Felmy: Dispelling oil price myths

American Petroleum Institute chief economist reviews the facts on oil prices, oil company profits and oil company investments

Alan Bailey

Petroleum News

With escalating gasoline prices hitting people’s pocket books and oil companies reporting record profits, phrases such as “windfall profits tax” and “gasoline price controls” have re-entered political dialogue. But what are the realities of the current oil price situation and are the oil companies really making excessive profits?

At a special meeting of the Resource Development Council and the Alaska Support Industry Alliance in Anchorage on May 2 John Felmy, chief economist for the American Petroleum Institute, went over some of the key issues relating to the economics of oil in the United States.

Fuel costs

Felmy started by displaying a graph showing that the prices of crude oil, gasoline and diesel fuel have all increased in lock step during the past few years. That demonstrates the tight linkage between fuel costs and crude oil prices, Felmy said.

“Consumers know what the price of gasoline is … but they have no idea what goes into the price of gasoline,” Felmy said.

“Yesterday ANS crude was around $71.97 (a barrel), or $1.71 a gallon,” he said. Add in taxes of about 46 cents per gallon for tax and you arrive at a base fuel cost of about $2.10 per gallon, before including cost factors such as refining and transportation.

In fact, 55 percent of the cost of the gasoline sold in the United States consists of the cost of crude oil; 26 percent of the cost goes to refining and distribution; and 19 percent consists of taxes, Felmy said. Oil companies make about an 8.5 percent margin from the refining and distribution, a figure that comes quite close to margins for U.S. industry as a whole. Even if you took out every penny of the earnings that the industry makes throughout the entire supply chain, fuel prices would remain high, Felmy said.

The current above average gasoline and diesel inventories cause people to think that fuel prices should be lower, Felmy said. But the inventories form a relatively small component of the overall supply chain and are really just designed to keep supplies moving smoothly through the system, he explained.

“If you have crude oil, you have to have a pipeline to keep it operating. You have to have tanks, so that the refinery will not shut down,” Felmy said. “It’s really more of a working inventory than anything else.”

Crude oil supply issues

“Cambridge Energy Research says that there’s 2 million barrels a day production offline because of Nigeria, Iraq, Venezuela and so on,” Felmy said. “There’s a very real … supply impact going on at the same time as higher demand.”

The high crude oil prices are clearly benefiting oil production companies — Felmy reviewed data showing oil company earnings in cents per dollar of sales compared with other companies. However, integrated oil companies have not done as well as oil production companies, because of tight margins in the downstream business. But, overall profits are not excessive — in terms of cents per dollar of sales oil company profits are a bit above the average for all industries, but not by all that much, Felmy said.

“When we hear politicians say ‘this is excess profits,’ it’s utter nonsense,” he said. “… Google, Citigroup, Goldman Sachs and so on make a lot more than the oil industry does, so the notion of a windfall profits tax is simply wrong.”

And Felmy continued to slam ideas for a windfall tax. How would raising industry costs through taxation help consumers, he asked. He also commented that a windfall tax would hit hard-working Americans.

“These politicians also seem to talk as though oil companies are owned by space aliens,” he said. “… Oil companies are owned by millions of Americans who invest their hard-earned savings in these companies.”

The people who are talking about this tax are the same people who have failed to fix social security, Felmy said. But retirement plans own a 41 percent stake in oil companies, with private individuals holding 59 percent.

“Even here in Alaska over 60,000 people are part of state and local pension plans that are invested in the oil companies,” Felmy said.

In addition, the oil companies are investing vast amounts from their profits in new developments (including investments in alternative energy sources), Felmy said. And the politicians who ask oil companies to invest more have also withdrawn huge areas of federal land from oil and gas exploration, he said.

Felmy also addressed accusations by television commentators, among others, that the oil companies have been cutting refinery capacities.

“It is absolutely not true,” Felmy said.

There was a cut in refinery capacity in the early 1980s when some small, inefficient refineries were closed, after President Reagan stopped the government subsidies for these facilities, Felmy said.

In the last 10 years we have seen refinery capacity increases equivalent to 10 new state-of-the-art refineries, Felmy said. That has been a result of improvements to existing refineries — no new refineries have been built since 1976 because of environmental restrictions and other issues.

Do no harm

“There is a whole range of things that the government can do,” Felmy said. “The key thing is let’s not repeat the mistakes of the past.”

For example, Felmy recalled an oil company windfall profit tax that the U.S. government introduced in the 1980s.

“They drained $79 billion from the industry, reduced production and increased imports for a classic failure,” Felmy said.

Felmy also dismissed ideas about government gasoline price controls, in a situation where world crude oil prices drive gasoline prices and refineries are expensive to operate.

But issues such as proposed tax changes, the introduction of low sulfur gasoline and the continued impact of hurricane damage to oil refineries will present some challenges in the coming months.

Current challenges also include mandates to add ethanol to gasoline — on a British thermal unit-equivalent basis, ethanol costs almost $4 per gallon, thus adding significant cost to fuel, Felmy said.

The need for a massive increase in the production of low sulfur diesel to meet a June 1, 2006, mandated requirement for the production of this fuel is also a major issue — production needs to go from about 109,000 barrels per day recently to 2.4 million barrels per day by the June deadline, Felmy said.

“We’ve got a lot of ramp up to do over the next four to five weeks,” he said.

Markets continue to drive prices

“We’ve got a real challenge in terms of meeting petroleum demand worldwide,” Felmy said.

Felmy also thinks that the push to have China revalue its currency might have the unintended consequence of pushing worldwide oil demand even higher — oil is traded in U.S. dollars, so that an increase in the value of the Chinese currency would reduce the price of crude oil in China.

But Felmy is skeptical about theories that world oil production has peaked.

“This notion seems to come around once every thirty years,” he said. “… They were wrong then and most likely wrong again … because these folks who say that we’re running out don’t take into account the role of technology and global markets.”

Markets ensure continuing supplies, Felmy said. Economists think that energy won’t run out but that prices will move higher in response to shortages. On the other hand meeting projected increases in global crude oil demand will require massive investment.

But is there any possibility of a fall in oil price?

There is a whole set of supply and demand factors that play into this, Felmy said. One possibility, for example, might be a slowdown in the Chinese economy — people are not sure how solid that economy is.

“The one big thing that would change everything is if you were to have a major outbreak of avian flu,” Felmy said. “It would shut down transportation. It would shut down a lot of commerce.”

But when it comes to understanding oil and fuel prices, Felmy thinks that people need to look at the markets rather than the machinations of oil companies. People are always looking to attack the oil industry, he said, observing that this tendency seemed to go back to the days of John D. Rockefeller (and perhaps J.R. Ewing).

“As an economist I tend to think that people either believe in conspiracy or markets,” Felmy said, adding that he firmly believes in markets.