Tuesday, October 31, 2006

Oil pricing conspiracy theory

Oil company profits are in the news again, along with lower gas prices and elections, leading to all kinds of conspiracy theories. But once again the news merely says that “Big Oil reported record $10.8 billion profit” without putting that amount into context. If Big Oil had $900 billion in sales, then that profit amount would be only 1.2% of sales, which is by no means outrageous.

I am not one who believes that profit is bad. Profit is why business exists. I do believe that unregulated capitalism becomes predatory, and that society suffers when an industry is allowed to operate without responsible government oversight to prevent it from behaving in a monopolistic fashion.

Larger profits are good for those who own the companies – stockholders. Profits are “predatory” when they become large enough that they take advantage of and harm the people who use the services of or buy products from those companies. That happens only in a non-competitive environment where there is only one producer or where producers are allowed to collaborate, and where the product or service is one which the consumer cannot reasonably do without.

There is a form of tacit collaboration where one producer raises a price and simply waits to see if the others in that industry will follow suit. When they do, simply because they can, the fact that there was no actual verbal communication between them does not mean that this is not monopolistic behavior.

The law of supply and demand is not an actual law. An increase in demand, or a reduction in supply permits the seller to increase the price, it does not require him to do so.

So I decided to do a little study to find out just which industries are “friendly” to us consumers in their pricing policies. I am far from any kind of economic genius, I have no formal education in the subject at all, and this study was certainly not rigorous or scientific. I picked companies which are rather dominant in their industries and who therefor would seem to have some freedom in pricing, and whose names most people will recognize. I had no preconceived ideas.

I looked at each company’s profits from three viewpoints, and will examine each one as we get to it. The results were not all that surprising. They do reveal that oil companies are a bit greedy, but perhaps not nearly as bad as the blaring news headlines would lead us to believe.

Profit as a percentage of sales

The first thing that I see missing from the headlines is, “To make that many dollars of profit, how many dollars did oil companies have to sell?”

The profit on sales is generally speaking a reflection of how much competition you have. If I am selling widgets that cost me $10 to make and no one else is selling them I can set the price at pretty much whatever I want. If someone else starts selling them at $12, however, then I need to set my price accordingly and my profit as a percentage of sales is going to decrease.

There are other factors that have powerful effects, so one cannot accept that statement at face value. Banks, as we will see later, have a huge profit margin on sales but there are other factors that make that a lot less attractive than it might seem.

Each of us will have our own opinion of what constitutes a “reasonable profit.” For me, if it costs me $10.00 to make and I can only sell it for $10.10, I’m probably going to look for another business to be in. Somehow 1-2% just doesn’t get me excited as a businessman. Volume is, of course, an issue but when you have a zillion stockholders dividing the profit volume has somewhat less impact.

Company NameProfit %
Bank of America30.05
Oracle Software18.66
General Electric12.38
Union Pacific Railroad10.54
BP Oil10.24
General Dynamics7.25
Boeing Aircraft4.70
Federated Department Stores4.70
Wal-Mart Stores3.60
Safeway Grocery1.84

Looking at this table, the real predators would seem to be banks and computer software, with Microsoft leading the way. Microsoft, as most of us know, has little or no competition in most of its products, and banks are a special case as far as pricing goes.

Railroads, defense contractors and oil companies seem to be pretty much head and shoulders above the rest of the field in terms of profit margins. Other than railroads, does that surprise anybody?

But are those profit margins really usurious? On the face of it, I would have said not, but companies like grocery and department stores have far lower margins and are considered to be successful and to be good investments. They keep stores open and even upgrade their stores and open new ones.

So while I’m not really outraged by the oil company profits at this point in my investigation, they do merit a little more study.

Profit as a return on investment

A more important measure of profitability is “for every dollar I spend on equipment, how many dollars do I get back in profit?”

Profit is a lot more attractive if I can make it without risk and without having money tied up in equipment that costs money, but some industries are just naturally equipment-intensive. Spending money on equipment and infrastructure that may or may not provide profit is a risk, and the profitability of the investment should reflect that.

Company NameProfit %
BP Oil14.51
Oracle Software9.29
Wal-Mart Stores8.65
General Dynamics7.91
Safeway Grocery4.75
Union Pacific Railroad4.66
Boeing Aircraft4.50
Federated Department Stores3.51
General Electric3.02
Bank of America1.56

Remember how banks and software, mostly Microsoft, seemed to be the ones doing the predatory pricing in the first table? Now Microsoft is still prominent but look who else showed up – oil companies. Banks have disappeared, and the reasons for that are interesting but are not really germane to this discussion.

So there is the oil company, right behind Microsoft and trailed by another big software company.

The “bad guys” argument has gained some momentum. Oil companies are keeping company in this table only with software companies who have no significant competition.

Defense contractors, in the person of General Dynamics, gets a dishonorable mention in this table, along with Wal-Mart, but remember that the latter is selling at only 3.6% profit on sales. Nobody else is even in the “bad guys” ballpark.

Profit as a return on investment

This third factor is basically a factor of “how well is the company’s profit rewarding its shareholders?”

This is sort of a “bogus” number, really. It is affected by the number of shares outstanding and by the selling price of those shares, so it changes almost from minute-to-minute. Since the selling price of shares is actually artificial, being determined entirely by what buyers are willing to pay for it based on often emotional factors, this return on investment is really artificial as well, but it is a factor worth looking at.

Company NameProfit %
BP Oil35.00
Boeing Aircraft26.00
Wal-Mart Stores21.82
General Dynamics19.00
General Electric18.40
Oracle Software17.97
Bank of America17.00
Safeway Grocery13.70
Union Pacific Railroad11.54
Federated Department Stores8.35

Wow, Microsoft and the oil companies blow everybody else out of the water, but defense contractors take pretty good care of their stockholders as well.

The average consumer can get along very well without computer software, while oil products have a huge impact on the necessities of daily life. So there is good reason to not really care about Microsoft’s pricing policies, but when we see oil company profits that are in line with those of a software company that has no competition…

Maybe we should vote for a Democrat next week.

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