Sunday, February 26, 2012

Oil Companies and the Relationship of Corporate Goals to Gasoline Prices

A. What drives corporate decisions?

In order to understand what drives the actions of any corporation, you must start with what motivates the executives who make the decisions. Nearly all major publically held corporations that are not managed by their founders, have the same mandated business objectives. The first objective of virtually every executive is to increase stockholder value and return to the investor. What that means is that revenue through sales must increase each year and profits must grow in order to increase the company’s stock price.

B.How are executives compensated?

Senior executives of these companies are compensated in a number of ways. They normally receive a salary, bonuses for meeting specific objectives, benefits, and stock options. The value of stock options may exceed all other compensation value if the price of stock rises high enough. Some executives can receive millions of shares of stock options in a single year. An option is an offer to the executive to buy a share of stock at a predetermined price. There is usually a time limit on when this share must be bought or the offer is terminated. If the price of the company’s stock increases during that time frame, the executive can buy and sell the share immediately and collect the difference between the offer price and the price sold. If the stock price goes below the offer price, then the stock is worthless to the executive, unless they simply decide to buy it anyway and hold it at a loss. Therefore executives are highly incented to make sure their company and profits are growing.

C. How does corporate growth affect prices?

The mandate of every senior executive is to increase stockholder value by increasing the value of the company. They must grow revenue each year, increase profits and the return to the owners (the investors), and increase the stock price. Unless they do this, not only won’t they earn as much, they may well lose their jobs. In the case of oil companies, there are only a few ways to increase these numbers. To increase revenue, they must sell more each year, increase prices, or acquire more market share through acquisition or merger. Increasing revenue through sales is very difficult in the fuels market because the public on average will use approximately the same amount each year, unless there are significant changes in the population of the society or the environment. However, over time even these conditions tend to average out. We tend to drive the same number of miles each year and the number of gallons consumed remains relatively stable and predictable. The single biggest factor that changes consumption is population growth. If the population increases dramatically through new births or immigration, then usage will increase accordingly. Growing revenue in this industry through sales then is relatively fixed in terms of volumes.

D. Growing revenue through price increases

Another way to increase revenue is by increasing price. In order to increase price, a company must have either a superior product or at least perceived superior by the consumer or significant control over the market to prevent competition from undermining their price through their own price cuts. Oil companies learned decades ago that price wars usually result in injury to all competitors and rather than increase revenue, they reduce it. Therefore they strive to avoid head to head price competition in markets. Most chose to simply match the price of their competitors. Since government environmental regulations have dictated the formulation of gasoline and other fuels, car engines have been designed to meet those specific standards and all gasoline tends to be pretty much the same regardless of who refines it. There is no real competition through product quality. Price competition then is not a viable way to increase revenue.

E. Growing market share through acquisition or merger

Another option for increasing revenue is to increase market share. Since oil companies avoid capturing market share through price wars, are limited to how much the consumer will increase usage, an option is to buy market share through acquisition or merger of a competitor. This has been a highly successful strategy for all of the major vertically integrated multinational companies in all industries, not just oil. A vertically integrated company is one in which it controls all segments of product production from raw material production to the finished consumer product, including distribution points in between. Once a company has a market share large enough that it can control the volumes going to market, it can also control prices. While these aren’t monopolies, their control over prices makes them oligopolies. Within the US market, and especially within specific regions, these oligopolies do exist. Over the last 20 years, oil companies have combined over and over, forming mega corporations. Dozens of companies have been acquired or merged and that activity continues today. The US now has 5 or 6 vertical oil companies that control a large majority of the refineries and gasoline production within the US market. Exxon/Mobil, the largest of the Big 5, had more than $418 billion in revenue in 2011 alone. They will soon be generating a half a trillion dollars in annual sales. Combine that with the other companies and we get some perspective of the size of this industry. The entire US gross domestic product (GDP) of all goods and services is only a little over 15 trillion dollars. The Big 5 sell under many familiar brands and consumers often have no idea that most of those brands all belong to the same parent companies. For example, Texaco was originally acquired by Royal Dutch Shell, broken up and the brand and some assets sold to Chevron. All Texaco sales are now part of Chevron. Nearly all the major brands fall under the Big 5 companies. In some parts of the country, only one or two of these companies may have refineries and are supplying most of the fuels to all gasoline stations in those states. Exxon/Mobil, Chevron, British Petroleum (BP), Royal Dutch Shell, Chevron, and Conoco/Phillips currently make up the group referred to as the Big Five. While there are others who have major assets and revenues in various fossil fuel production, like natural gas, the Big 5 continue have the dominate market share in the gasoline and refined fuels US market. While discussion of size is often debated, for purposes of the discussion, these five have dominant market shares of the gasoline market. Details of company financials are usually closely guarded by all large corporations and the same is true of the oil industry. How companies actually price their products is never discussed and only a few within the companies’ own financial organizations know exactly how those prices are established. Even other company executives may not be privy to that information. Company financial statements can give a glimpse into their operations, but they do not reveal such detail and analysis is based on what is released to the public. One example is that excessive highly profits can be disguised by using them to acquire other assets such the purchase of other companies or their assets. While not hidden, these purchases lower the profit numbers for those focused on profits.

F. Where do oil company’s refineries get their oil?

Most of the oil used in American refineries is produced by the same companies that own them. About half of the oil is produced domestically and is delivered to a refinery from the nearest production point. For example, much of the oil for the state of California is produced in or off shore in the state. Also, companies like Exxon/Mobil ship much of the oil they produce in Alaska to California or other refineries along the West Coast. Contrary to popular belief, only a small portion of the oil consumed in the US comes from the Middle East. Only about 9% comes from all Middle Eastern countries combined. The largest volume of oil imports come from Canada. Again, most of this oil is also owned by the same companies that refine and sell gasoline in the US. The oil that comes from most countries is produced by these same companies and is not owned by the country of origin. Oil from Canada is only Canadian oil while it stays in the ground. Countries or states may tax, lease the land or charge an extraction fee for the oil that the company pumps out. Once it is extracted from the ground, the oil company can do what it wants with that oil. If US markets cannot absorb that production, then it must be sold elsewhere or left in the ground. Drilling more new wells does not increase sales of refined products. Refineries have a finite amount of fuels that the market is able to buy. Producing more does not drive down prices, it just presents a storage problem. Because fuels like gasoline can degrade with time, they have a shelf life and must be sold within a specific period. Today, all demand is being met by the US market and they can’t sell more here. Any excess production must be sold to other markets if they exist. US refineries currently produce about 19 million barrels of refined fuels per day. About 17 million are sold domestically and the remaining 2 million are exported and sold to consumers in other countries. This is a surprising fact to many in the public. Producing more oil does not lower prices at the pump. It just increases the opportunity for sales in other countries. Since oil reserves will someday be depleted, exploration for new oil reserves is critical for the future. However, it does little for current markets.
Oil companies also import oil from Mexico (5%) the Caribbean, and various South American countries. Venezuela exports about 5% of consumed oil primarily through its country owned company, Petroleos de Venezuela and their US based subsidiary Citgo. While Citgo is controlled by the dictator Hugo Chavez, it represents less than 5% of the US gasoline market. Recently, Nigeria has increased its imports to the US as well. However, it should be noted that oil companies remain the major suppliers of their own oil. OPEC countries and other dictator controlled countries do play a role in the cost of oil around the world, but their production is not the major factor in the US market.

G. World markets versus regional and local markets

The term world market is often confused with the term world economics. World economics is the affects of various financial activity on the economies of countries around the world. Where it comes to products produced by any company, there are very few true world markets and that is also true of gasoline and other fuels. Nearly all products are produced for a specific region, such as a country or a defined area within it. Gasoline produced in the US is designed specifically for vehicles sold in the US. Some of those fuels cannot be used in other countries, just as those made in other countries can’t be used here without changing their formulation. Even the marketing of them is specific to the culture and specific needs of the consumers within the country or local markets. The term world, market when discussing oil, is grossly misused at times by the media. Even certain types of crude oil cannot be used by all refineries. Refineries must be designed specifically to process different types of crude oil. Automobile engines in the US are now designed to meet certain emission and performance standards and require specific blends of fuels. Gasoline in the US cannot always be used in Europe and vice versa. Oil company refineries produce what a region requires and price it accordingly.

H. Establishing price through price elasticity or what the consumer will pay.

Price Elasticity is a marketing technique that helps businesses establish the most profitable level for their product. Companies constantly test the market by raising prices to find out how much consumers are willing to pay for their product before more consumers quit buying. Losses in sales may offset profits gained when prices are too high. It is finding the point where profits are maximized that all executives seek. Oil companies are not nationalistic. They are multi-nationals and have no real national loyalty. They are simply businesses with the mission of maximizing return to stockholders. They are not charitable non-profits and their goal is to constantly grow their business. When people forget this and try to assign national labels or other goals to them, they misunderstand the business. Their constant goal is to make as much money as their market will allow. It is not to reduce prices and profits for other public goals. Any CEO who did that would soon find himself out of a job. They are only political to the extent that they must to protect their own companies and objectives. It is naïve to believe they will act otherwise. That is not what they are paid to do.

I. Spot market oil versus company production

Spot market prices for oil futures sold on the commodities exchange are often quoted in the media during discussions of gasoline prices. In terms of the cost of raw material or crude oil used by US refineries, this price has little bearing on the real costs for refining gasoline. First, most oil used by US refineries is produced by their own wells which have been in production for years. They don’t buy that oil from themselves on the commodities exchange. Investors who are speculating on the price of oil buy those contracts in the hope that the prices of oil sold to others by these oil companies will go up. Since most oil does not come through the commodities exchange but directly from oil they already own, those supply costs remain relatively stable with the exception of their own rising costs of labor and other business costs. These other costs make up the majority of the business costs anyway, not the actual oil. Oil is the single largest cost component in the production of gasoline, but it is considerably less than half of the total which includes exploration costs, drilling operations, transportation through ships, pipelines, and other means, refining operations, distribution, marketing, corporate overhead, investment, profit, and a number of other costs. Even when crude oil supplies must be augmented from other producers, that is only a percent of their total oil needs and does not account for the difference in the rate of price increases at the pump. One interesting note in executive expense is that a recently retired CEO of one of the Big 5 received a retirement package valued at more than $400 million dollars. That cost too must be passed to the consumer. It is also noteworthy that profits for all of these companies have been massively increased since 2005 compared to historic averages over the last few decades. They are currently at historic levels.

I. Other financial and political interests in higher prices

While oil companies themselves have an obvious interest in increasing prices, revenue, profits, and executive compensation, they have a lot of support from a vast number of other interested parties. There are investment houses that benefit from rising stock prices, commodities traders who want to attract investors, major stockholders, portfolio managers, and dozens of other financial organizations who financially benefit from rising prices and profits of these companies. There are environmental groups that see rising fuel prices as a good thing in the hopes it will reduce the dependence on fossil fuels. There are political interests who benefit from the support of these same people. Political agendas nearly always focus on factors that have little or nothing to do with the actual production of oil, its distribution, or the refining of gasoline and other fuels. The political discussion over construction of the Keystone Pipeline, off shore drilling, and expansion of drilling in Alaska are excellent examples. None of these projects will change the price of gasoline at the pump, but will create some jobs, improve the infrastructure, distribution, and possible oil reserves for the oil companies and our own needs in the future. However, many politicians have used these issues to promote their own electability while ignoring the actual affects on the consumer. Because of all of these various supporters, the trillions of dollars in revenue at stake, and affects on what most of these people earn, it seems unlikely that we will see any abatement to these pricing strategies. The dollars are too big and influence on policy makers too great. Only the limits on price acceptance by the public will limit how high prices can be pressed. Higher prices will continue to have major impacts on inflation, the growth of other industries, and the ability to reenergize the economy. If prices are stabilized long enough for the rest of the economy to absorb and adjust to them, then the country’s economy will be allowed to grow.

J. The role of the media in gasoline prices

Probably no other group has been more influential in consumer acceptance of rising gasoline prices than the mass media. There has been more disinformation and misdirection by television and publishers about the reasons for these increases than there has been real information. Most of the information they disseminate originates from all of those with a financial interest in seeing prices rise, either from paid industry spokespeople, financial houses, or political interest groups. Once this information is received, it is repeated over and over as though it were the final word on the subject. There seems to be no investigative journalists left who are paid to seek out objective facts and analysis of the oil industry. They seem to rely on college freshman economics and the stories that are provided by others. There have been few broadcasters who have even asked the questions that are raised here. Oil company executives themselves have avoided any personal interviews on this subject and when they have appeared, the questions directed to them have little relevance to the points raised in this document. Most executives would chose not to comment directly on them claiming that it was getting into company confidential information that might compromise their position with competitors. Recent opinion surveys indicate that the average American believe that most of the nation’s oil comes from Saudi Arabia and that spot oil prices are driving the cost of gasoline up. As previously stated, these do have some influence, but they do not account for the prices we are seeing for gasoline. Consumer expectations have a great affect on the decisions the oil companies make about when prices should be increased and by how much. Consumer expectation currently is that the price of oil will continue to rise, therefore gasoline prices, and that there is little they feel they can do about it. It is therefore highly likely that oil companies will continue to escalate their prices as high as consumers can afford to pay for it.

K. Political influence affects price

In 2007, Dr. Mark Cooper, Director of Research for the Consumer Federation of American testified on many of these same points to the Anti-Trust Task Force of the Judiciary Committee of the Unite States House of Representatives. For a copy of those comments and the charts presented, go to

Many members of the House have been advised for years of the growing problem of potential oligopolies being formed in this and other industries. Both the House and Senate have taken no legislative action to prevent these potential antitrust issues or to increase competition within the oil industry or any other. Major industries segments continue to merge and reduce any competition in their markets. Why this is allowed to continue is not yet factually determined.

All oil company executives are invited to provide data that is counter to the statements in this report.

1 comment:

  1. Hi John, this is great information and an excellent blog. Janette recommended I check it out, so thanks to her!

    You have given a great description of how this market works. I would like to add my opinion to this, that the key, crucial point here is "control". In your very first answer, you said that the goal of oil corporations is to maximize profits. I fully agree with this. I would endeavor that this is the goal of every human being on the planet as well. Profit is basically the excess value of your production after your basic needs (costs) have been met. Profit allows individuals to buy nice things, to do fun things, to travel for various reasons, to invest in new opportunities, etc. The same is true for businesses and corporations. Profit, in and of itself, isn't a bad thing... the real question is how you go about getting that profit.

    Along those lines, in answer D, you say: " In order to increase price, a company must have either a superior product or at least perceived superior by the consumer or significant control over the market to prevent competition from undermining their price..." The key word here is: control. The question is, how do those companies control the market? Is it simply due to their massive size?

    Well let's look at standard Oil. They were the big, bad, "evil" trust that had to be busted back around the turn of the 20th century. They owned the market, with something like 75-80% market share. Yet, during that time, the price of oil and refined products steadily dropped. So this would seem to indicate that size alone is not the determining factor for control, if the megalith Standard Oil couldn't inflate prices with such market domination.

    In my view, the control in this equation is government. The evil in this market is regulation. I know, regulation is always sold to us as being necessary and for the good of society. I contend that it is a shell game (no pun intended.) The reason the market is controlled by just a handful of large corporations is because they have successfully used the government to erect barriers to competition (regulations) that make it too costly and basically impossible for competing companies to come in and undermine prices. The drilling lease system, the EPA, OSHA, the department of energy, on and on, all represent an impenetrable fence of costs and barriers that startups simply can't get over. This is how the existing companies maintain the current low-supply, high prices market. (Demand, as you pointed out, being near constant on a per-capita basis.

    I do slightly disagree with you on one point (and this might just be an omission and not really a disagreement): In order to increase revenue the firm must increase prices or increase sales (and sales are constant relative to population.) I think there are a few more ways that they can do this. They could:
    1) Improve efficiencies - again limited by government
    2) Drill in more efficient, less hazardous areas - again limited by government

    I'm not an expert in how to run an oil company, but I have a cousin who is an oil man and he says he can't "use the restroom" (rephrased) without it being approved by some bureaucrat in Washington.

    Anyway, the problem as I see it isn't the profits, it is the "how", and how they get these profits is by using force (government) to prevent a real free market, allowing them to artificially prop up prices. They prevent new entrants to the market, new technologies for extraction and even to some extent, new methods of consumption. Not that I think electric cars are a solution, but there are many possible solutions that might just work - if there weren't so many barriers to entry. (Natural Gas cars, hydrogen cars, personal nuclear reactors, on and on)

    Thanks, Tom Utley


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