A little girl calls for the junking of oil deregulation in Manila in May 2006, where there have been steep oil price increases. (AP photo)
For oil industry, profits are one big shell game
ASK THIS | June 14, 2006
Firms make gains appear larger or smaller depending on who is asking; shareholders get one answer, tax collectors another. And authorities in one jurisdiction may get different answers from those in another.
Q. How do oil company profits compare with profits in other manufacturing industries?
Q. Is there any way to determine normal oil industry profits?
Q. What do the oil firms really do with their enormous profits?
By Henry Banta and Peter Ashton
High gasoline prices have set off an emotional debate over oil company profits. Thinking dispassionately about the issue doesn’t seem to be on many agendas. A few fundamental observations might help get beyond invectives and denials.
First, recent profits are certainly enormous, but in relation to what? Are they the results of “price gouging,” or are they just an appropriate reward for hard work and big risk? In a market economy it is customary to assess profits in relation to invested capital. How well does a company reward those who put up the money to finance the enterprise. In a recent article for National Review Online, Deroy Murdock expounded the current industry line: profits are not large as a percent of revenue. Wrong. Profit as a return on investment is the proper measure. Return of profit on capital investment attracts capital in the first place. At the risk of belaboring the obvious, this is why we call the system “capitalism.”
Not surprisingly, this is the concept that the major oil companies use when they are talking to their shareholders. In its 2005 Financial & Operating Review, ExxonMobil states:
"The Corporation has consistently applied its ROCE [return on capital employed] definition for many years and views it as the best measure of historical capital productivity in our capital-intensive, long-term industry, both to evaluate management's performance and to demonstrate to our shareholders that capital has been used wisely over the long term."
Each of the other major integrated oil companies also point to ROCE as the primary measure of its success to its stockholders. For example, in its 2005 Annual Report, ConocoPhillips touted its 32.1% ROCE in 2005 as follows:
"Refining remains our primary focus, and the business performed exceptionally in terms of return on captial employed (ROCE) and other key measures . . . We are an industry leader in downstream ROCE . . . ."
So what do oil company profits look like when viewed as return on capital?
The following table shows the ROCE for the five largest integrated major oil companies over the last two years:
Return on Capital Employed (ROCE)
ExxonMobi l 23.8% 31.3%
Chevron 25.8% 21.9%
BP 16.4% 19.9%
Shell 20.1% 25.6%
ConocoPhillips 23.3% 32.1%
AVERAGE 21.9% 26.2%
First quarter profits for 2006 are on par with if not better than 2005. These returns are very high in comparison with other capital intensive industries. Census Bureau data for 2005 shows that the rate of return on assets (not quite the same as ROCE, but close for comparison purposes) was 7.1% for all manufacturing.
The industry claims that the current high level of profit simply represents the workings of the market – resulting from temporary supply interruptions. High prices are necessary to efficiently reallocate the short supply to where it is most needed. This efficient allocation, however, comes at an extraordinarily high price. Does efficiency really require the transfer of billions of dollars from consumers to oil companies? If, as we may expect, we are likely to see future supply problems, how much of this “efficiency” can we afford?
Even if we were to accept the industry’s line of argument, we would still have a question: what are normal oil industry profits?
Oil companies have many ways of making their profits appear larger or smaller depending on who is asking. Shareholders and tax collectors are virtually certain to get different answers. Further, tax authorities in one jurisdiction will get different answers from those in another.
The truth is there is no way to be sure what the major oil companies are earning at any given level in any given jurisdiction. They are vertically integrated and operate in many nations. Getting a handle on their real rate of return is very difficult. A “vertically integrated” oil company explores for and produces crude oil, refines crude oil, distributes and markets refined products, and transports both crude oil and refined products. This creates many opportunities for “transfer pricing.” It involves “selling” petroleum or related services from one division in the company to another. “Price” becomes a very elastic concept when you are “selling” to yourself. Intracorporate “sales” are not real sales in the sense that they are between unrelated entities that bargain at arms-length. From the perspective of the corporation as a whole, the “prices” used in such internal transactions are inherently arbitrary.
The matter gets worse when there is more than one company involved. For example, two companies facing royalty payments for crude oil production on government lands (federal or state) can “sell” their oil to each other at an artificially low price. This “sale” is used to validate the artificial price as a true market price. As long as the “sales” between the companies are equal, neither company loses from the use of the low price – only the government. Once one understands the basic game, one can see how an infinite number of variations are possible.
At this point oil executives become indignant: never would they permit the use of a transfer price that did not reflect real market values. The long history of the industry tells quite another story. For decades when the industry was getting the tax benefit of the “percentage depletion allowance” on its crude oil production, it pretended to make most of its profit from crude production and barely break even on its refining and marketing operations. It did this because a dollar earned at the production level was worth more than a dollar earned at any other level. It did it by “selling” its crude production to its refineries at an artificially inflated price. Thus it earned most of its profits at the crude producing level and earned little at the refining and marketing levels where it was more heavily taxed.
In California things were different. Because the major companies had very little crude production of their own, the depletion allowance was not enough to create an incentive for high prices. Instead they used their control of pipelines to keep the prices of crude oil low. There has been an extremely bitter debate in recent years over royalties owed by the companies for production on the federal and state lands involving the complex trading devices that were used among the companies to conceal the real value of the oil being produced and therefore what was owed to the governments.
Just as vertical integration creates opportunities to move revenue from a level where it is heavily taxed to one where taxes are lower, operating in many jurisdictions creates similar opportunities. Profits earned in one jurisdiction can be reported in a jurisdiction with more favorable taxes.
When both vertical integration and multiple jurisdictions are involved the game can get particularly complicated. This was demonstrated by documents turned up by the Canadian government in an investigation after the first “energy crisis” in 1973. (It is notable that this was a rare real investigation; the RCMP raided offices and seized documents.)
For example, documents were obtained from the Sun Oil Company (now Sunoco) that explained why the parent company charged its Canadian subsidiary prices “normally higher than arm’s-length, world market crude oil prices.” It was “to the benefit of the consolidated Sun organization for Sun Limited [the Canadian subsidiary] to pay a price as high as possible that is also acceptable to the [Canadian] Department of National Revenue.”
As they put it, "In summary, the answer is that tax dollars are saved in Canada, and therefore, for Sun Oil Company overall, by this pricing method . . . for U.S. purposes, the parent company has a large foreign tax payment to use as a credit or deduction in computing U.S. taxes on consolidated results. Sun (U.S.) can, therefore, take in foreign-source income as, for example, via sale of crude to Sun Limited at high prices, and offset this by using these credits or deductions to eliminate taxes on such income here."
Sun was not unique; its analysts were just more quotable.
Between the vertical and cross jurisdictional operations the potential variations on the scheme are virtually endless. There is considerable discretion as to where and when profits are earned, where and when they are reported and to how much taxes are paid which government.
The next question is: What do oil companies do with their profits? The companies claim that high profits are needed for investment in future production. From the barrage of recent advertisements one could get the idea that most profits get reinvested.
In an earlier article on this Web site, Peter Ashton noted that the major oil companies in fact only reinvested 53 cents of every dollar of profit on new capital investment in 2005. This is not a high reinvestment rate – indeed the Chairman of ExxonMobil admitted as much in testimony before the U.S. Senate when he alluded to the fact that in the past the company had reinvested 100% of its earnings.
What was ExxonMobil doing with its earnings? In its 2005 annual report, ExxonMobil described it “core objective” as “delivering long-term growth in shareholder value.” To this end the company reported,
Since 2001, we have distributed over $71 billion to shareholders in dividend payments and share purchases to reduce shares outstanding. Of that, nearly half, or $33 billion, has been distributed to shareholders via dividends, which have grown 32 percent since the first quarter of 2001 – from $0.22 to $0.29 per share per quarter. The Corporation has paid a dividend each year for over a century, and has increased its annual dividend every year since 1983.
ExxonMobil has distributed over $38 billion of cash to shareholders through its flexible share purchase program during the past five years. By reducing the number of shares outstanding, we increase the percent ownership of the company that each remaining share represents. Since 2001, we have reduced the number of shares outstanding by 11.5 percent, thereby contributing to increased earnings and cash flow per share.
ExxonMobil is not alone; each of the major companies have massive stock repurchase programs. Shell has spent over $5 billion since 2005 in the repurchase of its shares “in order to return surplus cash to shareholders.” Chevron has repurchased about $8 billion of its shares; ConocoPhillips about $2 billion. BP acquired $11.6 billion of its own stock in 2005.
It is relevant to note here that BusinessWeek has reported that ExxonMobil has the largest pension shortfall on any corporation. Its pension fund assets are $11.2 billion short of projected obligations. The article notes that if airlines, steelmakers, and auto parts suppliers had contributed extra cash to their pension funds in good years the current pension crisis would not be nearly so severe. Of course, as has been widely reported, ExxonMobil has not been indifferent to the pension interests of all its former employees, rewarding its former chairman and CEO, Lee Raymond, with $144,573 for each day of the 13 years he led the oil company.
Oil executives frequently argue that their stock is very widely held, therefore what benefits their shareholders, benefits a large part of the public. Perhaps, but unlikely. There is no reason to believe that oil stocks are more widely held than stocks generally. Edward N. Wolff in his study of wealth distribution cites Federal Reserve Board statistics that show in 1998 the wealthiest top 1% held half of stocks and mutual funds in the U.S. The top 10% held 85% of stocks and mutual funds. The rest of us held about 15%. When the recent Federal Reserve data is analyzed, these numbers are most likely to be even further skewed to the top.
In sum it is reasonable to conclude that the high gasoline prices and the subsequent explosion in oil company profits resulted in a significant redistribution in wealth from consumers of gasoline to the comparatively rich owners of oil stocks.