Price of Oil and Oil Companies

As the price of oil continues to climb due to unrest in the major oil producers of the world, I happened to glance at a comment a person made about the Oil companies. They said that of course the companies will post record profits and they are being greedy and it is a conspiracy by them to take all of our money. Thinking about that I have to agree with the price of oil dramatically rising yet the cost of production staying level of course they will have record profits as the equation Profit=Sales-Expenses still holds true.

Of course as a consumer we get all riled up about having to pay more for gas and other oil byproducts, but it isn’t the oil company that really determines the price but everyone who buys oil products. Take this example, I have 20 units of product A and am looking for someone to buy it, along comes buyer A and offers $50 per unit for 15 units. As I am thinking over this along comes buyer B who offers $75 per unit for 12 units. Well I sell 12 units to buyer B and 8 units to buyer A at the arraigned prices. Of course buyer A could have come back with a higher offer of $80 for 15 units and the tables would have been reversed.

Notice that I never said how much it cost for me to make the units? Just because it costs me $15 per unit to create it, does not affect the price, although if the highest bid was $14 I would just keep all the units to myself or if I thought that tomorrow people would pay me $150 per unit I might keep the units to myself.

Now returning to the oil companies, they deal in a very volatile commodity that has a long lead time, meaning it can take years before production starts and also the price that it is today could be dramatically different then the price tomorrow, either up or down. Their expenses are pretty much fixed unless they invest in future capacity (new fields, more R&D, etc.) of course if they invest the money they will have to continue paying that money even if the price of oil drops below the sustainable cost. This of course would tick off investors and the people running your 401k/IRA/403b who then dump the stock making the company lose even more money. So when they plan their technology investments they look at what the price of oil will be in the long run, set their expenses accordingly and will pocket the excess of next year’s profit.

Another facet of this equation is that they are writing contracts for potentially far into the future (potential discount to the buyers), so they are filling the orders that were purchased months if not years ago at a set price that might be higher or lower than what they could get for it today. This of course leads to speculation by everyone who buys or doesn’t buy oil for their own products or to hold onto the paper and sell that paper promise of oil at a later date to someone else who will use the oil in their products (like gasoline). So returning to the example if we have buyer C who believes that demand will increase for my units driving the price up to $150 that people would be willing to pay for the units he makes his offer of $100 for all 20 units, I count my lucky stars and give him all 20 units and bank the $1700 profit, which might later be used for researching on how to make more units, make the units even cheaper, make the units better or invest in a new unit that I believe will replace my unit. Now buyer A and B need these units and realize that buyer C now holds them, they of course offer more than $100 for the units and of course pass the cost along to person who purchases their derived products.

Now some might say that the oil companies should just see the offer of $110 per barrel and politely decline and offer $60 instead, people buying oil products would LOVE that but all the investors, employees (who now don’t get raises), R&D deparments, etc. will not be too happy with the sales department as they do not have the resources to expand faster and further that they might have before.

There are of course the bad and the ugly, for example let us say that another supplier comes along with a better product which now buyers A and B can offer lower prices and get what they need. If I was smart I would offer to buy the company before they realized their potential, I then could shelve it (conspiracy theorists usually focus on this) or develop it and sell it making even more profit to research even better. There is a history in all companies for both paths.

Yes the oil companies haven’t had a perfect history and yes oil products are going to cost more as demand increases, but let us not place all the blame on speculators and oil companies as we all are in a way responsable for the increase in price. Let us also hope that they choose to invest these large profits into reasearching a better and cheaper product as that is really the only way to sustain a business for generations to come (and save our pocket books).


One response to this post.

  1. We need to get you a new jacket….. you’re always wearing that one!

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