Hydrocarbon Hype

November 6, 2005 • Commentary
This article appeared in the Washington Times on November 6, 2005.

After the unsurprising news big oil companies had reaped big profits, Fox TV’s Bill O’Reilly concluded: “My contention is the oil companies don’t have to double their profits. They can maybe make them two‐​fifths [40 percent]. Take a little less for the good of the nation.”

Exxon-Mobil’s recent profit margin was up to nearly 9 percent of sales. Suppose they tried to cut that to a nickel out of every dollar by offering crude oil for $3 a barrel less than the going price on the Chicago mercantile exchange? World refiners would instantly commit to buying every drop. The next day, the world price of crude would be same as before.

Suppose the Big Five oil companies got together and agreed to cut retail gasoline prices at their company‐​owned stations by 20 cents a gallon. Motorists would soon drain those stations dry, leaving the much larger number of independent gas stations able to charge even more. Meanwhile, independent station owners would file a complaint with the antitrust division of the Justice Department accusing the majors of collusive predatory pricing to drive them out of business.

If prices or crude oil and gasoline really rise and fall at the whim of U.S. petroleum companies, why would oil and gas prices ever fall? Texas crude fell to $12 in February 1999. Was that because U.S. oil companies suddenly became less greedy?

“Average U.S. gasoline price tumbles to $2.48 a gallon,” said a recent headline at USA Today, noting gas prices had dropped by at least 55 cents. The crude oil price dropped 9.8 percent in October. The Dow Jones stock index for oil and gas companies fell 9.2 percent. On the futures market, natural gas prices fell 18 percent in a single week.

Mr. O’Reilly’s spin zone had to spin a new theory. He now argues that, while prices rose due to some inexplicable hurricane of greed, they later fell because “oil companies have been scared into lowering prices of oil.” He claims “the worldwide demand for oil is the same today as it was eight weeks ago. But oil prices are declining — so what gives? Fear. That’s what gives. Millions of Americans are angry with big oil and are buying less fuel.”

Excuse me? If millions of Americans are “buying less fuel,” how could demand be the same? Trying to spin his way out of that paradox, Mr. O’Reilly differentiated “worldwide” demand. But worldwide demand must be entirely irrelevant unless domestic prices of oil and gasoline are set by supply and demand in worldwide markets, rather than corporate caprice.

Yet Mr. O’Reilly says, “The truth is that the American oil companies set the domestic price of fuel based upon what they think they can get away with.” But if domestic companies set oil and fuel prices, why even mention world demand? And if only American oil companies fix prices — up or down depending on their mood — why are the prices identical, here and abroad, at British Petroleum and Royal Dutch Shell?

In reality, Mr. O’Reilly could not possibly know if “worldwide demand for oil is the same today as it was eight weeks ago.” The International Energy Agency (IEA) estimates world demand by the month, and its latest was for September. “Chinese apparent demand is again revised down,” said IEA. “Spot gasoline prices were pressured [downward] on record U.S. imports.” If only they could accept Mr. O’Reilly’s notion that American oil companies set prices wherever they like, the IEA could just stop collecting such bothersome facts.

If you sell your house for much more than you paid for it, you will receive a “windfall profit.” When you take that windfall from selling your old home and go shopping for a new one, you’ll discover prices of replacement homes have gone up, too. That may explain why the Senate has not yet contemplated an extra “windfall profits tax” on windfalls homeowners receive when selling their homes. Since 1997, in fact, couples can pocket half a million dollars of such windfalls tax‐​free.

Aside from the tax break on homes, something very similar happens in any business whenever the price goes up for something bought earlier at a lower price. Raw materials processors hold inventories, for example, and those may have been bought for much less than the current price. When the book value of those inventories is adjusted to reflect today’s higher price, accountants add that difference to the firm’s profits. But this is called “inventory profit,” because those paper gains will soon be needed to replace the raw materials at the new, higher price. Then the gains vanish.

The oil industry holds a lot of inventory, and we should be glad it does. If an oil company stockpiled a lot of oil at $40 — before it rose to $60 — that will look almost as good (on the books) as the sorts of windfalls we’ve seen on home sales in Las Vegas. Since gasoline prices also rise when crude does (partly because crude accounts for half the cost), products refined from the cheaper $40 crude will also be unusually profitable for a while. But this is like making money on the house you sold but needing every dollar to buy a replacement home. Prices of oil likewise must reflect replacement costs, and the resulting one‐​time surges in inventory profits are not a problem but part of the solution.

On second thought, perhaps I should not have brought up this analogy between “windfalls” on oil and homes. Certain senators are looking for any excuse to tax anything. I surely do not intend to encourage such political pillaging.

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