Please explain the economics of energy and oil.

July 31, 2008 5:23 AM

How do gas companies get away with raising prices so much when they are reporting such high profits?

I just heard on the radio that Shell reported a 14% rise in profits over the last year, the largest increase in history for a US company. British gas here in the UK are raising prices by 35% (!), but they are reporting billions of pounds of profit - so much profit that the government are considering a windfall tax for British Gas, but is that something that is going to reduce that 35% increase? How do massive profits + massive price increases NOT equal profiteering?
I am obviously mostly ignorant about economics, but I would like to learn more, so any books/articles that will help me understand this would be appreciated in addition to your explanations

posted by F.Jasmine Addams to law & government (16 answers total)

I think the long and short of the price rise in Gas in the UK is that British Gas buy all their gas on short term contracts and lock in prices for periods of time.

In real terms, the whoelsale price of gas over here has goine from 40p per unit to 90p per unit since the beginning of the year which os only now starting to affect their bottom line (esp when they were charging 60p per unit until the price rise - they were selling at a loss).

So, now their prices are going up in accordance with the market rate.

The reason they are allowed to do this despite earning whopping profits is that we live in a free market economy and, it's their job as a company to return money to their sharehodlers and not subsidise people who may not be able to afford gas (that's where the govt tax credits and welfare subsidies come in).

At the end of the day, they are pricing the gas according to the market and running a profitable company, which is their job.
posted by moocheen at 5:34 AM on July 31, 2008 [3 favorites]

Oil companies have massive gross revenue. For instance, Exxon Mobile took in $138 billion for the most recent quarter. On that, they had an income of $11.68 billion, around an 8.5% margin. That's really not that great, and some pretty shoddy profiteering. And of course their revenue and profit are going to go up. How could they not if the product they are selling has gone up in cost and price by such huge amounts over the last year?
posted by smackfu at 5:38 AM on July 31, 2008

You could learn a bunch from the current earnings statement. Take, for instance, this piece. Not only is the margin low, as mentioned above, but only 1.6 billion of their 11.7 billion earnings were from refining and marketing. The rest were from exploration activities. The latter is less connected to short-run demand concerns and will only have increased profit margins as oil gets more scarce.
posted by fatllama at 5:44 AM on July 31, 2008

I just heard on the radio that Shell reported a 14% rise in profits over the last year, the largest increase in history for a US company.

Maybe for an oil company - I'd be surprised if Shell is the first US company to ever experience a 14% increase in profits year over year.

How do massive profits + massive price increases NOT equal profiteering?

Profiteering implies some sort of unethical activity is going on. What exactly is unethical about the profits and price increases?


The only way the price increases are actually a bad thing are if both of the following conditions are met:
(1) current proven petroleum reserves are actually sufficient for 100 years or so of consumption (in which case the petroleum companies have been lying about proven reserves)
AND
(2) burning petroleum products has no negative local or global environmental effect.


As far as I can tell, we are running out of petroleum, and using what we have isn't doing good things to the earth. Market dynamics are pushing prices up to the point where alternative fuels are worth developing. This is a good thing.
posted by b1tr0t at 6:23 AM on July 31, 2008

Maybe for an oil company - I'd be surprised if Shell is the first US company to ever experience a 14% increase in profits year over year.

That line in the question wasn't worded quite right. The record is in the dollar amount quarterly profit, which is a silly metric given mergers, currency fluctuations, and inflation.
posted by smackfu at 6:26 AM on July 31, 2008

Yep, it's margins. If the profit margins stay the same but the cost of the product (in this case $/barrell) goes way up -- about doubles in a year or so -- the net profits will go way up, too.

As for why it's "allowed," governments in free market economies don't tend to prevent companies from making money. In theory, higher profits is better for the economy as a whole (not to mention the tax the government realizes on the income).
posted by pardonyou? at 6:28 AM on July 31, 2008

You're right but you've got your orders mixed up. They're spending a billions on exploratory drilling because it's cost-feasible with $4/gallon gasoline. They're spending billions on "alt energy" because it makes them look better to consumers AND it's a tax break AND it lowers their margin so they can get away w/ record profits, and most importantly it lets THEM own the patents or the companies so that when they DO make a discovery---they can keep it on the DL and/or make the money off of it.

The oil scare of '08 has nothing to do with a true product scarcity, it's an artificial shortage to drive up prices and increase those revenues. They're a company, that's their job.
posted by TomMelee at 6:41 AM on July 31, 2008

This piece in the New Yorker answered pretty much all the questions I had about the subject.
posted by hecho de la basura at 6:53 AM on July 31, 2008

Oil companies book their inventory under FOIL accounting: "first out, in last." So when oil prices rise they immediately pass along costs (as opposed to having a time lag until extant, lower-price inventory is depleted), but when prices drop they may not be so quick to lower prices again, especially if their competitors aren't so quick to drop those prices either.

Funny how often that seems to happen.

Moreover, when prices do drop, consumers may hear of it but cannot possibly know if the lowered pump prices contain 'extra' profit over the cost compared to previous, lower prices, and in general consumers are placated by that 2¢ or 3¢ drop and don't ask questions (or know where to ask questions, or know to ask questions.
posted by skywhite at 6:59 AM on July 31, 2008 [1 favorite]

I work in the industry. Very rough estimate is that about 15-20% of current price is down to speculation. But margins are a lot lower than people think compared to other industries, it's simply a matter of the volumes being dealt with.

What you're failing to take into account is that as b1tr0t says, we're running out of oil. Not overnight, but we will see a steady decline as the plateau starts dropping down. Read up on Peak Oil for more information. We're reaping the rewards of bad decision making in the 80s when the oil price was much lower and the companies didn't want to invest in finding and developing new fields.

Yes, the industry is making record profits, this is supply and demand. There are no easy answers or solutions, and certainly not McCain's plan to open up extra offshore drilling acreage - it's not like turning on a tap, it'll take 15-20 years before that oil can come on line in anything like significant quantities.

Far better to work on conservation and developing new technology, with the rather nice side effect of reducing global warming, which our kids will like.

(On a side note, I didn't see everyone queuing up to help us out in the last down cycle when oil was at $15/barrel and those of us that didn't lose our jobs took massive pay cuts. That's simply market economics at work and it affects all industries. What the oil industry and everyone else wants is stability. Doesn't matter what the cost per bbl is, be it $20 or $200, as long as it remains relatively steady, people can predict costs and invest in infrastructure accordingly).

My 2c.
posted by arcticseal at 7:11 AM on July 31, 2008 [3 favorites]

There are many reasons why oil is relatively scarce:


- increased demand from India and China.

- inefficiently run nationalized oil companies (read: Venezuela and Iran)

- political instability/thread of war with producing countries

- restrictions on new exploration (US ANWR and bans on off-shore drilling)

- increased concern over carbon foot print

- weak dollar (we can't buy as much of it)

- and biggest of all, they aren't making any more of it!


Now, every smart person intellectually understands all the points above. But when it comes time to fill your tank at the pump, none of that smarty stuff matters. All we care about is "how much can I afford?"

Without high oil prices there would be shortages. High prices are the best way for the oil producers to tell the consumers that they need to cut back. No one is explicitly thinking in those terms (and I'm sure Shell, BP, OPEC, etc would love you to increase usage) but that's what is actually happening with the market.

The oil companies are allowed to continue as they have b/c the alternative is worse.
posted by sbutler at 8:35 AM on July 31, 2008 [1 favorite]

One small aspect is also that while one corporation may control the much of the process from exploration to your gas tank, it relies on a chain of subsidiary companies for each step.

MyOil Corporation has MyOil Exploration Co. to find the oil, and obtain the leases, which are then sold to MyOil Drilling Co. to obtain it (helped by MyOil Rigging Company) which then pays MyOil Shipping Co. to sell it to MyOil Refinery Co., where it is then sold to MyOil Gas Bars Inc. where you finally buy it. At most of these steps, the product is bought and sold at a profit, which all shows up on the books of MyOil Corporation.

At each step, the individual companies can say that they are buying at a price set by the sellers, and it is comparable to the market rate. (ie what the subsidiaries of YourOil Corp, HerOil, and HisOil charge each other for similar transactions, therefore there is no collusion or profiteering.)

This is overly simplified, and leaves out third parties that compete for and provide many of these services, but it is far from an actual competitive market.
posted by Chuckles McLaughy du Haha, the depressed clown at 9:08 AM on July 31, 2008

Market dynamics are pushing prices up to the point where alternative fuels are worth developing.

This is truly what I don't get. Shouldn't this have happened a long time ago? Why hasn't it? Why aren't the big automobile companies rushing into it? I'd love to get an alternative-energy powered car, but the ones avalibale are so damn expensive... I can only think that is because they are not a mass product. And why not? Kinda catch 22.

Anedoctaly, there's this one guy in Portugal who made up a Fiat 126 (IIRC) into a completely battery-run car, with energy costs of EURO1.00 per 100km. You juice it up via a normal electrical wall plug... He claims it cost him about EURO8.000,00 to convert, and all his friends are asking him to do it to their cars. And Ford/Honda/Fiat/whoever can't..?
posted by neblina_matinal at 9:30 AM on July 31, 2008

For battery powered cars, you pay a large premium to get a car that has very limited range. That's not a trade-off that consumers have shown a willingness to accept.
posted by smackfu at 9:51 AM on July 31, 2008

This is truly what I don't get. Shouldn't this have happened a long time ago? Why hasn't it? Why aren't the big automobile companies rushing into it?

Because companies that rush into things usually go bankrupt. Suppose GM had rushed into this in the 60's and 70's... at the time the price of oil was a huge concern. But then in the 80's and 90's GM would have lost it all because oil became cheap again.

I'd love to get an alternative-energy powered car, but the ones avalibale are so damn expensive... I can only think that is because they are not a mass product. And why not? Kinda catch 22.

Anedoctaly, there's this one guy in Portugal who made up a Fiat 126 (IIRC) into a completely battery-run car, with energy costs of EURO1.00 per 100km. You juice it up via a normal electrical wall plug... He claims it cost him about EURO8.000,00 to convert, and all his friends are asking him to do it to their cars. And Ford/Honda/Fiat/whoever can't..?

Your first paragraph doesn't support your second. Last time I looked at a Honda Civic the were ~$20,000. So to add that electric kit just made the car price over $30,000, a 60% increase in price! That is not a cheap addition.
posted by sbutler at 11:21 AM on July 31, 2008

The price of oil can be explained from a simple supply and demand framework. There is a growing international demand for oil which looks to only increase in the future and oil companies do not increase supply because with increased demand in the future the price of oil looks like it will increase.
I do not agree that speculation drives the oil price. If this were the case, then the price of oil would be artificially high in the market and there would be excess supply, but this is not the case in the market.
If you want to lower the price then lower the demand for oil.
posted by bucksox at 6:53 PM on July 31, 2008 [1 favorite]