As soon as oil gets cheap, investment in new energy stops, conservation stops, coal consumption drops. This puts both a cap and a floor on oil, a trading range that I believe to be significantly higher than $25. .

    Now anything can happen in the short term (2-3 years), it is a huge market with lots of liquid moving around so we could see $20 oil again in the next few years. Maybe even longer if Asia’s development derails. But for the 2.5 billion people in China and India and SE Asia to achieve anything like a Western standard of living sometime in the next 50 years will require enormous amounts of new energy which makes all existing stockpiles of energy worth a lot more. And yes, I have bet accordingly

  21. Paul,

    Well, I don’t consider myself a liberal but I have bet everything on energy. I did it 3 years ago, 95% of everything I had to invest, mostly 401k money. It has gone pretty well, if you consider over 500% return doing pretty well.

    Cheap oil is done, do the math, it is all about China. Do you think China will raise its standard of living? A rise in standard of living equals a rise in energy consumption. One person in the US consumes over 20 barrels of oil a year, in Europe, 15 barrels a year, in China, 1.5 barrels a year. For the Chinese to double their stand of living, which would still be 1/5 the standard of living in Europe, they will need an additional 5 million barrels of oil A DAY. That is 1/2 the daily production of Saudi Arabia. And we have not even talked about India.

    I know that China will burn coal when oil gets too high but as soon as oil gets cheap, China will switch back to oil. I also know that there will be other forms of energy developed, solar, nuclear, but only if oil stays high. As soon as oil gets cheap, investment in new energy stops, conservation stops, coal consumption drops. This puts both a cap and a floor on oil, a trading range that I believe to be significantly higher than $25. .

    Now anything can happen in the short term (2-3 years), it is a huge market with lots of liquid moving around so we could see $20 oil again in the next few years. Maybe even longer if Asia’s development derails. But for the 2.5 billion people in China and India and SE Asia to achieve anything like a Western standard of living sometime in the next 50 years will require enormous amounts of new energy which makes all existing stockpiles of energy worth a lot more. And yes, I have bet accordingly

  22. Ron Hardin,

    Your “both sides profit, producing a higher standard of living” argument, while applicable to luxeries, is not univrsally applicable.

    Example: Food.

    It doesn’t matter how much food costs: I have to have it to live. If the cost of food rises to the level of my entire income, I still pay it, resulting in a serious blow to my standard of living.

    Gasoline, for a great many people most of the time, is in this category: if they do not have gasoline, they lose their job. This would result in a precipitous drop in their standard of living. So, basically, their standard of living DECREEASES at times like this, as the cost of gasoline increases, while their return on their gasoline investment (they paycheck) does not.

    It is only an “increase” in their cost of living as compared to doing entirely without, which results in starvation (or the complete realignment of our society).

    As to

  23. Re Deoxy,

    Don’t I gain some utilization from not starving to death? Providing food at a price is good if it keeps me from starving. If it is too high, maybe I would start a garden or trap a pesky rabbit or something that people did when food prices were actually high.

    JBP

  24. Excess profits taxes for the oil companies?

    There have been a number of posts, generally negative, on excess profits taxes on the oil companies. This post from the always-informative Lynne Kiesling of Knowledge Problem is a good one. Kathy Hermann (alias Roaring Cat) of Big Cat Chronicles has…

  25. Excess profits taxes for the oil companies?

    There have been a number of posts, generally negative, on excess profits taxes on the oil companies. This post from the always-informative Lynne Kiesling of Knowledge Problem is a good one. Kathy Hermann (alias Roaring Cat) of Big Cat Chronicles has…

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