Energy Analyst’s Outlook

Energy Analyst Greg Winneke’s Outlook

Once again a windfall profits tax is being discussed in some circles as a response to high oil prices and high gasoline prices. Such consideration is a display of misunderstanding the dynamics of supply / demand and the reality of the oil market and the oil companies. Several points normally ignored or unknown by the major media need to be brought to light.

The next few pages will review (1) what determines oil prices, (2) Are there “windfall profits”, and (3) Who benefits from oil company profits?

1) Can oil companies actually determine the price of oil?

The International Energy Agency has stated that global oil production in August was 84.9 million bls/day. The major integrated oil companies, often collectively referred to as “Big Oil”, produce a combined 13.6 million bls/day. This is only 16% of global supply. The following figures are 2004 volumes in millions of barrels per day, compiled from several independent sources.

*Sample of
Major Integrated Company                      Government Companies

BP                          2.463                   Russian
Federation              9.285
ExxonMobil           2.178                   Petroleo
Brasileiro               1.599
RoyalDutch            2.178                   Petroleos
Mexicanos             3.825
ChevronTexaco     1.715                   Sonagal
(Angola)                .985
Total (French)        1.695
PetroChina                            2.133
ENI (Italian)           1.033
Total 17.827
ConocoPhillips    1.030
Statoil (Norway) .726 OPEC
Countries                    32.927
Repsol (Spain)               .569
Total                         13.59

*While some of these companies are ostensibly public, government control is the reality.

The above numbers show the major integrated oil companies with a 16% market share, a sampling of the larger non-OPEC national oil companies with a 21% market share, the OPEC countries with a 38.8% market share, and the remaining 24.2% market share scattered among thousands of smaller producers, privately held, public and government entities. Obviously collusion among such a diverse and disparate group is a fantasy.

Oil prices are high because of demand acceleration from industrialization of the Asia/Pacific area, and a sharply curtailed lack of excess capacity in global production. Demand growth from 1994 through 2002 was 12.9%, and then accelerated sharply. If the IEA estimate for 2005 proves correct, current consumption of oil will have increased another 10.2% in just the past three years. In comparison, oil production volumes grew only 10.9% from 1994 through 2002, as “just in time inventory” and supply complacency became accepted behavior. The demand acceleration then caused supply volumes to increase more rapidly trying to catch up, resulting in a rapid decline of spare productive capacity, and much higher prices.

2) Aren’t the oil companies reaping “windfall profits”?

The absolute dollar amount is large because the capital base is large. If party A earns $1 on a $10 dollar investment, that is a superior profit to party B earning $1,000 on a million dollar investment. The dollar amount is not the proper yardstick for profitability, but rather the actual return on total capital. The following table is a sampling of many diverse industry groups for their return on capital invested over the past five years.

** 2001      2002      2003      2004      2005 E     Average

Major Integrated Oil Companies        13.9%      9.0%     13.3%    17.9%    19.0%        14.6%
Home Appliance Industry                  12.8%    21.4%     18.3%    15.5%    16.0%        16.8%
Medical Supplies Industry                  16.4%    17.9%     17.6%    17.5%    17.5%        17.4%
Natural Gas Diversified                        9.6%      2.0%       6.1%      8.1%      7.5%          6.7%
Information Services                             8.4%    11.1%     11.9%    12.2%    12.5%        11.2%
Restaurant Industry                             12.4%    11.4%     11.3%    13.0%    13.0%        12.2%
Specialty Chemical Industry                 7.6%      9.4%       9.6%    10.5%    10.5%          9.5%
Metal Fabricating Industry                    8.1%      8.6%       8.2%    11.6%    13.0%          9.9%
Telecommunication Services                4.3%      7.7%       8.3%      6.9%      7.0%          6.8%
Auto Parts                                             6.6%      9.5%       8.6%      9.0%      8.0%          8.3%
Toiletries Cosmetics Industry              21.5%    19.9%     22.5%    22.5%    23.0%        21.9%
Retail Building Supply                        13.8%    15.5%     16.4%    17.4%    15.5%        15.7%
Home Building Industry                      11.2%    12.3%     12.9%    14.0%    16.0%        13.3%
Household Products Industry              20.3%    20.6%     20.1%    21.2%    22.0%        20.8%
Electrical Equipment Industry             19.3%    18.6%     17.5%    18.5%    18.5%        18.5%
Computer & Peripherals                     12.5%       8.9%     11.4%    13.0%    14.0%        12.0%
Office Equipment & Supplies             11.7%     11.4%    12.0%     12.3%   12.5%        12.0%
Basic Chemicals                                   5.2%       6.9%      7.6%     11.2%    18.5%          9.9%
Drug Industry                                     23.5%     21.1%     19.9%    20.5%    20.0%        21.0%
Food Processing Industry                   10.7%     12.0%     13.3%    12.6%    14.0%        12.5%
Beverage (Alcoholic)                         16.7%     19.0%     18.1%    18.5%    15.0%        17.5%
Soft Drink Industry                            16.5%     17.4%     16.5%    16.6%    17.0%         16.8%
Educational Services                          12.9%     14.3%     14.6%    18.1%    19.0%        15.8%
Apparel Industry                                10.0%     12.5%     11.2%    11.5%    11.5%         11.3%
Shoe Industry                                     14.7%     14.3%     14.6%    15.2%    16.0%         15.0%
Publishing Industry                            11.9%     10.1%     10.1%     10.5%   11.0%          10.7%
Petroleum Producing                          11.0%       7.2%     11.8%    13.4%    12.5%         11.2%
Oilfield Services/Equipment                 7.7%       4.6%       5.1%      5.8%      5.0%           5.6%
Computer Software & Services          16.0%     15.5%     14.5%    14.0%    13.5%         14.7%

** The five-year return on capital is taken from “The Value Line Investment Survey” as of the September 23, 2005 issue.

As is readily apparent to anyone, there is no such thing as “windfall profits” in the energy business. The major integrated companies have favorable returns on capital, but certainly not out of line with many other industries. The petroleum producing companies (independent producers) are among average returns on capital, and diversified natural gas and oil services actually lower than many other industries. The concept of a “windfall profit” is a fantasy.

3) Isn’t “Big Oil” making a lot of money at the expense of the “little guy”?

In a word, NO!!!. The companies commonly referred to as “Big Oil” are all publicly owned by the “little guys”. There is no Scrooge McDuck sitting in a vault counting his money. There are bank trust departments, mutual funds, IRAs, pension plans, financial annuities owned by all the “little guys” collectively known as institutional shareholders. The middle class worker paying the pump price is the guy that also holds an ownership position in the oil companies through his retirement plan, IRA, insurance annuity or mutual fund. The “little guy” through his retirement and pension plans receives the dividends and stock appreciation of the oil companies.

Of course that is after the industry invests heavily trying to provide enough oil, natural gas, and refined products to keep up with demand. The table below shows the estimated per share earnings, and reinvested capital expenditures for several of the oil companies. The estimates are all taken from “The Value Line Investment Survey”.

2005 Earnings           2005 Capital
Major Integrated Companies       per Share                   per Share
BP                                                   $6.25                          $4.00
ChevronTexaco                               $5.95                          $4.45
ConocoPhillips                                $8.30                          $6.55
ExxonMobil                                    $4.90                          $2.05
Royal Dutch                                    $6.60                          $4.30

Reinvestment of capital to fund the search for more oil and gas to provide consumers is estimated to take 67% of major integrated oil companies’ net income in 2005.

Anadarko Petroleum                        $8.00                         $13.45
Apache Corp.                                  $ 6.80                         $ 9.45
Burlington Resources                       $5.50                         $ 4.40
Chesapeake Energy                          $2.35                         $ 6.60
Devon Energy                                  $5.40                         $ 7.35
EOG Resources                                $4.00                         $ 6.65
Kerr McGee                                      $9.70                         $12.25
Marathon Oil                                     $6.40                         $ 7.10
Murphy Oil                                       $4.15                         $ 6.50
Occidental Petroleum                        $9.00                         $ 5.20

The independent producing segment of the industry is even more aggressive in capital investment in the search to provide more oil and gas to consumers. The estimate for 2005 is 129% of earnings will be reinvested for the continued search for more oil and natural gas. Reinvestment in excess of net income shows that cash flow including depletion is sourcing more drilling activity. This belies the assertion that depletion is merely a tax preference item. In actuality, it helps fund greater production of oil and gas.

It is clearly and easily observable with a minimum of effort that oil companies do not set the price of oil, do not reap “windfall profits”, and actually reinvest the vast majority of the money they earn in trying to provide the consumer with greater volumes of oil and natural gas. In fact the latest examples globally of government meddling in the energy markets have been disastrous. Russia, once thought of as a counter measure to OPEC has now experienced much lower than anticipated volume growth and forecasts after the “re-nationalization” of the oil business. Venezuela has turned about from an aggressive growth profile that threatened OPEC discipline to a struggling producer unable to even achieve their production quota. The United States does not need to make a mistaken policy based upon political fantasy that would discourage supply, and quite possibly lead to product shortages.

If you want to make oil, natural gas, and refined products such as gasoline more available and at a lower price, you can help to increase the supplies and bring down costs. Let your elected representatives know that you are in favor of opening up federal lands for exploration and production of oil and gas therefore providing greater quantities. Support relaxation of lengthy permitting processes and reduce bureaucratic delays in permitting of refineries. Allow refineries to be built throughout the consuming areas, not concentrated in a narrow swath of the Gulf Coast. This would reduce transportation costs, weather disruptions, and increase the supplies, resulting in lower prices.

By Gregory J. Winneke, CFA, CMM September 29, 2005