A question for those wiser than me.....

[Keith Lane]

And that's most everybody.

I e-mailed this same question to a popular public radio show (Marketplace) and am awaiting a reply. In the meantime I thought I'd ask here as well.​

Is there a good reason?​

Like most Americans who drive to and from work daily, I'm not among those who have the wealth to appear insulated from the day-to-day expenses that increasingly dominate our decision making and indeed our daily habits.
I have a question, that on the surface seems like a simple one, but I'm sure will have a very complicated answer. The only way I know to ask it, is in the form of a simple, hypothetical business model scenario. It involves a company that makes a product who's cost of material is $1.00 per unit. Our magic company has no other costs involved and sells the item for only $1.50. That's a profit of $.50 per unit. Pretty nice and simple. Now, say the material cost rises to $1.50. Assuming our company passes the increased cost of the raw material on to the consumer, the retail cost of the goods rises by the same as the cost increase of the raw goods, in this case $.50 per unit. If demand stays relatively flat, our company's net profit should remain relatively flat, right?

Now, back to the question. If, as the oil companies say, the cost of crude is driving the cost of gasoline at the pump, and as we are all painfully aware, oil prices are way, way up, why is it that the net profits at the oil companies is way, way up as well? If the oil companies are just "passing along the increased cost of crude", why are they reaping record profits month after month? This isn't meant as a rant, just a question.

If you choose to answer by e-mail, fine. If you are going to answer on the air, let me know when, as I don't have the opportunity to listen every day. If you aren't going to answer at all, then nevermind.
Thanks for your time and for the great programming at Marketplace.
Keith Lane
Conyers, (Atlanta) Georgia 30094

 

[EdFred]

Why should I invest more money and make the same amount as if I invested less money?

For example, you and I both buy some shares of CSX stock at the same price. You buy 100 shares, I buy 150 shares. We then sell them at the higher but same as each other's price a few day/weeks/months later. Should I only get the same amount of total return on my money as you did on yours?

Additionally say my cost goes to double or triple what it was. Now I have to start taking out loans to buy my new inventory if I don't make the same MARGIN as I did before. So there's another 5% I'm losing by tapping capital to buy my new goods at $2.00 a unit or $3 a unit.

 

[Greebo]

If the Oil industry makes about 10% profit on gasoline, and Gasoline is $1.00 a gallon, then it cost $0.90 to make that gallon, most of that being in the cost of crude. Call it $0.75 - making up numbers here.

If crude goes up to 3x its base cost, thats now $2.25, plus the original $0.15 on top of that, now you're at $2.35. Now mark that up by 10% and you get a 23.5 cent increase: $2.59.

So before they made 10 cents for 10%, now they make 23.5 cents for 10%.

Record profit, same markup, same margin.

 

[Greebo]

Moderator comment - this question is fine as it is, IMO - but if this discussion gets into the moral questions about oil profits currently in vogue, this thread will be moved to spin zone.

You have been cautioned.

 

[vontresc]

Also if you are in the extraction business (any Commodity) and the extraction costs (royalties and other expenses) stay relatively flat, when demand/speculation increases the price of said commodity profits skyrocket.

This may not fully explain the situation, but it probably is a large chunk of the income they are posting.

 

[TMetzinger]

The difference is the "record profits" reflect actual dollars, which are up, but the profit MARGIN is the same.

Just like a real estate agent making 3% makes twice as much money when he sells a $200K house as he does when he sells a $100K house.

And it really is the margin that matters, because all that "profit" pays off the stockholders of the company - like all the retirement funds and individuals who are investors.

 

[Keith Lane]

If the Oil industry makes about 10% profit on gasoline, and Gasoline is $1.00 a gallon, then it cost $0.90 to make that gallon, most of that being in the cost of crude. Call it $0.75 - making up numbers here.

If crude goes up to 3x its base cost, thats now $2.25, plus the original $0.15 on top of that, now you're at $2.35. Now mark that up by 10% and you get a 23.5 cent increase: $2.59.

So before they made 10 cents for 10%, now they make 23.5 cents for 10%.

Record profit, same markup, same margin.

So, in this scenario, the higher the cost of crude that the oil companies pay to OPEC, the more money they make? Again, I'm just trying to understand the rationale that says that all the increases are due to the price of crude. Lessening the margin would still afford the companies large profits, but at the expense of shareholder return. Sound like I've got it right?
I knew there was an answer. I'm just not edumecated enuff to know what it was.
Thanks

 

[Greebo]

So, in this scenario, the higher the cost of crude that the oil companies pay to OPEC, the more money they make?

If they don't change the margin, correct.

Again, I'm just trying to understand the rationale that says that all the increases are due to the price of crude. Lessening the margin would still afford the companies large profits, but at the expense of shareholder return. Sound like I've got it right?

Correct.

 

[TMetzinger]

Keep in mind that many of us (whether we know it or not) own a piece of oil companies. My 401K and my old pension plan are both invested in oil companies. So if I say to myself - Those oil companies should lower their profit margin, what I'm really doing is robbing myself.

The profit margin is generally set by market forces, and is kept from being too high by competition, and kept from being too low by the need to have cash reserves for leaner times. Oil in particular can have hellacious overhead and R&D costs.

 

[astanley]

(How long before Andrew, Bill and Chip have torn this apart? I've got the over/under on 3 posts)

--

These situations are far more complicated than things seem.

At the end of the day, margin is not static in an industry where the input is a traded commodity. Those of us with a profit-and-loss to manage at work have a EBIT target to hit; this is expressed as a percentage of revenue, or margin. (Markup and margin are two different things, for what it is worth margin is the percentage of profit in relation to revenue, markup the percentage in relation to cost of the goods sold).

That performance, along with other indicators, shows how efficient we are and effective at maintaining our operations. If margin is going up, we are (essentially) more efficient; go down, and I'm (arguably) less efficient. As input cost increases, we have an opportunity to control cost and re-invest into our infrastructure. Infrastructure investment usually lags when times are "thin", and then (depending on which project valuation model you use, like EVA or the more simplistic NPV/IRR mix), and can inhibit the ability to control cost and improve margin performance.

So, in the first few cycles of increased input cost, we index our price accordingly (on a percentage basis, potentially plus a hedge to keep cash flow positive) and focus on "freeing up cost" by investing in infrastructure that supports cost control and improved service delivery. Depending on which economic model I use for selecting my projects, I can start to see returns on that investment within a further few cycles of the business. At that point, if I'm doing my job right, we have secured better margin performance AND a stronger investment plan in our infrastructure to carry us to the next economic downturn.

The price, of course, of all of this is taxation. Taxation does not index in a linear fashion with EBIT; in fact, it is mildly exponential (although this is a bit alarmist to state), which is essentially a "windfall" tax in and of itself.

So, back to the original question:

My cost of goods sold in cycle 1 was $1, and I sold it for $1.50, which is a net 33% margin. In cycle 2, cost of goods sold was $1.5, so I sold it for $2.25. (net 33% margin again). I'm making $.75 versus $.25, a 50% increase in actual cash, which indexes nicely with our change in input costs. However... Price of goods sold and costs of goods sold do not change immediately. It takes time for these costs to trickle down from input to output, which cramps my cash management metrics.

If I'm smart, before cycle 3 comes along, I've included a mild hedge in my price (a bet) on the inflation of my input costs; if I don't do that, I've now eroded my cash flow metrics (again, percentage based) and have less percentage cash on hand to run my business; in some dire cases, instead of paying cash for my inputs, I now have to draw on debt (bad), dilute shareholder value by floating more shares (Bad), or draw on traded debt (BAD), which will just screw our whole operation into a cocked hat.

So, that hedge can appear as an increase in operating margin, but you have to discount that -- because if input costs increase beyond the hedge, I've now eroded margin performance again. Using this hedge, you manage your cash flow and investments in your enterprise based on the income from parking the cash in the bank versus the return on infrastructure investments. A smart group of managers will select projects that fit a tidy return on the investment profile within 2 cycles; ballsy ones (or private company ones) may go out 4-5 cycles, all the while ensuring that the firm's cash metrics are met and there is not an impact to the valuation of the firm (which impacts share price, which impacts shareholder wealth, which directly impacts most manager's compensation)

When you look at ExxonMobil (XOM), revenue from 03 - 07 increased 60%, but Costs of Goods Sold (CoGS) increased 80%, and Operating Income increased an amazing 120%. All of this, however, led to a 34% increase in margin over the time (13.0% to 17.5%), which is reflective of a cash hedging strategy (there is far, far more to this, but I’m not going to get into market hedging and stuff like that) and a strong investment program (borne out when we look at the Operating Expenses).

As things are cyclical, margin will eventually erode as pricing pressures increase and input costs go down. (I am leaving out any discussion of peak oil or other such issues) Margin is where they will cut first to maintain price, leaving “cost” for later (as it is “harder” to cut costs, some believe).

Record profits for an oil company aren’t always a bad thing, as long as they are plowing a portion of that profit back into the enterprise to a) guard it against economic downturns, b) diversify and improve overall firm performance into the future and c) improve valuation of the firm by managing cash flow effectively.

Clear as mud?

Cheers,

-Andrew

 

[etsisk]

Then what about all those years when they were NOT plowing a portion of that income back into the country? Didn't I just read a year or two ago that they had let the refineries go to hell in a handbasket, which is why a lot of them were breaking down under the excess load caused by the Katrina-smushed refineries?

 

[EdFred]

Then what about all those years when they were NOT plowing a portion of that income back into the country? Didn't I just read a year or two ago that they had let the refineries go to hell in a handbasket, which is why a lot of them were breaking down under the excess load caused by the Katrina-smushed refineries?

I *thought* it was because of mandated EPA upgrades which were cost prohibitve at the time. They couldn't just fix it. It needed to be approved. Think FAA, and replacement parts.

 

[ApacheBob]

Moderator comment - this question is fine as it is, IMO - but if this discussion gets into the moral questions about oil profits currently in vogue, this thread will be moved to spin zone.

You have been cautioned.

Does the emperor have any clothes on?
"No one sees the wizard, not nobody, not no how!"

 

[astanley]

There are a great deal of reasons that I'm aware of, if only because I have recently become involved in capital-intensive manufacturing.

The biggest reason for the lack of refining capacity was the 1980s: a painful confluence of a powerful EPA (which was smacking everyone in sight for even the slightest of transgressions, an over-correction from years of poor oversight), low investment tolerance and poor capital availability. The economy was difficult in the 80s and the credit markets even more so, and with equity markets challenged on multiple occasions, investors had a low tolerance for low cash flow and margin performance that generally comes with an infrastructure investment cycle.

Greenfielding a large industrial facility such as a refinery is a long, painful process. Site selection, capital investment, and project planning (including the long permitting and impact assessment process). Profits were by no means "record" during that time frame and cost cutting was the way to meet the street. Extend the above malaise slightly, include a raft of new regulations and NIMBYs, and you get the 1990s. You can actually see a rather large uptick in infrastructure investment during the bubble of 1999-2001, which then trails off and slowly increases as oil prices continued their post-Katrina climb.

Cheers,

-Andrew