Monday, May 01, 2006

# Posted 11:23 PM by Ariel David Adesnik  

WOULD TIM RUSSERT PASS ECON 101: This exchange with Energy Secretary Samuel Bodman was quite memorable:
MR. RUSSERT: Mr. Secretary, if, if demand is up but supply is down, why are the profits so high?

MR. BODMAN: For that reason.

MR. RUSSERT: No, think about that.

MR. BODMAN: You know?

MR. RUSSERT: Play it out.

MR. BODMAN: Demand is up.

MR. RUSSERT: Correct.

MR. BODMAN: Right?


MR. BODMAN: So you’ve got more demand, you’re going to force price up.
You’ve got, you’ve got limited supply, and you’re going to have...

MR. RUSSERT: But that’s a decision by the oil companies.

MR. BODMAN: No, it is not...the producers determine the price of oil.

MR. RUSSERT: They determine, they determine, help determine the price at the pump. And if the, if their profits are going up, they have made a decision to add on the cost at the pump at such a level to guarantee higher profits.
Perhaps the oil companies will "decide" not to raise their prices in line with demand as soon as NBC "decides", when its ratings go up, not raise the prices that advertisers pay for buying airtime.
(11) opinions -- Add your opinion

That's GREAT!!! I'll share it with my economics students today.
David: ignoring your shot at NBC's ad rates, Russert has a decent point: that oil company profits are a result of the oil companies raising their prices - and not just for the oil that they long ago 'paid' for... and were they to not do so, their profits wouldn't be so high and we wouldn't be paying so much for gas right now. This isn't to say that there is anything fundamentally wrong with the oil companies doing what they're doing... but it's wrong for them and their supporters to act like they innocently stumbled upon the profits they are now making.
Steve, demand(meaning more gas,oil is being used)means more profits. When you sell more of a certain item that you produce you make more money by selling more volume. The US, China, India, and the world in general is using more oil and gas. This equates to more volume and thus higher profits. The good news is that many Americans own stock in oil companies which also make money from China,India, and the rest of the world, thus money is flowing back to the US from some of these areas. No I do not own any stock in an oil company(unfortunately).
I think what is driving these high profits is the fact that many of the oil companies actually own oil fields in the US. So as the world price of oil rises, so does the price of our domestic oil. I think this is what Steve is referring to. As to what component of these profits is coming from increased volume of sales, I'm sure it has an effect, but is not a primary driver. Looks like Houston is getting ready to be a boom town again.
The price of oil is the marginal cost of producing the last barrel used. If demand increases, or the marginal cost of the last barrel used increases, the price goes up. That increases the profit on all the earlier, easier-to-extract barrels of oil, if the cost of extracting them has not risen.

This is what people call "windfall profits," because the oil companies (and governments, like the Saudis) are getting extra profit not because their oil is becoming more expensive to extract, but because other, more marginal oil supplies, are becoming more expensive. (Say, in Venezuela, where Chavez is destroying that country's infrastructure.)

(Of course, if oil is becoming more scarce, it only makes sense to conserve it more by raising the price.)

People always get the idea that it would make sense to tax away windfall profits. The idea is that companies and countries should make a reasonable profit on each barrel of oil, conceding that charging $60 for a barrel that costs that much to extract makes sense, but denying that it makes sense to start charging $60 for a $5 barrel instead of $40 when the cost of that barrel doesn't change.

It's an attractive argument, and makes sense in some ways. HOWEVER, while it makes sense in the short term, it never works in the long term. In the long term it prevents investment and new exploration, and actually limits supply and raises prices.
As a long time senior manager in a commodity based business, it astounds me that so little is known about this process. The "oil companies" (refiners) no more set the price of crude oil than farmers set the price of Soybeans. The refiners buy futures contracts for oil on a commodities futures board. The refiners buy most of their raw material in this way (otherwise we'd buy gas at Saudi Arabian or Iranian gas stations). The profit margin of the refiner is very dependent on their skill in acquiring futures contracts at the lowest market point. No one cries when the refiners buy futures contracts higher than the market and the difference shrinks their margin, but you can bet it happens. To make matters worse the refiners does not set the market price of the refined product, it too is sold on a commodity board. So the refiner is left winning or loosing in a commodity business and they either win big or lose big and it's called gouging when the do what they are paid by the stockholders to do!
Mr. Russert's problem is one that he shares with many journalists: he knows nothing about economics. President Bollinger of Columbia suggested at one point requiring courses in economics for students majoring in journalism, but whether or not that has come to pass, most of the prominent members of the MSM today have never taken any economics classes.
It's not merely that MSM types are economically illiterate. That illiteracy seems at least a little evident in the comments above.The main reason that the price charged for gasoline at the pump must rise when the spot market price rises, is that the next gallon bought by the distributor must be paid for at the present price. Therefore he must charge the consumer the present price regardless of what he paid for "old" gas, since he must have that much money to replace his inventory with new gas.
I despair, what with the state of education in the US, of any significant fraction of the population knowing even the first thing about basics, let alone the importance of fiscal policy and monetary policy on an economy. I would make, what I believe to be, a suckers bet that I cannot find fifty percent of the people who comment here who can even tell me what fiscal policy and monetary policy are.
Bodman blew it. He could have done a much better job of explaining how prices work. When demand exceeds supply there are three ways of handling the situation:

1. Raise prices until demand gets in line with supply.
2. Sell your current supply at current prices until you run out, so the people at the end of the mile long gas line have to do without.
3. Ration gas either by coupons, or limiting fillups to a set quanity so people will have to go around again to the end of the mile long line to fill up again.

And then 4. ask Russert whether he would prefer to pay 1$ a gallon more for gas or wait in line about an hour per fillup, if he is lucky.

I went thru the gas lines in the 70's and 80's. I prefer no lines and higher prices.
Isn't there a live question about barriers to entry leading to a not particularly competitive industry? That is, given the fairly large profits available to each company at the current price, why isn't either one of them or a new competitor selling at a lower price in order to capture a greater share of the market?
(I have no idea if the formatting will come out in this post, apologies in advance if it doesn't)

Isn't there a live question about barriers to entry leading to a not particularly competitive industry? That is, given the fairly large profits available to each company at the current price, why isn't either one of them or a new competitor selling at a lower price in order to capture a greater share of the market?

As to the high barriers to entry, that's true in this case, but the gas/oil market isn't a free market to begin with. The suppliers are mostly government-run monopolies (OPEC) and the futures market dictates the price of a barrel of oil. Then you also have the bottleneck imposed by environmental regulations (no new refining capacity built since I believe the 1970's, the new ethanol restriction that has led to some shortages in the Northeast) between barrels of oil and the gas you buy at your Mobil station.

As for the profit angle, it's really overblown (shocking!)

From Exxon Mobil's Annual Report

Annual Reports Profit Revenue %
2005 36,130 358,955 10.07%
2004 25,330 291,252 8.70%
2003 21,510 237,054 9.07%
2002 11,460 200,949 5.70%
2001 15,320 208,715 7.34%

Quite simply, most of that record profit comes because of record revenue. For comparison, charts I've seen put profit % at about 19% for Pharmaceutical Industry, by far the highest, with the Banking and Investment Services industries also at about 13-17%. Overall industry numbers are about 7%. A large part of the uptick on profit % is due to the accounting system used. They don't sell gas at the price they paid for it, but at replacement cost.

Say theoretically, you want to start trading oil by buying one barrel of oil at a time. The current market price is $50 and you want to make a $2 profit - not unreasonable IMO. So you are buying one barrel of oil at $50 and selling at $52 for awhile. It's going great, you're making a nice little profit when suddenly, I don't know, Iran tests a nuclear weapon and the market price doubles to $100 while you have one barrel in your possession. Now, you're going to sell at $102 or so - giving you a profit margin of over 100% while in reality you aren't making any more profit than any other barrel provided you replace said barrel and keep going with your plan.

The lesson here, as always - instead of being a sheep and bitching when the price of a commodity keeps going up, invest in the industry and make other people pay for it. And, um, don't rely on the media or politicians for your economic understanding.
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