Oil Profits Explained

I'll admit I was a little disheartened last week when I learned that oil companies were posting record profits for the last quarter. I thought maybe that the liberals were right and that the companies were engaging in unethical behavior to drive the price of gas up. I thought, just perhaps, that maybe the free enterprise system was not working. However, I also thought that maybe there is something I don't know or don't understand that would reasonably explain the jump in profit.

I am glad that I choose to investigate and fully understand things before jumping to a conclusion. I discovered there is a lot I didn't know about the oil business that explains these jumps in profits. First is the different between an absolute jump in dollars and the profit margin. Simply put, the absolute profits are the real money that's left over from gross revenues after a company pays the costs of doing business. Profit margins , on the other hand, are the percentage of gross revenues that are left over after those costs are paid. So, a doubling of profits combined with a doubling of the cost of doing business would have the exact same profit margin. The newspapers kept reporting dollar amounts, but not profit margins. I have to wonder if the profit margins stayed close to the same, which we would expect because the cost of doing business (i.e., buying crude oil, refining oil) rose.

Then, Alan Reynolds, a Senior Fellow at the CATO Institute, has written an editorial where he explains something called "inventory profit." This is a profit that appears on paper when a company holds a large inventory of a commodity. Basically, they may purchase the commodity (in this case oil) when it is cheap ($40/barrel). The commodity then rapidly rises in price ($60/barrel). This means that the value of the inventory has risen as well. When accountants book the value of these inventories, they add the profit (i.e. value increase due to current price) to the profit line of the company. However, this is a profit on paper only. As the company consumes the raw material and seeks to replace it, they will have to pay the current rate ($60/barrel). Mr. Reynolds actually does a better job of explaining the concept and compares it to selling a house and getting a profit, but needing that profit to buy a new house because housing prices have increased so much.

Anyway, between the two concepts, one can reasonably see that the oil companies profits are paper profits only and the have not been taking undue advantage of us. Free enterprise still reigns supreme.