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.


18 thoughts on “My Answer is Different from Tyler’s

  1. Lynne, I agree with you that Tyler was probably answering a different question than DSN asked — although it is hard to tell, because DSN himself does not seem clear on what an oil company does — and I also agree that it is important to distinguish between production/extraction and refining activities. (In fact, see my comment at Tyler’s post.) But how do you square your analysis with Tyler’s point that most of Exxon’s profits are coming from the production of oil, not the refining of gasoline? Geoff Styles has been doing a great job reminding folks that refining margins have been slim during the current run-up in prices (see here for a clear explanation, but his blog in general has chronicled this for the last several months). In fact it seems that refiners and consumers are sharing the hit from high oil prices — consumers are paying more for gas while refiners are making much less profit per unit than they have historically.

    Thoughts?

  2. Nah. Two quotations from XOM’s most recent 10-Q:

    “Upstream earnings for the first six months of 2008 were a record $18,797 million, up $6,803 million from 2007.”

    “Downstream earnings in the first six months of 2008 of $2,724 million were $2,581 million lower than 2007. Lower
    worldwide refining and marketing margins decreased earnings approximately $2.9 billion while higher operating
    costs reduced earnings about $300 million. Improved refinery operations increased earnings about $600 million.”

    And why should refinery profits increase when the cost of their major input increases? You say “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.” True enough, but the “share” is still less than 100%, is it not?

  3. Although Tyler seems to be answering a slightly different question from the one DSN asks, I’m inclined to his answer. Also, the unnamed commenter “at Aug 6, 2008 9:43:51 AM” and the following comment by “Spencer” get the answer well.

    Contrary to Lynne, but in keeping with Daniel Hall’s comments here and at Marginal Revolution: it is a bad time to be in refining (because the cost of oil is so high), but a great time to be owning oil resources.

  4. Yes, the initial question seems to make the fundamental mistake of confusing the upstream (exploration and production) and downstream (refining and marketing) sides of the business.

    Upstream profits more when the absolute level of commodity preces is high. (Oil and natural gas, that is.)

    Downstream profits more when the price of refined products is high relative to the price of crude oil.

    Companies like ExxonMobil are primarily upstream companies.

    From their last earnings release upstream earnings were $10 billion (2 billion US) and downstream earnings were $1.5 billion (0.2 billion US). Upstream earnings were up 4 billion from 2Q07, but downstream earnings were actually down 2 billion.

    So, they make record earning when oil & gas prices are high because their business is primarily investing capital to produce and sell those commodities.

    Imagine you owned a lemonade stand and had pre-bought a big tank full of lemonade that would last you 10 years selling 100 glasses per day. If the price of lemonade in the current market goes up $1 per glass, you have $100 per day more revenue straight to the bottom line. Record lemonade prices mean record profits for people who previously invested in the full tank. It’s about that simple.

  5. Although refining profits have improved in the last couple of years refining is still one of the lest profitable industries in the US in terms of both profit margins and return on capital.

    It has little or nothing to do with problems firms have getting permission to build new refineries. Rather, poor profits is the market’s way of telling us that the US does not need need refineries.

    There is no refining shortage.

    If there was a shortage it would be reflected in higher profits.

    Why do you think there a shortage when the existing refinery operating rate of 88% is about the same as it has been for decades?

  6. Although refining profits have improved in the last couple of years refining is still one of the lest profitable industries in the US in terms of both profit margins and return on capital.

    It has little or nothing to do with problems firms have getting permission to build new refineries. Rather, poor profits is the market’s way of telling us that the US does not need need refineries.

    There is no refining shortage.

    If there was a shortage it would be reflected in higher profits.

    Why do you think there a shortage when the existing refinery operating rate of 88% is about the same as it has been for decades?

  7. Isn’t it also the case that the oil companies own a lot of oil (either in tanks or in the ground), which seems to have become a lot ore valuable lately?

  8. Isn’t it also the case that the oil companies own a lot of oil (either in tanks or in the ground), which seems to have become a lot ore valuable lately?

  9. My view is very simple, but much like the example given by diz. I figure that the big oil companies have a long physical position in oil, i.e., supplies in the ground that they can tap. I’m sure they sell some of it forward, but certainly not all of it. In any case, to the extent that supplies are greater than the current consumption level, somebody out there is long on oil. But the oil is always moving into production, and when it does it draws profits at the current market price. When prices of any commodity spike, I fully expect that people who have ownership of lot of the commodity will sell and make huge profits, even if they sell at the same rate (speed) as before prices went up. They invested in the exploration drilling, and accepted the risk of holding the commodity. Why do they do that if not for expectation of profit? So, it never surprises me that the oil companies post record profits during price spikes, but I am uniformly dismayed that the public reacts as if it were a crime. Yet, all of these people value their own housing investment at market price rather than on an original-cost basis. Have you ever known anybody to sell a house way below market so as to limit their own profit to “respectable” levels?

    This is the same phenomenon, I might add, that we witnessed in California power markets in 2000-2001. Regulators made sure that buyers stayed short and generators stayed long, i.e., completely unhedged. When the market blew up (because of high load and low hydro, neither of which could possibly have been caused by Enron), any simian with a power plant could have earned “exorbitant” profits. Yet, it was blamed on the producers and the middlemen, treated as a crime, and the profits were extorted away through endless, groundless litigation. Having been personally involved in this (CA), I say he who gets profits when his unhedged asset suddenly becomes valuable should get what he can from it (if he had no influence on the market price). May the blame fall where it belongs!

  10. “as gas prices have risen and we’ve substituted into bicycling and into buying more fuel-efficient vehicles, the demand curve shifts”

    Since you are talking about elasticity here don’t you mean that the curve pivots?

  11. Wow, thanks for the great discussion! Let me clarify, because I was insufficiently clear in my initial post, for which I apologize: I was speaking more generally about the effect of the refining bottleneck on prices over the past, say, 7 years or so.

    I do think that the shrinking of refining margins in the past year is consistent with the conjunction of higher oil prices and the change in demand (whether a pivot shift or not, but I think a pivot shift makes sense) due to rising retail prices.

    Scott’s comment points out a distinction that has been made here and at MR only obliquely: the distinction between the vertically-integrated oil company and the standalone refining company matters. If you are a standalone, like Tesoro or Valero, then your input costs have rise unless you are on some serious long-term contracts (and to my knowledge that’s not a very extensive practice in this industry). If you are vertically integrated, then yeah, you are earning rents on the extraction rights you possess.

    It’s important to remember (and it ties back into Tyler’s original observation) that oil companies don’t “own” oil extracted from foreign deposits, at least not in the standard fee-simple way that we usually think of property rights. In most locations the national government claims ownership rights to the oil deposits, and leases those rights for a fee. Thus the integrated majors have extraction rights, but not pure ownership rights.

  12. Wow, thanks for the great discussion! Let me clarify, because I was insufficiently clear in my initial post, for which I apologize: I was speaking more generally about the effect of the refining bottleneck on prices over the past, say, 7 years or so.

    I do think that the shrinking of refining margins in the past year is consistent with the conjunction of higher oil prices and the change in demand (whether a pivot shift or not, but I think a pivot shift makes sense) due to rising retail prices.

    Scott’s comment points out a distinction that has been made here and at MR only obliquely: the distinction between the vertically-integrated oil company and the standalone refining company matters. If you are a standalone, like Tesoro or Valero, then your input costs have rise unless you are on some serious long-term contracts (and to my knowledge that’s not a very extensive practice in this industry). If you are vertically integrated, then yeah, you are earning rents on the extraction rights you possess.

    It’s important to remember (and it ties back into Tyler’s original observation) that oil companies don’t “own” oil extracted from foreign deposits, at least not in the standard fee-simple way that we usually think of property rights. In most locations the national government claims ownership rights to the oil deposits, and leases those rights for a fee. Thus the integrated majors have extraction rights, but not pure ownership rights.

  13. To extend D.O.U.G.’s point one step further, when companies experience “windfall profits”, the federal and state governments also experience “windfall income tax revenues”. However, governments generally “feel” they are entitled to those “windfall income tax revenues”.

    States which tie their gasoline excise taxes to wholesale prices also experience “windfall excise tax revenues”.

  14. I do think that the shrinking of refining margins in the past year is consistent with the conjunction of higher oil prices and the change in demand

    Although it’s a subject of some debate over the years, I would say that refining margins are largely independent of crude prices. There are periods when both go up at the same time (e.g., 2007 or Gulf War I) and there are periods where one is going up and the other is going down.

    Of course, we may now have for the first time in decades a situation where the absolute level of crude prices is affecting the demand for refined products in a material way. There would logically be correlation between refining margins and crude price when the crude price begins to affect demand and hence refinery utilization.

    But through most of the last few decades this has not been the case. Demand has chugged along at a 1-2% growth hardly without interruption. Refining margins fluctuate with local conditions. Sometimes there is a refinery bottleneck, sometimes there isn’t. As capacity gets tight, margins tend to fly up. As capacity is slack, prices can be expected to settle out at a point where a marginal return on the marginal unit at a marginal refinery is close to zero.

    In other words, refining margins can largely be explained using classical microeconomics. At least their trendencies can. Crude, on the other hand, is a global market dominated by basket casse governments. At least on the supply side.

  15. I do think that the shrinking of refining margins in the past year is consistent with the conjunction of higher oil prices and the change in demand

    Although it’s a subject of some debate over the years, I would say that refining margins are largely independent of crude prices. There are periods when both go up at the same time (e.g., 2007 or Gulf War I) and there are periods where one is going up and the other is going down.

    Of course, we may now have for the first time in decades a situation where the absolute level of crude prices is affecting the demand for refined products in a material way. There would logically be correlation between refining margins and crude price when the crude price begins to affect demand and hence refinery utilization.

    But through most of the last few decades this has not been the case. Demand has chugged along at a 1-2% growth hardly without interruption. Refining margins fluctuate with local conditions. Sometimes there is a refinery bottleneck, sometimes there isn’t. As capacity gets tight, margins tend to fly up. As capacity is slack, prices can be expected to settle out at a point where a marginal return on the marginal unit at a marginal refinery is close to zero.

    In other words, refining margins can largely be explained using classical microeconomics. At least their trendencies can. Crude, on the other hand, is a global market dominated by basket casse governments. At least on the supply side.

  16. But there hasn’t been a “refining bottleneck” in the past seven or so years. The refineries have consistently run at 85-90% of capacity, and continue to do so.

    If you want to argue that refineries are in short supply—instead of the standard argument that there were too many refineries and the more inefficient ones went out of business without affecting production—then you have to explain why (especially) those non-integrated refiners aren’t reopening the ones that shut down.

  17. As it turns out there were some efforts being made to reactivate some old refineries a year or so ago. I new a guy who worked for a company that had rhe rights to 4 or 5 of them and was looking for money to get them restarted.

    During 2007 refining margins were in fact very high and contrubuting significantly to the price of gasoline. Now, they are back to something more within the historical range.

    Anyway, most of the refineries that shut down were shut down for a reason. They were small, inefficient, and/or poorly located in relation to today’s crude flows. I wouldn’t count on them being competitive with expansions to existing refineries.

    The only reason a great many of them ever existed was due to regulatory subsidies that existed prior to 1979.

  18. As it turns out there were some efforts being made to reactivate some old refineries a year or so ago. I new a guy who worked for a company that had rhe rights to 4 or 5 of them and was looking for money to get them restarted.

    During 2007 refining margins were in fact very high and contrubuting significantly to the price of gasoline. Now, they are back to something more within the historical range.

    Anyway, most of the refineries that shut down were shut down for a reason. They were small, inefficient, and/or poorly located in relation to today’s crude flows. I wouldn’t count on them being competitive with expansions to existing refineries.

    The only reason a great many of them ever existed was due to regulatory subsidies that existed prior to 1979.

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