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« Assorted links | Main | The Street Porter and the Philosopher »

A reader's query about energy markets

DSN asks me:

With all the talk of a (misguided) windfall profits tax on petroleum producers, I have a related question...: 

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?

Here's one source, I am not sure how reliable:

...about two-thirds of Exxon Mobil's profits come from oil and natural-gas production outside the United States, with rising production in Africa, the Middle East and Russia consistently offsetting declining output in the United States, Canada and Europe.

Exxon Mobil said it pumped 7 percent more oil and natural gas than it did during the same quarter a year earlier.

In other words, Exxon already has paid for a concession in Nigeria and when the oil price is high profits for the company go up.  In that simple model a windfall profits tax leads to less pumping in the short run and even less pumping if people view the tax as temporary.  The tax also means fewer oil concessions in the longer run.  It is also possible -- if you take the bargaining solution between Exxon and Nigeria as more or less given -- that in the long run the tax redistributes income from the government of Nigeria to the government of the United States.  The less Exxon earns on net, the less it will offer Nigeria for the concession in the first place.

Addendum: Lynne Kiesling comments, worth reading.

Posted by Tyler Cowen on August 6, 2008 at 06:18 AM in Economics | Permalink

Comments

Perhaps a more straightforward answer to the question is that oil is not an "input" from the perspective of a company that extracts oil from the ground -- it is, rather, the product the company sells. And when the price of a commodity rises due to higher demand, as is the case here, sellers of the commodity make higher profits.

Posted by: Richard S. at Aug 6, 2008 8:14:49 AM

Other goods face stronger competition from substitute goods.

Posted by: Cyrus at Aug 6, 2008 8:18:29 AM

1) Maybe I'm a fool, but I don't understand how what Tyler said answers the reader's query ("How then are oil companies able to make huge profits when oil prices rise significantly. Is this not a competitive market?")

2) Question: wouldn't a windfall profits tax that leads to less pumping make the market more efficient, as it internalizes oil's negative externalities?

Posted by: brian at Aug 6, 2008 8:31:15 AM

I am not if this was DSN's original intent, but this talk of "raw materials" makes me wonder if he is thinking of the refining business rather than the production business. Of course as Tyler points out Exxon is making most of its money off production (oil) not refining (gasoline, diesel). And in fact it is not a very good time to be a refiner, as refining margins have been very low relative to historic rates during the recent run-up in oil prices.

Posted by: Daniel Hall at Aug 6, 2008 8:44:03 AM

The problem here is that Exxon's payments to Nigeria (or any country) are not fixed - they are usually negotiated as a production sharing contract (PSC). Exxon will get enough crude to cover its costs, and then the remainder will be split between the partners (depending on the structure, there could be other partners who have a claim on the venture as well). High oil prices are a double-edged sword for Exxon however, because if the price of crude is high, they will get fewer barrels as payment for their operating costs and a larger share will accrue to the country. Higher oil prices also encourage countries to renegotiate their contracts and while you could try to take them to international court, unless its so egregious (Venezuela) then its probably just best to let them have it. Finally, higher oil prices encourage governments to hook up with less scrupulous operators who are willing to give better terms. These smaller firms are much worse at safety and efficiency, and are less risk-averse so they are willing to take on projects with a negative NPV in the hopes of striking it big.

A windfall profits tax is a terrible idea because it raises the return on investment hurdle for US companies. If Exxon is bidding for a contract against another firm who is not from the US, all things being equal the rival will have the advantage because they don’t have the additional US tax burden. This results in fewer projects for Exxon, so they pay less taxes, distribute less profits to shareholders, and they hire fewer workers. That’s a lot of wealth that no longer comes back to the US. At a time when the economy is already weak, why would you try to handicap a very successful firm (that paid $40B in taxes last year) and enable its foreign competitors? So if Exxon is out of the picture, who are you going to buy your crude from? The Russian national oil companies? Venezuela? Any one of the corrupt regimes in Africa? Would you really rather see these players in control of the situation?

If you make it uneconomical for Exxon to produce oil then they are not going to do it (they already return billions in cash to shareholders each year through stock buybacks because they can’t find enough projects with a decent rate of return). If that happens, you’ll be giving 100% of the crude revenues to foreign governments (rather than the current split between Exxon and the foreign country) and you’ll be getting $0 in tax revenues (I’m pretty sure the government of Nigeria is not a US taxpayer). At the same time, plenty of good paying Exxon jobs in the US will be lost.

This windfall profits tax is a bunch of populist scapegoating that will have serious negative implications for the US economy.

Posted by: RexKillerson at Aug 6, 2008 8:49:52 AM

"2) Question: wouldn't a windfall profits tax that leads to less pumping make the market more efficient, as it internalizes oil's negative externalities?"

Yes.

A profits tax is probably not be the first-best way to internalize this externality, but it is more efficient than doing nothing, and certainly more efficient than a) cutting the gas tax, or b) additional tax breaks for oil companies, as McCain has been suggesting.

Posted by: a student of economics at Aug 6, 2008 9:21:44 AM

DSN, this is an excellent question.

The oil market is not competitive in the textbook sense because 6 or 7 large firms control the majority of world market share for refined oil products.

When input costs go up in an imperfectly competitive market, almost anything can happen. One possibility is that the rise in input costs bumps the market from a low price, low profit equilibrium to a more collusive higher price, higher profit equilibrium. Of course whether this can happen depends on what the initial equilibrium was.

A relevant example is the U.S. tobacco industry after the master settlement agreement. Gruber has argued that the tobacco industry (where most market share held by a few big firms) was able to use the "tax" on its product to coordinate on reaching a new high price equilibrium. After the settlement, the big tobacco firms took in revenues well in excess of those needed to cover their payments to the states, so profits actually rose.

Posted by: brian at Aug 6, 2008 9:42:31 AM

The situation DSN describes is in fact true for pure refiners like Valero and Tesoro, whose stock prices have taken a fairly big hit lately. They buy crude oil and refine it into things like gasoline and heating oil, and have not been able to pass on the full impact of higher crude oil prices to the consumer. When oil prices nearly doubled from $70 to $140 in less than a year, gasoline prices went up by a much smaller percentage (otherwise we would have had gas at $6 a gallon).

By contrast, companies like Exxon are vertically integrated: they pump the oil out of the ground and they also refine it. If they sell some of their oil to the pure refiners like Valero or Tesoro, then they would presumably make a hefty profit on that.

By the way, it is a common misperception that the global oil supply is controlled by large corporations like Exxon, Chevron, BP, Shell, etc. In fact, nowadays they control barely 10% or so of the world's oil reserves; the rest is controlled by governments and their state-owned companies. A windfall profits tax might discourage Exxon from seeking to develop new supplies of oil, but would have very little impact on the global oil supply or oil industry.

Posted by: at Aug 6, 2008 9:43:51 AM

You have to look at the cost of production to understand this. Most people think of a standard production model where the firms buys inputs at current cost, puts them together and sell a product. Most of the cost are variable cost and have to be repeated.

But oil is a very different industry. The overwhelming cost in oil production is fixed, or sunk cost. A firm spends money to drill an oil well. That accounts for the overwhelming bulk of its cost of producing a gallon of gasoline. The cost of that well is sunk or fixed cost and will not change as the price of oil changes.
This is the basic idea behind why a raw material producer like an oil company is highly profitable when the price of oil goes up. Unlike an auto company, for example, where most of their cost are variable cost and change from one period to the next.

The profits are the difference between the largely fixed cost from a well and the current market price. the current market price is supposedly set in the long run by the cost of drilling the new marginal oil well.

This is also the concept behind a windfall profits tax. If the sunk cost are $50/bbl and the market price goes from $55 to $100 profits go from $5 to $45.
Since all the cost are sunk the jump in profits from $5 to $45 is a windfall or/ and an economic rent and even if you tax this away from them it does not change their incentive to continue producing the oil that cost $50.

In theory that other $40 of new windfall profits are suppose to go into investing for new oil and a windfall profit tax reduces the profits available to finance new investment -- the source of the overwhelming source of capital spending in the US system. But in practice Exxon and many other big oil companies are now paying out much of this "windfall" profit to stockholders in the form of dividends and stock buybacks rather then spending it on new oil drilling and exploration.

So the standard economic model where virtually all costs are variable costs most economist are use to dealing with really is a poor model for understanding oil economics.

Posted by: spencer at Aug 6, 2008 10:01:05 AM

Exxon does not own the oil in Nigeria Tyler uses as an example and a windfall profits tax would not apply here.

Exxon's work in places like Nigeria is a service it provides under contract that has little or nothing to do with the price of oil.

Tyler's example is a very poor example.

Windfall profits only apply to oil in the ground that oil companies own themselves.

Posted by: spencer at Aug 6, 2008 10:05:28 AM

Even if the oil market was perfectly competitive we could still rationally explain the profits: oil is priced by the marginal barrel. If a company has low cost production, then their profits increase when the cost (and, hence, price) of the marginal barrel go up.

This is stunningly simple, I don't understamd why Tyler doesn't mention it.

Also, I don't understand what the question asker means when he says that firms are not able to pass on commodity price increases. If all firms in the same business face the same cost increases, then the supply curve will shift up and price will increase. Of course, there will now be less sold and some firms will either endure losses or go out of business, but most of the sub-marginal producers will have no problem passing on the costs.

Posted by: bartman at Aug 6, 2008 10:07:19 AM

Bartman is right.

Another way to say this is that the oil companies aren't making higher profits when the price of oil goes up, they are collecting greater economic rents on the oil they own. That is, the inframarginal unit of oil that can be produced at say, $50/bbl is much more valuable when the world price (based on the marginal unit) is $120/bbl. The extra $70 per barrel of cash flow is an economic rent.

See
http://en.wikipedia.org/wiki/Economic_rent

Posted by: a student of economics at Aug 6, 2008 11:26:18 AM

As the others said, refining (think of it like a manufacturing business; crude inputs in and refined products out) is much different that oil production. Historically low margin business.

No, there is not an oligopoly or cartel in production. Truly this gets old to listen to. I live in Western Canada and there are literally hundreds of oil companies here. Thousands around the world.

Profits are high right now because reserves were developed historically at lower costs, and the oil sold from them right now benefits from the current high price. Finding and developing reserves is a multi-year, multi-decade cycle. Most oil companies now are worried that costs have risen dramatically, there is a significant risk that if the price is low in the future, there will be a long period of low or negative profits. That's probably why they pay out higher dividends or buy back stock instead of reinvesting.

The fundamental principles of economics still apply very well.

Posted by: asparagus at Aug 6, 2008 11:39:19 AM

How then are oil companies able to make huge profits when oil prices rise significantly. Is this not a competitive market?"

The profits are large in terms of absolute dollars because companies like Exxon are enormous (Exxon also paid more in taxes on those profits than the bottom 50% of individual income taxpayers combined, btw). However, profit margins still lag behind other industries. When politicians and the media refer to "huge profits" they are looking at the absolute dollars, not the profit margin.

We should note that petroleum prices are pretty volatile. Exxon and other producers were posting huge losses in the late 90's when the market price for oil was roughly $10-15/bbl. If we tax away all the profits in boom times, we're going to have to significantly subsidize production during busts or, as RexKillerson pointed out, we'll be buying all of our oil from foreign companies. We tried the windfall profits tax in the 70's and ended up importing more oil, not less.

Posted by: Methinks at Aug 6, 2008 11:48:31 AM

Lynne Kiesling is not answering your question and her answer is factually wrong anyway.

Her answer is based on the meme that there is a refining shortage in the US because politicians have prevented new refineries from being built.

That may play an insignificant, and boy do I mean insignificant role, but the dominant reason there are no refineries in the US is that we do not need any.

Refining is one of the lest profitable industries in the US both in terms of profit margins and return on capital. I know this has improved some in recent years, but not by much. Poor profits is the market's way of telling us that we do not need need oil refineries.

Refining operating rates are currently around 88%, about the same as they have been for decades. Moreover, as high gasoline prices lead to lower gas and oil consumption the need for new refineries will fall even further.

There is no refinery shortage in the US and there will not be one on the immediate horizon.

Posted by: spencer at Aug 6, 2008 1:00:44 PM

The fact that we are importing more oil has nothing to do with the windfall profits tax.

While there is no or little causal relationship, US oil import tanked while the windfall tax was in place and it is about the only time US oil output rose since US production peaked in 1969.

I am not in favor of a windfall profits tax, but I am in favor of using the correct facts when discussing it.

Posted by: spencer at Aug 6, 2008 5:15:25 PM

Rexkillerson -- a windfall profits tax should not have any impact on a US firms ability to compete on service contracts in a country where that government owns the oil. The windfall profit tax will not apply in a situation like that because the foreign government is the entity that owns the oil in the ground and makes "windfall" profits and they are not subject to US taxes.

Posted by: spencer at Aug 6, 2008 5:21:24 PM

Spencer,
First, I've not heard anyone state that service revenues (as opposed to production revenues) will get separate treatment for windfall profit taxes. I doubt the legislation would make such a distinction.

The bigger problem with your statement is that integrated oil companies (like Exxon) don't make money by selling services to foreign governments that have oil deposits. Those governments don't have the cash (they need USD) on hand to pay for services and their sovereign credit ratings are so low that they can't borrow from the capital markets. The government can either lease the rights to a parcel of land that may have petroleum deposits or they can form a joint venture with the US firm. In either case, the oil company has to contribute capital as well as technical expertise. If the company is investing capital (it can cost $200MM to drill an offshore well and even then, the odds of getting a good find are <10% even if you do seismic studies before hand) then they need to earn a rate of return that is commensurate with the risk. If you drill 9 wells at $200MM each and they turn up dry, you need to make $1.8B on the 10th well just to break even, and that is before you have covered your cost of capital (presumably the shareholders want to see positive accounting profits above the risk free rate). The imposition of more taxes on exploration and production (indeed, they are already taxed quite highly around the world) only further limits US oil companies' ability to win bids on these contracts. That results in fewer taxes remitted to the US, fewer jobs in the US, and fewer profits distributed to shareholders in the US. And I would argue that if the US oil companies disappeared tomorrow, you would have much less efficient production (see Pemex if you don't believe me) with reduced employee safety, greater fraud/corruption, and less protection for the environment.

Posted by: RexKillerson at Aug 6, 2008 6:23:33 PM

"The oil market is not competitive in the textbook sense because 6 or 7 large firms control the majority of world market share for refined oil products."-brian

Yeah, no. See Scale, Economies Of (Chapter 7 in your textbook). See the United States' Airline industry for an example of what happens when the Government thwarts the proper formation of Economy of scale through merger. Result: they are unprofitable, they go under, and then you pay for a bailout via higher taxes, which gives government more control over your life. Repeat ad naseum. Profit is the motive which drives industrialization. That enables an increased quality of life for all. Cheers.

Posted by: Jason Armstrong at Aug 6, 2008 7:37:05 PM

integrated oil companies (like Exxon) don't make money by selling services to foreign governments that have oil deposits.

I'm gonna have to go ahead and disagree with you on that one. I used to work for the NOC of a Persian Gulf country, and basically all of the oilfield work, from exploratory geology through refining, transportation and marketing was done by big IOCs (Shell, BP, Total, etc) on basically a cost-plus fee-for-service basis. They earn modest returns with almost no risk. For example, one company is paid $1 per barrel lifted, with the parent NOC covering all fixed and variable production costs from the revenues. After a few years, when the locals do enough learning about the processes (the IOCs are obliged to hire locals), the NOC decides to do all the work themselves, essentially nationalizing what were previously joint ventures with the IOCs. Since this is all under the guise of contracts, its entirely legit. The Arabs got hosed by the IOCs in the 50s and 60s, but the shoe is on the oter foot now.

The IOCs are slowly coming to terms with this new world - moving away from being owners of leases to being providers of services.

Posted by: bartman at Aug 6, 2008 10:55:52 PM

Next time I see Lynne I'll have to ask about her refinery statement. It seems a little odd, and she's not the kind of person to spout nonsense.

Spencer is basically right. What he didn't mention is that the US has lots of spare gasoline refinery capacity, except it's located in Europe. In the refined products business, the North Atlantic Basin - Western Europe and North America east of the Great Plains - is basically one big market. What is exceedingly scarce is diesel fuel production capacity. In the last ten years there has been a massive shift to diesel-powered cars in Europe - now over 50% of all cars - and that has messed up a refinery slate that was built to serve a market that was 20% diesel and 80% gasoline. The end result is that the Europeans ship lots of gasoline over here, and we ship lots of diesel over there.

That's why crude to gasoline crack spreads are so weak - $2 or $3 per barrel. It's the diesel (AKA distillate) cracks that are keeping the refiners' heads above water.

This situation has manifested itself in a few odd ways. For example, New York now has the cheapest pre-tax gasoline in the country, since it is the main port for gasoline imports. This certainly wasn't the case, say, five years ago. Another effect: notice how expensive diesel is, now, in the middle of the summer? For as long as anybody can remember, diesel was always cheaper than gasoline in the summer. But not this year, for the first time since records have been kept.

Posted by: Bartman at Aug 6, 2008 11:13:22 PM

Rexkillerman everything you say is very good but it has nothing to do with a windfall profits tax. Such a tax is only levied on old already producing well.
It is not applied to new wells and that is what you are discussing.

So I stand by my point that the WPT does not apply to the situation you are describing.

Thanks Bartman, But I have a question.

When I look at the oil import data I see is a long term trend that products share of total oil imports is falling--despite short run cyclical upward swings --
while the share of crude is growing. I would have though the long run trend would be for refined products share to rise. Do you know why it is falling?

My first response is that it implies that there is actually more excess refining capacity in the US than I thought.

Posted by: spencer at Aug 7, 2008 9:07:21 AM

One final point on oil refining capacity.

Since the last US refinery was built in 1976 us oil production has fallen about 40%

With 40% less oil to refine, why do we need new refining capacity?

Posted by: spencer at Aug 7, 2008 9:21:07 AM

Spencer:

Import share of refined products is down, but absolute values are up - gasoline imports have gone from 400,000 bbl/day in 1996 to over 1.2 million in 2006 (peaking at 1.6 million in May 06.)

However, the product share of refined products is decreasing because crude imports dwarf product imports, and are growing faster. The growth in imported crude almost perfectly offsets declining domestic production. If you look at the past ten years of data, you'll see that domestic crude production plus non-SPR crude imports are almost flat, and refining outputs are also almost perfectly flat, on an annual average basis, over the past ten years. Any growth in gasoline demand has been met by importing, which is the swing variable in the equation.

Bottom line is that US refinery capacity has (more or less) reached a steady state, and is humming along at practically full utilization, given some seasonal ups and downs. So we have enough refining capacity, except in the occassional summer month, when it gets maxed out, but that's why imports spike up in the summer. It's just that we don't have any excess refining capacity anymore, like we did in the 70s and earlier. But excess capacity is an expensive luxury, especially when imports are readily available.

Why do we import crude and not finished products? One answer is that crude is denser than products, so on a mass basis, it is cheaper to transport crude than products. Also, especially in the US, products often have to be closely tailored to the correct regional specifications. Refinery operations costs are also probably cheaper here than in Europe (although not cheaper than in the Caribbean, which is the next largest source of imported gasoline.)

Posted by: bartman at Aug 7, 2008 10:12:08 AM

One way US oil firms has gotten around the NIMBY objections to new refineries is to build ones in the Caribbean that are really dedicated to the US market.

So in a way shouldn't we actually include the Caribbean refineries in the US refinery count?

Posted by: spencer at Aug 7, 2008 12:51:51 PM

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