Should the Oil Industry Make a Profit?

April 30, 2008— -- The price of gasoline has never been higher, with many Americans feeling the pinch on their wallets. But not those who own stock in oil companies.

As soaring gas prices have turned into massive profits for big oil, the shareholders of these companies are cashing in. And if you own a mutual fund, that may even be you.

BP yesterday reported a staggering 63 percent surge in first quarter net profit to $7.6 billion, and Royal Dutch Shell posted a 25 percent increase to $9.1 billion. Last week, ConocoPhillips reported a 16 percent rise in net income to $4.1 billion.

The earnings bonanza is expected to continue when ExxonMobil and Chevron report earnings later this week.

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But is there anything wrong with that? Isn't earning a profit the American way?

Robert Strom, director of research and policy at the Ewing Marion Kauffman Foundation, which works to advance entrepreneurship, could not speak directly about oil companies but pointed out that profits are the driving motivation behind most business ventures.

"In a market economy, production is driven by a profit motive," Strom said. "If I'm an entrepreneur and I'm starting a business and there's no prospect of me making a profit, there is little, if any, reason for me to undertake that activity."

The same can be said for existing companies looking to launch new production or make innovations to existing technologies.

For its part, the oil industry concedes that the oil companies are making lots of money, but Rayola Dougher, senior economic advisor at API, the industry's trade and lobbying group, said those companies are also spending billions and billions of dollars.

"That's just one part of the story. They are earning a fortune. That's tens of billions of dollars. But they're spending hundreds of billions getting the product to market," Dougher said.

Fair Share of Profits

The profits seem so giant, Dougher said, because of the scale of the industry.

But if you take a closer look at each dollar invested and how much is earned, Dougher said the oil industry earns a lot less than some other major industries. API says its members earn about 8.3 cents per dollar invested, compared to 18.4 cents for pharmaceutical manufacturers and 19.1 cents for beverage and tobacco producers.

"A lot of consumers think that [a $2 per gallon run-up in gas prices] is all in profits, it's all going to some fat cats back in some room somewhere," Dougher said. "It's 8 cents. It's fair. The other 92 cents is going back into investments, back into operations, to bring more product back to the market."

The oil companies' profits are a frequent target of the driving public and some politicians in Washington.

Earlier this month, top executives of the nation's largest oil companies were summoned to Washington to testify before Congress about their profits.

During that hearing some of the frustration and anger that many Americans feel with the oil companies bubbled up.

"On April Fool's Day, the biggest joke of all is being played on American families by big oil," Rep. Edward Markey, D-Mass., chairman of the Select Committee on Energy Independence and Global Warming, said at the hearing.

Markey expressed frustration that some oil companies aren't taking more of their profits and putting them into development of alterative energy products.

At issue during that hearing were $18 billion in tax breaks the oil companies are receiving over a 10-year period, making big oil a target for many politicians and environmental groups.

"While regular Americans are struggling to figure out how they are going to afford to drive to work and take their kids to school, oil companies are making record profits," said Kristina Johnson, a spokeswoman for the Sierra Club. "We need to stop subsidizing big oil. They are the last people who should be getting breaks from the government. American families need help, not big oil."

The House voted last year and again in February to end those tax breaks and, instead, use the money to support wind, solar and other renewable energy sources. But the measure has not passed the Senate, and President Bush has promised a veto, should it ever land on his desk.

Expensive Delivery

Finding oil, extracting it from the ground and getting it to America is not cheap. That oil then needs to go through a very costly refining process to make it into the myriad of different gas and oil products U.S. consumer use. Crude oil is turned into everything from gas for cars, to oil to heat homes, to fuel for jet engines.

In order to produce all those types of oil products, the industry has pumped billions of dollars into its refineries. No new refineries have been built since 1976. But through expansions of existing facilities and technological upgrades, the industry has increased refining capacity by 20 percent since 1985 — and that's with 576 fewer refineries.

But that increase has not kept up with gasoline demand, which has jumped 23 percent since 1990, according to the Energy Information Administration.

Critics say the industry hasn't done enough to expand refineries and other parts of its infrastructure. They also say that the companies could spend more on exploration and buy back less of their companies' stock, something that props up the share price

Biggest Refinery's Earnings Shrink

Oil refineries are not always profitable and are often a reminder of the risks in the business.

This week Valero Energy, the largest U.S. oil refiner, posted sharply lower quarterly earnings. That's right — when BP and Royal Dutch Shell reported big earnings, Valero showed signs of struggling, with earnings of $261 million. The reason: very narrow margins in the refining process, as crude oil prices rose even faster than gas at the pump, and losses from unplanned outages at its refineries.

While crude oil has gone up from about $66 a barrel to almost $119 — an 80 percent increase during the last year — gas has gone from $2.71 a gallon to $3.60, an increase of only 33 percent.

That may not seem like such a small number to someone filling up a gas tank, but for an oil refiner, that difference takes a major bite out of profits.

Refining is just one aspect of the business for most oil companies, and any losses there are more than made up by profits from the actual extraction and sale of oil.

So, Who Profits?

As for who reaps the biggest reward from these massive quarterly oil profits, many people may imagine a group of oil privileged executives or tycoons. And they do own millions of dollars in stock, but nothing compared to what the rest of the public owns.

For instance, Rex W. Tillerson, chairman and CEO of ExxonMobil, owns more than 900,000 shares of his company's stock, worth more than $84 million, according to SEC filings.

But that is a pittance to mutual fund giant Vanguard which has more than $18 billion in ExxonMobil stock. Most of that is owned by investors in the company's S&P 500 index fund and its total stock market index fund. And it's not just Vanguard. Almost every major mutual fund company owns oil stocks. Two of Fidelity's mutual funds, for example, rank in the top 10 holders of ExxonMobil stock.

The oil companies are "broadly owned by tens of millions of middle-class Americans, anyone with a pension plan or 401(k) or IRA account, a mutual fund," Dougher said. "They're really the owners. So, when their stock portfolios go up, that's really who benefits."

That might be nice to know when looking at your stock portfolio, but even that knowledge can't ease the pain watching the prices creep up at the gas pump.