As many know, oil has been climbing…not skyrocketing but steadily climbing due to the middle east unrest and such…
Recall when oil was 150 or so a couple of years ago and companies like Exxon and Chevron were posting RECORD profits…
My question is…If I own a business and my input costs rise by 50% that would kill me! assuming everything else stayed the same and my margins couldnt cover the increased cost of goods…correct?
Say I own a widget shop that makes wood widgets and the cost of lumber goes up by 35%…(trying to keep it to basic material input)
If i sold a widget for $1.00 previously, now I must sell it for at least $1.35
to break even
The only way to survive would be to pass those costs on to the consumer ( my customer)…
That has to be whats being done here correct? Obviously prices at the pump are going up so the costs are being passed down to us…Big Oil companies dont pay for them…we do.is that accurate?
If the costs are passed down to us and the company at the same time is recording record profits ( as will most likely be the case) then there is an arbitrage opportunity for companies to pay 1.5x for oil and charge us say 3.0x
You’re missing a lot of nuance there. I think the biggest piece missing is that Exxon, Shell, BP, etc all produce a TON of oil. I don’t know for sure, but I’m pretty sure the bulk of their profits come from sales of oil, not gasoline or other refined products. But, even if the profits come from downstream sales, their ownership of the upstream product (oil) ensures they’re largely protected from soaring oil prices.
You also assume that retailers (widget companies) are operating at near break even. In actuality, most retailers work with large mark-ups so they can absorb rising input costs to a certain degree.
As for arbitrage opportunities, there are some smaller gasoline retailers who take smaller profits in return for higher volume and do very well. I don’t think there are any independent retailers with a significant prescence in North America, however. Why that it is, I don’t know. Probably has something to do with the oil oligarchy in North America. Or maybe economies of scale. Someone smarter is probably opining as I write this.
Your basic observation of passing along costs appears to be sound. However, in this particular example, it has yet to be determined:
[ul]
[li]Why is the price of oil/barrel climbing so fast?[/li][li]Is there speculation afoot?[/li][li]Is there price gouging afoot?[/li][/ul]
There may be sufficient information from this DOE site, or from this site, that may assist you in your quest. In any case, oil just isn’t any commodity. It is the lifeblood of commerce. Oil companies and governments will do whatever it takes to secure its supply at what even level the market will bear, real or imagined.
got it…my “widget” example should have included a margin of say, X…it was silly of me not to put that in there… because most retailers strive for ample margins…
so in answer to my question…it seems like these companies in their Upstream
operations actually own the oil and as you mentioned are protected from the increased cost?
What you’re missing is the price inelasticity of oil. Even when the price goes up, people still need it so they pay the higher prices. That’s probably not true of your wood widgets. Your customers might buy a tin widget or a plastic widget instead.
Why is it that oil prices are determined by the markets and not by the refiners? I know that may not be the ideal case…but for the sake of asking…ill ask
Noted…since the “good” ,oil in this case, is very inelastic there should be some premium or built into the prices and this is exactly what we experience
If the cost of wood is say 30% of the cost of making your widget, which you sell for $1 with a gross margin of 30%, then a 35% increase in lumber cost means:
If you absorb the increased cost of lumber your 30% margin falls to 22.7%
If you pass on the increased cost of 7.35c/widget your gross margin falls to 27.9%
If you increase prices to $1.105, you maintain your 30% gross margin.
If you increase prices by 35% because lumber has increased by 35%, and you have inelastic demand, then your gross margin increases to 42.7% and your are getting an idea of how Big Oil makes so much money.
Those big oil companies are producers of oil, not just middle men. BP, Exxon, Chevron, Shell are all in the drilling, pumping, and refining business. In some cases they also get a cut from the neighborhood filling station, but in many cases those are franchises. Those franchisees suffer when prices go up just as the OP supposes. As do “Brand X” resellers. They are just middle men, and higher prices mean people buy a little less (but not much less due to enelasticity mentioned up-thread) and folks have less to spend on high profit Slurpees, Beef Jerky etc. and don’t want to because they blame the retailer for the high fuel price he is passing along.
The reason the oil price goes up is either because Asians want it more than Americans, (demand) or because the cut throat Arabs aren’t able to put enough on the market to keep the prices down.(supply) *
Notice that neither one of these impacts the oil company’s oil production costs. Now there are probably some royalties to be paid that are based on selling price, but like income tax, that only kicks in because you are making more money. Higher oil prices are almost pure profit for an oil producer.
*Sounds racist, but the Arabs do have very low production costs, and Asia is where the big demand is.
There are plenty of independent gas stations in America. They usually buy gas on the spot market whereas those stations that are affiliated with an oil company buy gas on a schedule. Thus if the price of gas changes dramatically quickly then there could be a significant difference in the price between two gas stations. This happened after Katrina hit the gulf oil platforms but does not happen enough for the independent gas stations to outcompete those affiliated with a big oil company.
Not sure if I agree with this. Producing oil requires the expenditure of energy. If the market price of diesel and gasoline goes up (as a result of a spike in oil prices), doesn’t it make it more expensive for the oil companies to operate the machinery to get the oil out of the ground in the first place?
Yes, similar to a power station using some electricity to run machinery in order to generate electricity. However, the amount input is a small fraction of what is output, so overall the net profits from drilling oil are greater when the price of oil is higher.
I read somewhere (I don’t have a cite, unfortunately) that an oil company must burn approximately 1 barrel of “old” oil to retrieve 3 barrels of “new” oil out of the ground.
If that’s true, then they are 2 barrels ahead. It’s that difference which is reflected in their net profits.
(And if it took 3 barrels to get 3 barrels out of the ground, then either they would stop drilling for oil, or they’d use another energy source like coal, and oil would probably be a lot more expensive.)
How do you figure? Profits are the difference between cost of goods and price at sale. High prices do not necessarily mean higher profits. If higher prices mean fewer sales, then higher prices could mean lower profits.
higher prices **could ** mean lower profits:however, it depends on the elasticity of the good in question.
In my example, oil is very inelastic
so people will pay what the prevailing prices are…
although, they may drive less and travel less, yes, but they will certainly not stop driving to work
Well… typically if you’re that vulnerable to a volatile raw material, you take steps to cushion price fluctions like:
long-term lumber supply contracts at some known pricing schedule (fixed, formula, or whatever)
long-term sales contracts with your customers at some pricing shedule (to ensure you can pass on price increases)
multiple supppliers
financial hedges
vertical integration: buying your own lumber farm
exploring production options that don’t require as much raw materials or use a different raw material (e.g. machine upgrades that waste less lumber or using plastic instead of lumber)
Companies do it all the time. It ensures that the smart ones stick around and the dumb ones go out of business. You can substitute lumber for whatever input is in question. It could just as easily be oil, natural gas, paper, or even labor.
