The View From 1776
Friday, April 28, 2006
Oil companies are not, as angry consumers believe, generating higher profits by gouging at the gasoline pump. Demanding that your political representatives impose windfall taxes or price controls will guarantee even higher pump prices long into the future.
One legacy of New Deal socialism is the now unquestioning assumption that the Federal government can and ought to fix whatever problems come our way, rather than allowing the ingenuity of millions of individuals to find accommodations and solutions.
Liberal Republicans and Democrats have proposed windfall taxes on oil companies and have presumed to exercise business judgment by instructing oil companies how to invest their money. Surveying the handiwork of Federal bureaus, under both Republican and Democratic administrations, will convince a disinterested and non-ideological observer that the Feds are about as effective as a blind ape performing brain surgery with a sledge hammer.
Price controls and windfall taxes can be crippling to consumers as well as oil companies. President Nixon, proclaiming “we are all Keynesians [socialists] now,” imposed price controls from 1971 to 1974. OPEC responded to Nixon’s price controls with the 1973 oil embargo. Spot market oil prices immediately doubled and began a sustained climb to an inflation-adjusted price of $95 per barrel in 1980 at the end of the Carter administration. And we had to sit for hours in lines at service stations to get a few gallons of fuel.
Because of its recent record-high quarterly profits, ExxonMobil has been the maximum-visibility target for angry consumers of all political persuasions. But those record profits, by themselves, do not prove gasoline price gouging.
1. Most of ExxonMobil’s profits are made from international oil and gas ventures, not from gasoline sales in the United States. Those profits accrue from consistent investments of billions of dollars over many decades, in places like Chad and offshore Angola.
2. A significant part of ExxonMobil’s profit increases have resulted from year-by-year increases in operating efficiency. Worldwide sales increased 72% from 2001 to 2005, while the total number of worldwide employees dropped from 98,000 to 84,000. Additionally, ExxonMobil has the industry’s largest and most highly integrated refineries, which has made it more efficient than most other major oil companies.
3. Oil companies like ExxonMobil exhibit what is called operating leverage. A high portion of their operating costs is fixed; that is, those costs do not change much if at all when sales rise or fall.
Pumping more oil and gas from existing wells and processing petroleum in refineries doesn’t require hiring more employees or running additional shifts, in contrast to manufacturing in the automobile industry. Oil company operations run 24/7 with no shutdowns, except for periodic maintenance. Refineries, wells, and pipelines are closed systems through which oil, natural gas, and refined products flow, with relatively little human intervention. Because of their enormous capital investment and fixed operating costs, refineries are particularly vulnerable to fluctuations in oil prices, their profits bobbing up and down. Many major oil companies, as a result, have sold their refining operations.
Operating leverage means that changes in sales volumes disproportionately affect net income. When world oil prices rise, sales volumes go up more than operating costs, and a large portion of the price-driven volume increases flow to the bottom line net income. Operating leverage also means that when oil prices fall, operating costs don’t decline much, and net profits drop more than proportionally.
In 2003 when oil prices increased 78%, ExxonMobil’s net income as a percentage of sales jumped 59%. But in 1999, when oil prices dropped 8%, ExxonMobil’s net income to sales percentage declined 19%. Oil prices have declined in three of the past ten years. But ExxonMobil’s net income percentage dropped, as much as 87%, in five of those ten years.
Angry consumers look only at ExxonMobil’s profits in recent quarters and are unaware that, over long time spans, the company is as much vulnerable to low oil prices as it is the beneficiary of current high prices.
Over the past decade, ExxonMobil’s net income as a percentage of sales has averaged a relatively modest 7.3%, with the high point in 2005 at 10%. This pales in comparison to the operating leverage of Microsoft, where software development costs are analogous to oil companies’ fixed costs, and duplicating and distribution costs are a small fraction of sales prices. Microsoft’s net income to sales has not been less than 25% in the past decade and has gone as high as 41%.
4. 68% of ExxonMobil’s net income over the past five years has been plowed back into finding and developing new energy sources, which is part of a continuing effort that has been markedly effective over many decades. Liberals in Congress, however, wish to supplant management’s authority and require that capital funds be diverted to a repeat of the 1970s Federal synfuels fiasco.
Apparently inescapably, liberals suffer the socialistic state-planning delusion that they merely have to conceive an idea and pass a law to make it reality. In the words of a CNNMoney.com article, “Jimmy Carter’s synfuel project flopped in the 1970s. In the 1980s the government poured billions into the black hole of fusion. In the 1990s solar energy amounted to little more than an expensive toy for tree huggers.”
Windfall taxes or price controls will reduce the amount of funds available for finding new sources of energy, thereby curtailing future supplies of oil and guaranteeing higher gasoline prices here. Finding new energy sources has become hugely expensive as off shore drilling operations have moved from 600 foot depths fifteen years ago to as much as 7,500 feet under water today. Future production from difficult sources like tar sands will require much larger investments than past drilling ventures.