Monday, February 18, 2008

Oil Profits: Simple Economics

This essay discusses a critical part of the economy, and some myths therein. Since oil prices have an enormous effect on the economy, with subsequent bearing on employment, I have decided to opine about it. I hope you enjoy. At some point in the future I will also write about Ricardo’s Theory of Comparative Advantage and its effect on free trade policies.

Gas Prices and Profits

With gas prices rising the chattering classes are busy carping about price gouging, excess profits, etc. with the same reliability as Congress voting itself a pay raise. Yet, in fact, there are five very simple reasons why oil companies make increased profits whose dollar amounts – and increases – seem “obscene,” particularly as prices go up. These five reasons are:

1. “Elasticity of Demand”
2. “Substitutional Elasticity”
3. Profit per unit vs. profit margin
4. “Inventory Turns”
5. Volume

In laymen’s terms, what does “Elasticity of Demand” really mean? It means how easily you can adjust your use of something when the price changes. We hear the term “Supply & Demand” constantly for many things, and it is, in fact, a basic law: The more something is demanded, the higher the price goes as people pursue their own enlightened self-interest to make money. The higher the price goes, the more incentive suppliers have to increase their output to make more money in turn. As the supply increases relative to demand, the price falls back. At least, that’s how it works in theory.

In practice, it’s not quite so simple. Some things are easier to give up than others. Gasoline is one.

For the sake of argument, let’s say that my daily commute, each way, is one gallon’s worth of gasoline given the mileage of my current car. Five days a week, twice a day, I drive that distance to get to and from work. Ten gallons a week. Plus, I drive to go shopping, making several trips to the store to pick up one thing or another that, somehow, runs out despite careful attempts at planning and making exhaustive shopping lists. Plus there are other driving trips – to the mall, driving to the post office when I could walk, etc.

So, the price of gas goes up. What can I change? The vast majority of my driving is my daily commute to work; ballpark estimate is that my commute is 90% of my driving. And even with that remaining 10 percent, with diligent planning I could probably only cut it in half. Semantically, Elasticity of Demand is defined as the percent change in quantity demanded divided by the percent change in price. When this number, in absolute value, is greater than one, demand is elastic: The amount people purchase is very dependent on the price.

But in the case of gasoline, it’s the opposite. If the price of gasoline goes up by 20%, 50%, even – God forbid – 100%, my ability in the short term to significantly affect my usage is very limited. Now, in the long term, all things are elastic (you can move, make carpool arrangements, buy a fuel efficient mode of transportation – I admit the idea of a motorcycle in the summer is appealing – or even find a new job closer to home). But I’m not talking about the long term.

Take-away #1: The ability for most people to significantly affect their usage of gasoline downward is very low when the price increases.

The second is “Substitutional Elasticity”. This is to say that when the price of one good goes up, the consumer is able to substitute another. As an example, consider Green Giant frozen baby peas (the best, when I’m in the mood for peas). If the price of these peas doubled, it would be fairly easy to substitute the store brand, or perhaps Bird’s Eye, or, if the price of peas went up across the board, perhaps another legume whose price is more stable could be substituted. The dishes that require legumes themselves could be benched in favor of other vegetables. In other words, the ability to rapidly adapt and substitute when prices rise.

Gasoline is gasoline. You can’t just pour motor oil in and expect it to work, nor will cooking grease work (though I’m all in favor of biodiesel and diesel in general, as I think diesel has great potential). Even the noted ethanol has both potential and problems, though the idea of a flex-fuel vehicle plan would have, I think, greater impact than the new MPG mandates precisely because of the ability to substitute ethanol for gasoline more readily.

But that’s beside the point. My car runs on gasoline. I can put only gasoline in it. If the price doubles, I still can only put gasoline in it. My substitutional elasticity is very low. I’m stuck with gasoline regardless of the price.

Take-away #2: The ability of people to substitute another, less expensive fuel, for gasoline is very limited due to engine technology (availability is another issue altogether and beyond the scope of this essay).

Third, there is the difference between profit per unit and profit margin.

Profit per unit is simply how much profit, in dollars, a company earns for each unit sold, regardless of the actual sale price. A one dollar item sold with a 10 cent profit earns the same profit per unit as a ten dollar item that happens to sell with a 10 cent profit.

Profit margin, on the other hand, is a measurement of the efficiency of each dollar invested. Who here would put the majority of their savings into a savings account that returned a 1% interest rate? On the other hand, who reading this would not seriously look at a savings account that returned a 20% interest rate?

Take-away #3: Investors judge a company by its profit margin; i.e., the return on their investment. This can be dramatically different than the actual profits in a dollar amount.

The fourth piece of this puzzle is “Inventory Turns.” This is, essentially, how fast inventory moves through the system. Consider the proverbial grocery store with the proverbial-and-often-quoted 1% profit margin. They buy a can of soup for $1, and sell it within a week for $1.01. That’s a 1% profit margin. They then take that dollar, buy another can of soup, and the cycle repeats weekly.

From a pure accounting standpoint, the profit margin is, in deed, one penny for each dollar invested. A lousy return. But thanks to the miracle of rapid Inventory Turns, that original dollar invested returns a much nicer 52 cent profit at the end of the year – remember that the subsequent cans of soup are purchased not with that start-up, original dollar, but with the gross profit of the sale.

Take-away #4: The faster you turn your inventory, the more profit you make. That's why there's so much interest in lean manufacturing and just-in-time inventory schemes.

I’ll save the fifth point, volume, for last, strictly as an arm-waving exercise. In the meantime, let’s look at an example.

Big Evil Oil Company (BEOC for short) purchases 1,000,000 units of raw oil at, for the sake of argument, $1 a unit. And they sell it directly to end users for $1.10 per unit. The profit per unit is 10 cents; the profit margin is 10% (which, if you investigate, is pretty close to the actual profit margin of most oil companies). Ten cents times 1,000,000 yields a total profit of $100,000.

Let’s assume that Inventory Turns are almost weekly – for the sake of round numbers let’s say 50 Turns per year. I don’t know what the real numbers are, but judging by the number of gasoline trucks I see, I think that’s a realistic SWAG (scientific wild-ass guess) for a delivery cycle. Remember the can of soup example? Each time BEOC Turns inventory, they are purchasing 1,000,000 raw oil units and converting it to gasoline, for a profit margin of 10%; they are also making a profit per Inventory Turn of $100,000. Multiply that by Turns per year, and we get $5 million in profit per year.

Note that there’s nothing untoward here. No accounting tricks, no nothing. Each time BEOC Turns Inventory, they earn a 10% profit margin. They buy $1 million in oil, they refine it and sell product for $1.1 million. Period.

Now, let’s suppose that the price of that raw material doubles to $2 per unit. To maintain a profit margin of 10% - a number that is often demanded by investors who read the financials to determine where to put their money - the price to the customer is $2.20. Since the price has doubled, but the demand is inelastic with low substitutional elasticity exacerbating the inability to reduce demand, the end users can only reduce demand by 10%. People still need to drive, they still need to go shopping, take the kids to school, etc. Because of this only-slightly decreased demand, delivery cycles fall to 45 times per year representing that 10% drop in volume.

Each cycle the company purchases 1,000,000 units, as before, transforming it into gasoline, and selling it. Each time BEOC’s inventory turns, they earn 20 cents on 1,000,000 units – remember that the profit margin is still 10%. This is critical to understand: the profit margin remains the same, the actual dollar profit per unit doubles.

So now we have a profit per Inventory Turn of $200,000, not $100,000 as before. Profit per unit has doubled (note again that profit margin has not changed!). Factoring in 45 Turns, we have 45 times $200,000 equals $9 million profit per year. And, of course, the wailing and gnashing of teeth starts... over what, precisely? The unfairness of a company wanting to make the largest profit it can? Isn't that why every company is in business?

Had there been price elasticity, demand could have fallen faster than the price increased. Profits would have gone down. Because people cannot reduce their usage easily nor can they easily substitute other fuels, the net profit goes up. This is Microeconomics 101. I remember my coursework; one of the things pointed out was that for a product with an inelastic demand, you increase prices to increase profit. It is competition between companies in the field that keeps things in check - that, plus the threat of new technologies or products that can substitute.
(As an aside: There are many technologies being developed that could break our addition to oil, particularly imported oil. Many of these are only economically viable now, at the R&D stage, competing with oil at current day prices. It's been supposed that once some technologies really start looking good, OPEC will cut prices, burning investors and destroying the competition. I do recommend looking at the website for Changing World Technologies - I like the idea and would put my own money in to invest if I could!)

Now, let’s look at that last factor, volume. Just how many gallons of gasoline get sold? Lots. Lots and lots. Lots and lots and lots. Millions of gallons every day. It doesn’t take that many billions of gallons times, say, 30 cents per gallon to yield enormous profits. Just keep in mind the enormous expenses of having to find new supplies every day, the incredible overhead in logistics, not to mention the fact that we've not build refineries to keep up with the burgeoning demand. Oh, and did I mention that other countries are now drinking oil feverishly too, adding to the demand on the world supply? Countries like China, who has now taken over as the largest CO2 emitter, and India who, 20 years ago, used only a fraction of the oil they do now?
One more thing. Oil prices are set by speculation, not pure trading. When speculators get nervous, the price goes up even if the supply has not changed. It is this price we pay, not pure supply-and-demand, that determines the cost of raw oil going into BEOC.

Lastly, I’d like to observe that profits are not evil. They are the engine that drives the economy. Nobody would start a business if they didn’t think they could earn the most they could make. Nobody would remain in business if their profits, and profit margin, didn’t meet their needs.

Imagine you run a grocery store; your supplier prices go up. Thus, your prices have to as well. Would you accept the local community saying that, because food is another inelastic good – people need it regardless of price – that you should cut your profit margin just to make people happy? You might do so out of the goodness of your heart, but not from a financial standpoint.

So, how do we solve the energy crises? Here are some of my recommendations:

1. Drill for oil in ANWR and the Gulf of Mexico. And anywhere else we can, domestically. Every dollar we send overseas risks funding the terrorists who attack us… and by increasing the available supply, we should see prices drop. We'd also bring a lot of jobs back to America.

2. Implement a mandatory flex-fuel option for cars. Thus will ethanol have a much larger potential base of customers, giving incentive to develop better ways for production and distribution.

3. I also do like some of the great progress shown in diesel technology, and biodiesel is – I think – a lot more easy to generate than ethanol.

4. A lot of oil gets burned to create electricity. There are better ways. Solar & wind have potential and should definitely be encouraged; but more importantly, there are many new nuclear plant designs. Fuel cells can be run off landfill or sewer waste, and can generate electricity for facilities plus generate heat too. Other companies are focusing on smaller cell systems, cars and even hand-held electronics. Save oil for fuel.


Anonymous said...

Great thoughts. An additional comment that people never discuss is our plastics consumption. All we think is oil = gas. However, oil = plastics too. Our plastics come from oil. Amazing how many people do not know that. A huge way to save is to cut down on our disposable plastics consumption. Recycle. Very simple solution. Then as you pointed out more of our oil can go to fuel. There are solutions other than blaming big oil for wanting (actually needing) to make a profit.
Angela Young

Anonymous said...

I may suggest that firing all managers may be worth more than initially suggested. It would allow for the corporate deck to be reshuffled, bringing new faces and motivations to bear on prior stagnancy. Also, it would provide wonderful experience for those MBAs with limited social skills and personalities to learn how to adapt to the change wrought by their actions. And, well, it would be some good clean fun as well. Perhaps it would be the best opportunity to observe those who erect dysfunctional behavior and organizations to modify them into performing structures with a focus beyond the quarterly report.

Greg Chenevert