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Why are oil companies making more profits?

Posted by Chance on May 5, 2006

No, I won’t let this issue die just yet. As long as Congress keeps considering measures to punish oil companies for making “windfall” profits, I will keep talking about this issue.

With the price of crude oil going up, it is obvious why the overall cost of gas is increasing, but it is not so clear why profits are actually increasing. Alan Reynolds of the Cato Institute explains it this way

The oil industry holds a lot of inventory, and we should be glad it does. If an oil company stockpiled a lot of oil at $40 — before it rose to $60 — that will look almost as good (on the books) as the sorts of windfalls we’ve seen on home sales in Las Vegas. Since gasoline prices also rise when crude does (partly because crude accounts for half the cost), products refined from the cheaper $40 crude will also be unusually profitable for a while. But this is like making money on the house you sold but needing every dollar to buy a replacement home. Prices of oil likewise must reflect replacement costs, and the resulting one-time surges in inventory profits are not a problem but part of the solution.

In other words, the oil company profits that are calculated are based on the price of the purchase of crude whenever it was purchased some time back (I’m not sure what the time period is from purchase of crude to finished product). It’s not like Exxon Mobil uses all of their profits to go on fancy cruises or trips to Disney Land. If they want the company to actually last, they will have to reinvest their profit into the purchase of more inventory, in the form of crude oil. So, because the price of collecting inventory goes up, so do the profits needed to afford the inventory. But since the reported profits are based on the price of the crude oil used in the product being sold today, the profits will be high for some time.

Reynolds compares it to the selling of houses:

If you sell your house for much more than you paid for it, you will receive a “windfall profit.” When you take that windfall from selling your old home and go shopping for a new one, you’ll discover prices of replacement homes have gone up, too. That may explain why the Senate has not yet contemplated an extra “windfall profits tax” on windfalls homeowners receive when selling their homes. Since 1997, in fact, couples can pocket half a million dollars of such windfalls tax-free.


One Response to “Why are oil companies making more profits?”

  1. The Prophet said

    Good Post.

    I haven’t thought a whole lot about gasoline prices and why they increase and decrease. I do believe that pretty soon gasoline will be a thing of the past.

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