My answer is different from Tyler’s

Lynne Kiesling

I think Tyler is answering a different question than DSN asked, and I think he’s made it too hard. DSN asked

Based on logic and observation of input cost and profit trends in various industries, when the cost of raw materials rise, companies in a competitive market are often not able to pass through these cost increases and, therefore, may see a decline in profitability. How then are oil companies able to make huge profits when oil prices rise significantly. Is this not a competitive market? What is the economic process in oil production, processing, and marketing that allows oil companies to make record profits when the price of their raw materials is at historically high levels?

Tyler’s response to DSN focuses on concessions/royalties that oil companies pay to foreign governments. I think the answers to DSN’s question are simpler and closer to home.

First, yes, the retail markets for refined petroleum products are competitive, as the FTC has found over and over and over … but, the demand for refined petroleum products is relatively inelastic. That inelasticity means that a larger share of input cost increases will get passed on to consumers in retail markets for refined petroleum products than for other goods. That enables revenues to exceed costs by a larger margin. Note, however, that as gas prices have risen and we’ve substituted into bicycling and into buying more fuel-efficient vehicles, the demand curve shifts.

Second, recall that over the long run (say, calculated over 15 years), profits in the refining industry are in the range of profits for the S&P 500. Thus the profit booms and busts in this industry tend to average out over time, so there aren’t really “supranormal” profits. Not surprising, given the high fixed-cost infrastructure characteristic of the cost structure.

Third, to the extent that there could be “supranormal” profits, they arise from the refining part of the supply chain, not the oil extraction and supply part. Refining capacity is the bottleneck, so given the inelastic demand mentioned above, as long as demand exceeds refining capacity, that refining capacity scarcity is going to be reflected in retail prices. Recall that the last refinery built in the US was built in 1976, and although refiners have tweaked their processes to squeeze more production out of existing capacity, those have been incremental increases that have not changed the fact that refining is the bottleneck.