26 May 2007

High Gas Prices Mean Big Profit for Big Oil

Your Pain, Their Gain
High Gas Prices Mean Big Profit for Big Oil
By Christian E. Weller, Amanda Logan
May 25, 2007

Read "Pain in the Gas," a report on gas prices
Watch the Pain in the Gas video
The American Petroleum Institute ran full page ads in The Washington Post this week declaring that the oil industry only made a 9.5 cent profit for every dollar spent on gasoline in 2006. Yet when they made this claim, it seems like they were banking on readers not remembering the similar ads that ran last year in The New York Times.
Last year’s New York Times ads showed oil industry earnings for 2005 at just 8.5 cents on each dollar of gasoline sales. By the industry’s own numbers, that means that the profit margin of the oil companies increased by 11.7 percent from 2005 to 2006, at a time when gasoline and crude oil prices rose.

The American Petroleum Institute ads imply that crude oil price jumps and not profits are a bigger part of the story of higher gas prices. But whenever the helpful people of America’s oil and natural gas industry try to educate consumers, it pays to be skeptical. After all, the statement about net income is taken out of context. Most consumers are not experts in gasoline production or corporate finance. And people paying the highest prices in more than a quarter century to fill their gas tanks probably want to know if their friendly neighborhood oil conglomerate is sharing in the pain by lowering their profit margins.

Since the beginning of this year, the ratio of gasoline prices to crude prices—a rough approximation of the oil companies’ mark-up over their input prices—rose 37 percentage points. In fact, gasoline prices jumped 39 percent while crude prices only increased by 9.1 percent since December 2006. That spells big profits for oil companies, and when the lobby runs the same ad next year, it just might show an even larger profit margin.

This is not the way it is supposed to work. When input prices rise in a short period of time, profit margins should decline. Companies often absorb input price shocks, such as higher crude oil prices, by reducing their profit margins while also passing on part of the price increase to their customers. If companies instead pass the full price shock on to their patrons, they may be able to preserve their profit margins, but they could lose business as demand for the product dropped off due to higher prices.

Imagine, for example, that the price of a gallon of milk increases by 25 percent over three months. Most food producers and grocers would not increase prices by 25 percent because such a steep increase would lead many consumers to switch to other substitute products, such as soy or rice milk.

Yet gasoline is clearly not milk. The data show that oil companies have increasingly been able to pass higher crude oil prices on to the consumer rather than absorb the price increase themselves.

If crude prices increase sharply, gasoline prices should rise at the pump as well, although the gasoline increase should be less significant. In other words, the ratio of gasoline prices to crude prices should fall since oil companies presumably cannot pass on the entire crude price increase to the consumer. The more the ratio of gasoline prices to crude oil prices falls, the less oil companies can pass the spike in crude prices on to consumers.

The data show that when crude prices rose by 10 percent, 15 percent, or even 20 percent over a period of six months, gasoline prices did not rise as quickly and the ratio of the two prices fell, just as expected (see Figure 1). When the crude oil price rose by 15 percent during a six-month period in the 1980s, for example, the ratio of gasoline prices to crude prices fell by 51.5 percentage points. The same ratio also declined in the 1990s and early 2000s, when there were sharp price increases.

Notes: Authors’ calculations based on data from the Energy Information Administration, 2007, Short-term Energy Outlook, Washington, DC: EIA. Averages are calculated for business cycles, unless otherwise noted.

The data also show that oil companies had a slightly harder time passing crude oil price increases to consumers in the 1990s than in the 1980s. In each instance, the drop in the ratio of gasoline prices to crude prices was on average larger for the 1990s than in the 1980s.

Yet after 2000, oil companies apparently became much better at passing the crude price increases on to consumers. The decline in the ratio of gasoline prices to crude prices during times of sharp oil price hikes dropped substantially to around 20 percent. And after 2004, the average decline was down in the single digits—the same time period that Americans experienced the largest price spikes of the current business cycle, which started in March 2001. Put differently, after 2004, oil companies were able to translate the jumps in crude prices almost one-for-one into higher gasoline prices at the pumps instead of absorbing some of the oil price hike themselves.

Had the relationship between crude and gas prices remained the same as in the 1980s, gas prices would have climbed substantially less than they did. The last time crude prices were as high in inflation-adjusted terms as they have been in the past year was in the middle of 1983. Back then, the ratio of gasoline prices to crude prices was approximately 170 percent. Now it stands at 225 percent. Prices at the pump would have to decline by 25 percent to $2.43 from their current level of $3.22 to reestablish the same relationship with crude oil prices that prevailed in 1983.

Another way to look at this is that crude prices would have to be much higher, based on past experience, to justify the high gas prices that are prevailing today. Based on the experience of the 1980s, the current price at the pump implies that a barrel of crude oil should cost $80 rather than the current $60.

The fact that gas prices and crude prices have parted ways means that oil companies have become better at passing on increases in input prices to their customers. This eventually shows up as higher profit margins for oil companies—as the friendly people at the oil industry’s own advertising firms have demonstrate in their full-page ads. So it is no surprise that the big five oil companies combined have made a quarter trillion dollar ($254 billion) profit since 2005.

The industry has apparently figured out how to turn higher crude prices to their advantage, turning basic economics on its head. Unfortunately, their extra billions in profits come straight from our pockets.

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