A Second Helping of Perspective

Greetings from the Left Coast, where we here at LeftCoastBlues do the heavy thinking for those who just can't be bothered.

The other day I was headed out to lunch with some business colleagues, and the subject turned to fuel prices. I was astounded when one of my colleagues went off on the "obscene profits" the oil companies were making. I was astounded because this person used to work for a consulting company that went into troubled businesses, analyzed their financial statements and business practices, and told them what they needed to do to fix things. Of all the people I know, he certainly understands - at least intellectually - that the percentage numbers are what matters, not the dollars. Yet he was joining in the chorus condemning Exxon Mobile for their Q1 profit number - the biggest ever, as we have repeatedly been told.

Now I understand that people are hurting, and they want someone to blame. Heck, I've got a pretty fuel-efficient car, and I live less than 10 miles from my office, and I'm still not crazy about paying nearly five bucks per gallon for gas. And the oil companies are an easy, obvious target, and it's all too easy for the people who are really to blame for this mess to shift our attention to the big, bad oil companies.

But can we have some perspective here, please?

Exxon Mobile is a publicly traded company. It is therefore required to make its financial statements public as well. You can go to their Web site and download their annual report, along with several other documents that they are required to publish.

In 2007, Exxon Mobile's net income was roughly 10.4% of sales. Of course, sales and other operating revenue totaled almost $400 Billion, so that 10.4% is a huge number. But the revenue number is also huge - almost mind-bogglingly huge - and the income number is only important as it relates to the revenue number. Now a net income of 10.4% is indeed good, solid performance. It's about on par with AT&T, whose net income was about 10%. It's a heck of a lot better than, say, Costco, whose net income in 2007 was only 1.7% of sales, or Fluor Corporation, with 3% of sales. On the other hand, the Boeing Company had net income of 12%. Do we need a windfall profits tax on the obscene profits of the aerospace industry? 3M had net profits of 16.7% - do we need a windfall profits tax there? How about the software industry? After all, Microsoft's 2007 net income was 27.5% of sales! Oracle's was 23.7% of sales! Time for a windfall profits tax on the software industry!

A publicly held corporation exists for one and only one reason: to deliver value to its shareholders. So who are the shareholders of Exxon Mobile? No corporate officer or board member owns more than 0.02% of the company's outstanding shares. We know that, because that's the kind of information a publicly held corporation has to publicize. The rest are owned by...well, by everyone from millionaire investors to the proverbial little old lady in tennis shoes. You may own some if you have money in a mutual fund, or a retirement or pension plan. And the corporate officers and board members have a fiduciary responsibility to the shareholders that can result in them going to jail if it is breached. Remember Kenneth Lay and Enron?

Congress doesn't have the power to repeal the law of supply and demand. If supply is constant or declining, and demand is rising, the price will go up. It's one of the most fundamental laws of economics. If you want to see lower prices in a free, global market - which the market for crude oil is, whether we like it or not - you must either increase supply or decrease demand. And if you control prices by artificially forcing them lower without increasing supply, you will have shortages. Anyone else out there remember the days of the Arab oil embargo and the long lines at the gas pumps back in the 1970s? Want to go back to that? Me neither. Right now gas is expensive, but it's available. That's a good thing. That's how free markets work, if they're allowed to function.

Can someone tell me, please, exactly how a windfall profits tax on the oil companies is going to make the price of crude oil or gasoline go down? Those of you who are in business, imagine a situation where you are told by the government: "Look, you're making too much money on this stuff you're producing and selling. So we're going to pass a special tax that will take away from you any money you make that's in excess of what we think you should make." Is that going to give you an incentive to make more of whatever it is that you produce, or less? Why should you try to make more of it if you aren't going to get to keep the fruits of your labors?

Next in line for blame seems to be "the speculators." Even the Saudis are now blaming "the speculators" for bidding up the price, and denying that the law of supply and demand is responsible. Of course they are. After all, they and their OPEC colleagues are guilty of artificially controlling supply to keep prices high. If you're looking for villians in this situation, OPEC certainly is worth of consideration. So naturally they want to deflect responsibility to someone else - even as they increase the amount they're pumping for fear that the price will go too high, people will seriously start turning to alternate sources of energy, and they'll be hurt in the long run.

But "speculators" are nothing more or less than investors who are trying to figure out whether the price of something is going to go up or down in the long run (no different in that respect from investors in the stock market), and they actually provide a stabilizing effect on long term commodities prices. Suppose you're General Mills, and you need a lot of corn for making corn flakes. It will really help your business planning process to know what you're going to have to pay for corn in the next 12 months or so - particularly when the Law of Unintended Consequences is pushing the price of corn through the roof because...wait for it...demand has gone up because people are now using corn to make ethanol. But I digress. Thanks to the commodities market, you can purchase a contract today for corn to be delivered at some point in the future at a price fixed by the contract. It helps General Mills, because it now knows what it's going to pay for corn. It helps the suppliers, because they now know what they're going to get for their corn.

Here's where you get to play. If you think the price of corn is going to go up, you can buy a contract for a million bushels of corn to be delivered, say, six months from now at today's contract price. You can buy that contract for a fraction of the actual value of the corn. Seeing as how you probably don't have a driveway big enough to hold a million bushels of corn, what you're counting on is that sometime in the next six months, you'll be able to sell your contract to someone (e.g., General Mills) who actually does need the corn. If the price goes up enough, you'll be able to make a profit, and the person who buys the contract from you will still pay less for the corn than if they had to buy the corn at the market price at that time. And the profit can be substantial, because the profit will be the difference in price on the whole million-bushel lot, whereas you only had to put up a fraction of that amount to buy the contract in the first place.

Sounds like a great deal, doesn't it? But if you guess wrong, and the price of corn goes down in the next six months, you're going to end up having to sell your contract for a loss - and it could be a really big loss, because, once again, the loss will be the difference in price on the whole million-bushel lot, meaning that you could lose a lot more money that you put up to buy the contract.

Conversely, if you believe that the price of corn is going to go down, you can sell a contract to deliver corn that you don't actually have yet, in the belief that, before that contract comes due, you'll be able to buy the corn at a lower price than the one you've contracted to sell it for. Once again, if you guess correctly, you can make a lot of money. If you guess wrong, you can lose a lot of money.

It certainly is possible for buyers and sellers in the commodities market to bid up the price of something in the short term, if a lot of people believe that the price is going to keep going up. But it is not possible for them to keep the price up by themselves. At some point, demand will begin to fall off, prices will stabilize or begin to decline, and if you're stuck with the wrong kind of futures contract, you will lose a lot of money.

We're already beginning to see this reduction in demand. Somewhere between $4 and $5 per gallon, gas hit a point where we began to change our behavior to use less of it. We started to drive less. Public transportation ridership is up. We've started buying smaller, more fuel-efficient cars. Hybrid sales are up. It's painful, but free market forces are working, and we are adjusting. Our politicians may not be noticing, but the Saudis are. Whatever you may think about them, they're not stupid, and they didn't decide to increase production by a half-million barrels per day out of the goodness of their hearts. They did it because they saw our behavior patterns starting to change, and they're afraid we will find a way to wean ourselves away from our oil dependence, which would, of course, reduce demand even further, which would at some point begin to hurt them financially.

So, if it isn't the oil companies, and it isn't the speculators, who is to blame? That, my friends, will be the subject of our next post - this one is already long enough.

Thanks for listening.