Friday, May 29, 2009

Oil Profits

With gas prices rising over the last few weeks, energy companies - such as ExxonMobil and Shell - profits are bound to be on the rise.

In fact, last Summer during the height of the rise of gasoline prices ExxonMobil reported a 2nd quarter profit over $11.6 billion, which someone calculated to be around $1400 per second, and many consumers were angry over the immense profits being made by the energy company. ExxonMobil's CEO defended the high profits, and if I were in his position, I would do the same.

The oil, gasoline and natural gas industry has some unique industry features. One is that the industry has economies of scale, which allows the firms to lower their per unit (or average) costs the more they produce, and the second is that consumers of especially gasoline are price inelastic, which I wrote about previously.

From an economic perspective, companies like ExxonMobil are doing exactly what they should be doing, using resources (in this case natural resources) to generate value for customers and sell those valuable products in a way that the costs of exploring, extracting, transporting, refining, distributing and retailing the product are less than the revenues from selling the product. Which makes me wonder, as economists, are we really all that successful at explaining what profits really are?

So, let me take a second and try to do that. There are really three economic functions - that I can think of right now - of profits. One, profits are a reward for gains in efficiency; thus as a firm becomes more efficient, those gains are captured in potentially higher profits, which is what both CEO's seem to be trying to get across to their audience. Yet efficiency is not the only function of profits.

Another function of profits is that they reward innovation. In both of the links below, the interviewers question the respective CEO's whether each energy firm is investing enough in alternative fuels. Innovation and the costs that go with it, are only beneficial if the expected profits from innovation are greater than the costs - many times that is sunk - in investing in innovation. The problem is that for oil and natural gas energy companies, developing alternative fuels too soon will reduce their overall profits since they are in essence creating a new substitute for their existing products. This is a tricky path to take, so you may get a less than socially optimal amount of substitute fuel investment from energy firms. This means that other firms outside of the energy market - what economists call potential competitors - will need to drive innovation in this budding market.

In an earlier interview, Rex Tillerson (ExxonMobil CEO) talked with Matt Lauer and tried to explain in general terms the implications in terms of higher oil prices and the exploration constraints the firm faces in terms of investing in finding new energy sources. I have included the interview below.

In a different interview, Robin Roberts of ABC asked the CEO of Shell - John Hoffmeister if Shell "... could you cut back a bit on your profits..." that Shell makes to help out their customers. Hoffmeister explained that the managers have a duty to the shareholders to use the money the shareholder's have invested with the firm wisely - in other words - to maximize Shell's profits. While this is absolutely true - it is not all of the story.

The last function of profits is that it is a payment to companies for supplying capital. If as Roberts was asking Shell - or any other publicly traded company - to make decisions that were less profitable, then the firm would have less capital in the future to use for exploration and investment in alternative fuels. With reduced exploration and alternative fuel investment, there will be less oil and natural gas produced, which will result in even higher oil and natural gas prices. So, be careful for what you wish for.

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