On “The Daily Show” the other night, John Stewart hosted an oil industry expert talking a bit about current oil prices. She was a very happy woman, and her engaging, bubbly personality was just charming enough that she could repeatedly evade John’s questions without being too obvious. I thought I’d step in and answer her questions for her.
Why are gas prices so high?
John asked why gas is so expensive. She replied, “supply and demand. When demand goes up, prices go up.”
So far, so good. She’s quoting basic economics. John was ready for her: “Yes, but why do profits go up? If oil is more expensive, wouldn’t that offset the higher prices resulting in the same profits?”
Bubbly oil company rep: “Oh, but John, when demand goes up, prices go up.”
… and this exchange was repeated about four times.
Should gas prices go up while oil profits don’t?
At first glance, it seems like John’s logic is sound. Let’s say oil costs $1/gallon. Let’s assume it costs an oil company 50 cents to refine, transport, and sell the gasoline. They sell it at the pump for $2.00. Their profit:
| Original | |
|---|---|
| Revenue | $2.00 |
| Cost of oil | ($1.00) |
| Cost of processing | ($0.50) |
| Profit | $0.50 |
If oil goes up 50 cents to $1.50/gallon, the oil companies should pass that cost through to the consumer, sell the gas at $2.50, producing:
| Higher prices | |
|---|---|
| Revenue | $2.50 |
| Cost of oil | ($1.50) |
| Cost of processing | ($0.50) |
| Profit | $0.50 |
Same profit. So if they’re enjoying record profits, they must be price-gouging, right? Wrong.
The problem is Wall Street or, more accurately, how we all treat money.
Oil companies just don’t pass costs through to consumers. We as investors and Wall Street don’t look at the actual dollar amount of profits. We care about profit as a percentage of sales. We don’t say “My investments made $3,000 for me last year,” we say “My investments made an 8% return last year.” That’s the profit margin. Profit margin is a company’s bottom line profits divided by top-line sales.
Let’s look at the above scenarios again, but this time we’ll look at profit margin, not profit dollars:
| Original | |
|---|---|
| Revenue | $2.00 |
| Cost of oil | ($1.00) |
| Cost of processing | ($0.50) |
| Profit | $0.50 |
| Profit margin | 25% |
| Higher prices | |
|---|---|
| Revenue | $2.50 |
| Cost of oil | ($1.50) |
| Cost of processing | ($0.50) |
| Profit | $0.50 |
| Profit margin | 20% |
When oil prices go up, if oil companies simply passed through the cost without an additional markup, their profit margin would fall. In the world of investors who care about percentage profits, this is a strict No-No.
So when oil companies raise their prices to keep their profit margin constant, they have to raise their prices from $2.00/gallon to $2.67/gallon even though the oil price change was only 50 cents:
| Higher prices (constant profit margin) |
|
|---|---|
| Revenue | $2.67 |
| Cost of oil | ($1.50) |
| Cost of processing | ($0.50) |
| Profit | $0.67 |
| Profit margin | 25% |
Instead of gas going up 50 cents when oil prices go up 50 cents, keeping profit margin constant means gas prices will raise 67 cents when oil prices go up 50 cents. That extra 17 cents flows straight to the bottom line. In dollar terms, profits formerly at $.50 are now at $.67.
(So that is a 34% increase in the actual dollar amount of profits! Even though the profit margin (percentage) stayed the same, the media will likely be reporting it as “a 34% increase in profits.” And it’s quite a large increase for the company doing nothing but marking up their product using a standard business markup practices.)
Now we can ask whether oil companies are using the tight supply to mark up their oil even more. If so, that’s where the unethical behavior and price gouging is coming in. But sadly for the rest of us, unless we want to let oil companies report lower percentage profits without penalty, every increase in oil prices will be offset by a much greater increase at the pump.
By the way, oil CEOs shouldn’t be paid for huge profits from supply price increases. That just rewards them for tightening supply and not investing in new energy sources!
Now that you know the rational side of the argument, visit my rants blog to learn why we’re getting exactly, precisely what we have said we wanted for the last thirty years.