Recently, a “progressive” blog ran this tweet: “Once again: Oil and gas companies are making record profits and have no interest in reducing the price of gasoline. This is not a government regulation issue, no matter how many times Republicans tell you otherwise.” Their blog then goes on to talk about how Shell plc, a major integrated oil company domiciled in the UK, had “obscene” profits and will buy back shares and increase its dividend by 15%.
The obvious leftist line is that oil companies control the prices they can charge for their products, and that they are intentionally gouging the end consumers of their products and laughing all the way to the bank.
If only life were so simple, and if only the minds behind “Colorado Pols” understood the economics of a very complex global industry.
Oil and Gas 101
The oil and gas industry is composed of hundreds if not thousands of companies, publicly and privately (and even government) owned throughout the world engaged in the business of extracting fossil fuels from the Earth, transporting and converting them into usable products, and selling those products to the end users directly – as at the gas pump; or indirectly – via a natural gas furnace or an electrical outlet.
This oil and gas (O&G) industry is generally considered to consist of three segments, with most companies operating in one or two of these segments, and the “major”, or “integrated” companies operating in all three.
The economics of all three are different and the cost pressures vary, but one thing that is common across the industry is the laws of economics. Another constant is fierce, unrelenting hostility from climate activists and their captive Democratic Party.
Upstream
So-called “upstream” or “exploration and production (E&P)” companies are engaged in the business of identifying oil and gas reserves on land or under the ocean, drilling exploratory and production wells, and extracting the fuels we need to power our modern life from the Earth – petroleum or “crude oil”, natural gas and natural gas liquids (NGLs).
In the early days of the industry, this was an enormously risky business because the location and extent of oil and gas reserves was not always evident. Now, thanks to advanced geology and modern technology, it is easier for companies to locate and identify possible oil and gas reserves. When title to the land is obtained through leases or outright purchases, the company will drill an exploratory well to see if the field contains oil and gas reserves. Once it is determined that it does, that field (usually within a larger “play”) is considered to be a “proved reserve”.
Drilling an oil or natural gas well is a highly capital-intensive construction project. Drilling rigs are expensive, and it can cost over $20,000 per day to rent one. With the number of days it takes to drill a well, the costs of the materials, casing, labor costs, sand and water add up very quickly.
Over the life of a well, the company incurs lease operating costs to keep the well operating, and at the end of its life, there are costs to plug and abandon the well. Contrary to the leftist narrative, oil and gas companies reserve funds to cover these expenses and carry the liability on their balance sheets. (Look for “asset retirement obligations”).
In order for these companies to be profitable, they need to sell the products for more than it costs to extract them from the ground. Obviously, the higher price they receive the better it is for them. But they don’t control the prices they can charge – that is controlled by the forces of global supply and demand. When prices are low – as they sometimes are – these companies may not be able to sell their products for enough to recover their costs. When the probable cash flows from proved reserves are lower than the asset values, companies are required by generally accepted accounting principles to record impairment losses. To my knowledge, no lefty is ever upset about oil and gas companies losing money, which they often do.
The various markets for the different grades of crude oil are denoted by the indexes for light sweet crude – Brent, NYMEX WTI, Argus WTI Houston, etc. These indexes give us knowledge of what an oil company can sell a barrel of oil for. If Brent is selling for $80 per barrel, an E&P company can’t sell it for $90, and they’d be crazy to sell it for $70.
But let’s be clear: without E&P companies, there would be no oil and gas extraction and no modern life as we know it. These companies require a lot of capital to operate, and they face hostile operating environments – from hostile governments to hostile climate-change zealots to who are doing everything they can to hamper, hinder and harass the industry.
Midstream
The midstream segment of the industry is where the storage, trading, and transportation of fossil fuel products takes place. Companies in this segment purchase crude oil and natural gas from E&P companies and get it to the ultimate consumers.
The primary means of transporting crude oil is via tanker, truck, railroad or pipeline. Pipelines are the least expensive and safest for the environment (with fewer carbon emissions). Once the products are extracted and separated, they are transported to refineries where they are further processed for end use.
Again, prices midstream companies can charge are determined by the laws of supply and demand. Companies that don’t generate enough revenue to cover their costs don’t stay in business very long.
Sometimes people complain about exporting fossil fuel products. Sometimes they complain about the fact we import fossil fuels. Due to the nature of the industry, the United States does both. Imports and exports are governed by the differences between domestic and foreign supply and demand. In addition, the U.S. imports oil to the East and West coasts to provide for the consumers on those coasts. Because of the leftist opposition to fossil fuel development there is insufficient pipeline capacity to carry oil and natural gas from domestic plays like the Permian Basin and others to coastal refineries. Thus, midstream and downstream companies import oil to meet the demand from those consumers.
Downstream
The downstream segment is where the refining and transportation to end users takes place. The gasoline you put in your car came from a refinery via diesel tractor-trailer truck. The electricity you use to power your modern life is from the coal, natural gas or nuclear power generated at various facilities. The wind and solar power so beloved of the climate crowd are part of the mix too, but only a very small part – about 11% in the US and even less in the rest of the world.
While there used to be dedicated “gas stations” operated by the various oil companies (where an attendant would come out and pump your gas, clean your windshield and check your tires), today most gas sales are via convenience and grocery stores. Often they are on adjacent corners, with big signs advertising their prices for various grades and types of fuel.
Now, say the operator of “Jim’s Quik Stop” is a greedy guy who wants to charge as much as he can for gasoline. If he prices his gas higher than what the 7-11 across the street is charging, he won’t sell much gas and won’t make any money. In other words, the prices he can charge are governed by the market forces of supply, demand and pricing competitiveness.
Pricing Mechanisms
As with any other market, the laws of supply and demand will establish the prices for various products to sellers and buyers at every stage of the value chain. The price you pay at the pump for a gallon of gas is based on what it cost the retailer to bring it to you (among other things, more on that later). In turn, his cost is based on what it cost the refiner and transportation company to bring it to him. And so on. The molecules of stored energy that you put in your gas tank today were originally produced by an E&P company weeks or months ago and they’ve long been paid whatever the market rate was at that time.
What you pay at the pump isn’t simply the result of the interaction of supply and demand, either. Thanks to government interference in energy markets, leftist hostility (now official US government policy since climate zealots are in control) and taxes imposed by government, your price per gallon costs you far more than it should.
According to www.eia.gov, the base product in a gallon of gas – crude oil – accounts for only 54% of the price. Refining and transportation costs account for another 33% with the remainder going to taxes.
In Colorado, you pay a state excise tax of $0.22 per gallon (California, who Colorado Democrats want to emulate, charges $0.6698 per gallon!) in addition to a $0.184 per gallon federal excise tax for a total of $0.404 per gallon. Those taxes are included in the price per gallon, so when your gallon of gas is, say, $3.227, 13% of the cost is going to governments in the form of taxes. When Democrats talk about raising the gas tax (and they frequently do), remember that it will directly cost you more to fill your tank. This is not a tax on “the rich”. This is a tax on everybody. And not one dime of it goes to those evil oil and gas companies.
Profits
It should not have to be said, but the purpose of a business – any business – is to earn money (called “profits”) for its owners. If the business is efficient and effective and if the market allows for the company to charge a price for the product or service that is in excess of what it costs to provide, the business will make a profit that is available to owners in the form of distributions or dividends. If a company has to sell for less than cost, it loses money.
Now take an E&P company. It costs a lot of money to extract fossil fuels from the ground. The company should be able to charge a price that will cover costs and earn a profit. But the companies in the industry can’t set those prices – markets do. So companies will enter into what are called “derivative” transactions so that they earn a target base amount of money if prices fall below a certain amount.
Say it costs a company $50 to produce a barrel of oil, and oil prices are $80 a barrel today. That means the company will earn a gross profit before expenses of $30. If oil prices dip below $50, the company loses money not only on production, but likely through impairment losses as well.
It needs to be said – again – that the companies in the industry have no control over what prices are. They can use derivatives to protect the downside, but they have no more control over what they can charge than you do.
Capital Returns
Now we get to the issue of dividends and capital returns. I wish the lefty bloggers I mentioned at the top had the most rudimentary understanding of business, because then they would know that paying dividends is something that most businesses normally do. It’s one reason why people buy shares of stock in them.
Companies will also buy their own shares in the open market to reduce the number of shares outstanding which then increases the earnings per share and theoretically the market price of their shares. Companies in every industry do this, and oil and gas companies are no exception.
When times are good, companies will increase dividends. When times are bad, companies may cut or eliminate dividends. When the market for oil is in the high $80s to low $100s E&P companies stand to earn a lot of profit. It’s normal and natural to return some portion of that money (we call it “Free Cash Flow”) to shareholders.
Now let’s take a look at why oil prices are so high. One reason is the war in eastern Europe, which has disrupted oil markets considerably. But the biggest reason, I think, is the unrelenting hostility of the dominant Left to the oil and gas industry, which, since they control the federal and many state governments, makes it more difficult and expensive to extract the oil and natural gas that everybody demands. By closing off oil and gas development on federal lands, they put artificial constraints on resource availability. By imposing excessive regulations, taxes and fees, they make it more expensive to do business. And finally, with their regulatory hostility, they make it difficult to do long-range planning which – for organizations that raise and spend billions of dollars in capital investments – is crucial.
Another reason for capital returns in investor pressure. As investors see the hostile environment in which the oil and gas companies operate, they prioritize return of capital over production increases. That was a difficult lesson for the industry to learn over the past several years, but it is well-ingrained now.
Conclusion
Fossil fuels make our modern life possible – indeed they are one of the Pillars of Modern Life. The companies that make their use possible are providing an incalculable boon to humankind and deserve our thanks instead of the hatred and hostility that they receive from the climate-obsessed Left.
I’m standing to defend the industry because I stand in defense of our modern life and modern business practices. Whoever wrote the tweet I referenced above should be embarrassed by their obvious ignorance of how businesses operate and how everyone, themselves included, benefit from fossil fuels.
Don’t like high gas prices? Blame warmongering tyrants enabled by weak Democratic presidents. Blame the hostility of the Left to the oil and gas industry. Blame the weather. Blame OPEC. But don’t blame oil and gas companies, because they have no control over what you pay at the pump.
It’s just that simple.
2 Responses
Very good article. Thank you.
I’ve heard this nonsense from the Socialist media outlets too. Besides climate change, what are their other motives in declaring record profits? Do they want to Nationalize the oil industry like they did the healthcare industry?
My other comment is to request not to use the phrase “Fossil Fuel.”
Love the read.
I plan to share as much of it as possible.