Oil Industry Profits: Analysis of Recent Performance

CRS Report for Congress
Oil Industry Profits: Analysis of Recent
Perf o rman c e
August 4, 2005
Robert Pirog
Specialist in Energy Economics and Policy
Resources, Science, and Industry Division

Congressional Research Service ˜ The Library of Congress

Oil Industry Profits: Analysis of Recent Performance
High prices for crude oil in 2004 and into 2005 have reduced consumers’
purchasing power and raised costs for businesses while providing billions of dollars
to the oil industry and oil exporting countries. The industry’s increased revenuesth
have led to record profit levels. As the 109 Congress engages in oversight of recent
broad energy legislation which aims to increase the domestic supply of crude oil to
mitigate oil price increases in the longer term, another key factor in determining
increased supply is how oil companies decide to allocate their profits between
shareholder returns and investment in oil production. This report is written in
response to a number of requests from Congress concerning profits in the oil
industry. This report provides background information concerning the level of oil
industry profits, the sources of those profits, and a discussion of the potential uses of
In response to the increased price of crude oil since the fall of 2004, profits of
virtually all firms in all segments of the oil industry have increased. However, the
greatest increases have been in the downstream, or refining and marketing, segments
of the industry. These increases in profit are apparent whether the major integrated
oil companies, the independents, or refiners are considered, lending some credence
to the viewpoint that industry profits are the result of factors beyond the elevated
price of crude oil. Historically, the current combination of high oil prices and high
profits have been seen before, and periods of low prices and profits tended to follow.
The relatively high profit levels earned in refining and marketing suggest that
conditions in the petroleum products markets, including the gasoline, diesel, and jet
fuel segments, contributed to earned profits above and beyond the effect of higher
crude oil prices. Key factors in these markets included tight refining capacity and
low inventory levels. Mergers, acquisitions, and asset sales may also have changed
the relative profit positions of many firms in the industry. All of these factors have
been influenced by investment decisions in the oil industry.
Firms in the oil industry are likely to use their recently earned profits in a variety
of ways. They are holding record cash balances, buying back their shares and
increasing dividends. Merger and acquisition activity in the industry again appears
to be on the rise. In addition, the major oil companies are investing in a variety of
energy related projects, although not necessarily oil, including liquified natural gas
and gas-to-liquids technologies. These projects tend to be international in scope. In
the longer term, investments in exploration, production, and refining capacity are
likely to be needed to mitigate the high prices of 2004-2005.
This report will not be updated.

Profit Performance.................................................2
In troduction ..................................................2
Major Oil Company Profits in 2004...............................3
Independent Oil Company Profits................................10
Independent Refiners and Marketers..............................12
Use of Oil Profits.................................................14
Refinery Investment...........................................14
Mergers and Acquisitions......................................16
Dividends and Share Purchases..................................17
Conclusion ......................................................18
Appendix: Measuring Profit........................................19
The Profit Rate ..............................................20
List of Figures
Figure 1. Spot Price of WTI, 2003-2005...............................4
Figure 2. Real Price Difference Between Light Crude Oil and Heavy Crude
Oil, 1978-2003................................................5
Figure 3. U.S. Spot Market Price for Reformulated Regular Gasoline,
New York Harbor, 2003-2005....................................6
List of Tables
Table 1. Refiners Composite Acquisition Cost of Crude Oil, 2003-2005,
Quarterly ....................................................4
Table 2. Financial Performance of the Major Integrated Oil Companies,
2002-2004 ...................................................7
Table 3. Upstream Financial Performance of the Major Integrated Oil
Companies, 2004..............................................8
Table 4. Downstream Financial Performance of the Major Integrated Oil
Companies, 2004..............................................9
Table 5. Financial Performance of Independent Oil
Companies, 2004.............................................11
Table 6. Financial Performance of Independent Refiners
and Marketers, 2005...........................................12
Table 7. Refining Margins, 1996-2004................................13

Oil Industry Profits: Analysis of
Recent Performance
The rapid increase in the price of crude oil which began in 2004 and has
continued into 2005 has been a major factor contributing to the record profits earned
in the oil industry. However, other factors were likely also at work. High capacity
utilization in the refining industry led to increases in profit for refiners exceeding that
for the industry as a whole. Companies’ ability to expand output, either of crude oil
or petroleum products, also might have affected profitability. The effects of mergers,
acquisitions and other asset transactions also likely affected the profit performance
of many firms in the industry.
Perhaps of even more long term importance than the level of profits in 2004 and
2005 is what the oil industry chooses to do with them. If firms invest earned profits
into expanding capacity at key stages in the production chain, consumers might
expect to see expanded supply with a moderating effect on price. If firms do not
make significant investments in production capacity, or if those investments
experience sharply diminishing returns in terms of volumes of oil and petroleum
products per dollar invested, then the moderating effect on price is likely to be
In a market economy, decisions on the use of profit is the responsibility of the
industry in which they are earned. However, because of the central importance of
petroleum based products to the functioning of the economy, as well as the direct
effect of oil prices on consumer’s budgets, public interest in the level, as well as the
use, of profits tends to be high. Also, government regulation can have a direct impact
on the ability, or willingness, of firms to make investments (i.e. refineries), and this
could have a ripple effect on other upstream and downstream investments and
ultimately affect petroleum product supply on the market.
The price of crude oil surged during the last eight months of 2004, with the
price of a barrel of West Texas Intermediate (WTI), the standard benchmark oil,
reaching over $55 in October. This price represented a 60% increase over the low
price for the year, reached in January 2004, of $34.31. The average price of WTI per
barrel was 25% higher in the last six months of the year than in the first six months.
After moderating somewhat at the end of 2004, and early in 2005, crude oil prices
went above $60 per barrel in the summer months.
Gasoline prices, which more directly affect consumers, peaked in May 2004,
earlier than those of crude oil, which peaked in October. The price of reformulated
gasoline at New York Harbor in January 2004 was $1.00 per gallon; by May 2004,

that price had risen 41% to $1.41 per gallon. Gasoline prices peaked again in June

2005, rising to $1.58 per gallon.1

These price increases represent a money transfer from consumers of oil and
petroleum products to the U.S. oil industry and foreign oil producers. For example,
U.S. consumers used, on average, about 9 million barrels per day of gasoline in 2004.
With the average price of gasoline for the year about $0.28 per gallon higher than in
2003, American consumers spent an additional $105 million per day for gasoline
compared to 2003. This money became increased revenues for the oil industry. In
a functioning market economy, increases in revenue are likely to lead to investment
in the industry, expansion of supply, and ultimately moderating prices for consumers
in the longer term. If this self-correcting process is not working, this could be an
indication that factors other than traditional profit and investment incentives are at
work. These would likely result in additional long term increases in price and profit
for the industry. The public has an obvious interest in determining whether the
market process is working effectively to expand supply in the oil industry.
In 2004, the net incomes of the nine integrated oil companies rose by 39%
compared to a similar period in 2003, while revenues rose by 26%.2 Net incomes of
independent oil and gas producing firms rose by 37% over the same period, while the
net incomes of independent refiners and marketers rose by 190% over the same time
period on revenue increases of 27% and 45%, respectively.3 An obvious explanation
cited for these elevated profit levels is that the world price of oil was high, a factor
attributable to forces in the global oil market; a force over which even the largest oil
companies have little direct control. This report analyzes the profit performance of
firms in the oil industry, evaluates factors that might have affected profitability in the
oil industry, and examines the use of profits by the industry and the implications for
the development of the oil market.
Profit Performance
Profit analysis may be carried out using total profits and their yearly growth, or
with profit rates. Total profit analysis is useful in evaluating the effect of the
industry’s profitability on expenditure flows within the economy as well as the
potential command over resources held by companies in the industry. Yearly growth
of profits can show whether the industry is becoming more or less of a factor in over-
all expenditure flows in the economy.
Profit analysis based on profit rates is useful in examining the effectiveness of
the firm’s management in using available resources. Profit rate analysis is also useful

1Energy Information Administration, Weekly Petroleum Status Report, for the week ending
July 22, 2005, Table 14, p.27. Gasoline price data does not include taxes.
2Oil Daily, Profit Profile, November 15, 2004, p.7.
3 Ib i d .

in making comparisons based on the relative performance of firms in the industry and
is widely used by investment analysts.
In this report, the focus is on total profits and the growth of profits within the
oil industry and the likely uses of profits by the industry, specifically the potential
ability of the industry to invest in oil supply related projects.4
Profits in the oil industry have been volatile over the past three decades,
reflecting oil price changes as well as other market effects. For example, net income
for the major energy companies, as defined by the Energy Information
Administration (EIA), increased almost threefold by 1981, compared to 1977, on the
oil price increases associated with the Iran-Iraq war. By 1986, net incomes of the
major energy companies had sunk below 1977 levels. Profits peaked and declined
at least three other times during the period 1987-2002.5 Volatility in the price of oil,
which leads to volatility in profits, makes investment planning risky. Investments
which might qualify for implementation if a high oil price is assumed may not qualify
if a lower price of oil is assumed. This uncertainty may have contributed to the
cyclical nature of investment and capacity expansion in the industry.
Major Oil Company Profits in 2004
Oil industry profits are widely identified as related to world oil price levels.
Figure 1 shows the movement of the monthly price of WTI crude oil at Cushing,6
Oklahoma from 2003 through 2005.

4A more complete discussion of profit analysis is in the Appendix to this report.
5Historical net income data for the major energy companies is available at the EIA website,
[http://www.eia.doe.gov/pub/energy.overview/frs/s5110.xls] (as viewed on July 19, 2005).
Net income totals are not adjusted for inflation.
6West Texas Intermediate is the benchmark crude oil which is the basis for futures trading
on the New York Mercantile Exchange. Cushing, Oklahoma, is the delivery point for New
York Mercantile Exchange traded crude oil.

Figure 1. Spot Price of WTI, 2003-2005

Dollars per Barrel
Jan 2003May 2003Sep 2003Jan 2004May 2004Sep 2004Jan 2005
Source: Energy Information Administration. Weekly Petroleum Status Report, For Week
Ending May 20, 2005. Table 14. p. 27.
Upward pressure on the price of WTI, which began in 2003, strengthened during
the summer of 2004, leading to peak price levels in October 2004. The daily peak
price for the year, $55.17 per barrel of WTI, occurred in late October. The average
price of WTI for the second half of 2004, $46.01 per barrel, was 25%, or almost $10
per barrel, higher than the average price for the first six months of the year, which
was $36.79 per barrel. If the profit performance of the oil industry was based, or
related, only to the price of oil, given normal lags in the production chain between
producing crude oil and distributing petroleum products, it might have been expected
that profits might have risen late in 2004 and into 2005.
Table 1. Refiners Composite Acquisition Cost of Crude Oil,
2003-2005, Quarterly
(dollars per barrel)
1st Quarter31.3931.9142.27
2nd Quarter26.5634.8047.43
3rd Quarter28.0339.43
4th Quarter28.4341.49
Source: Energy Information Administration, Petroleum Marketing Monthly, June 2005, Table 1, p. 5.
Although the price of WTI attracts the most headlines through its association
with both the future and spot market prices, a more reliable measure of the real cost

of crude oil to the nation’s refiners is the refiner’s acquisition cost of crude oil as
shown in Table 1 for 2003 through 2005. This composite cost measure is a weighted
average of the cost of domestic and imported crude oils used by refiners and also
reflects the mix of various qualities of crude oils used in refineries.
Refineries of different levels of technological complexity can use different
mixes of crude oil to produce varying mixes of petroleum products within
technological limits. This ability to vary the production mix can be used to enhance
profitability when price differentials between sweet light and heavy sour crude oils
or between light and heavy product mixes change. Figure 2 shows the difference
between light and heavy crude oils was generally less than $10 per barrel during the
period 1992 to 2002. The spread increased in 2004 and into 2005. The average
monthly difference between light and heavy crude oil in 2003 was approximately $7
per barrel. The average difference increased to over $10 per barrel in 2004,
approaching $15 per barrel at times. For the first three months of 2005, the
differential remained at approximately $12 per barrel.7
Figure 2. Real Price Difference Between Light Crude Oil and
Heavy Crude Oil, 1978-2003

Source: Energy Information Administration, Performance Profiles of Major Producers 2003, March
2005, Figure 31, p. 31.
Figure 3 shows the movement of the monthly spot market price of reformulated
regular gasoline at New York harbor during 2003 and 2004.8
7Energy Information Administration, Petroleum Marketing Monthly, June 2005, Table 27,
p. 53.
8Energy Information Administration, Weekly Petroleum Status Report, for the week ending
December 31, 2004. Table14, p.27, and for the week ending May 27, 2005, Table 14, p. 27.

Figure 3. U.S. Spot Market Price for Reformulated Regular
Gasoline, New York Harbor, 2003-2005

Cents per U.S. Gallon
$1 6 0
$1 4 0
$1 2 0
$1 0 0
$8 0
$6 0
$4 0
$2 0
Jan 2003May 2003Sep 2003Jan 2004May 2004Sep 2005Jan 2005
Source: Energy Information Administration. Weekly Petroleum Status Report, For Week
Ending May 20, 2005. Table 16. p. 30.
After a relatively stable year in 2003, gasoline prices peaked twice in 2004,
reaching record nominal levels. The first peak, of almost $1.41 per gallon, occurred
in May, before the summer driving season began in the United States. The second
peak, of almost $1.38 per gallon, occurred in October. The timing of these peaks are
similar to those observed in the crude oil market. Prices continued to be high in 2005,
with a peak price of over $1.52 per gallon attained in April 2005.
The high gasoline prices of 2004 also brought what some identified as a partial
decoupling of the oil and gasoline markets. Fears related to limited refinery capacity,
low inventory levels, and strong demand growth in China and other parts of the world
led some analysts to conclude that gasoline prices might remain high even if crude
oil markets weakened. These conditions might be expected to yield high margins for
Table 2 reports the basic financial performance of the major integrated oil
companies from 2002 through 2004.

Table 2. Financial Performance of the Major Integrated Oil
Companies, 2002-2004
(million of dollars)
Net IncomeRevenues
Company 2002 2003 2004 2002 2003 2004
Exxon Mobil$11,220$21,654$25,330$178,909$213,199$298,027
BP 6,922 10,437 16,208 178,721 232,571 294,849
Roya l 9,577 12,606 18,536 179,431 201,728 265,190
Chevron Texaco1,1897,50613,32891,685112,937155,300
Conoco Phillips7624,5858,12950,51290,458136,900
Marathon 709 1,314 1,261 27,214 36,678 49,907
Amerada Hess-21846797711,93214,31116,733
Occidental 1,240 1,657 2,491 7,338 9,326 11,368
Murphy 97 301 701 3,966 5,275 8,359
Total $31,498 $60,527 $86,961 $729,708 $916,483 $1,236,66
Source: Oil Daily, Profits Profile Supplement, vol. 55, no. 39, February 28, 2005, p. 8; and Financial
Data by Company at [http://www.Hoovers.com].
Aggregate net income rose in 2004 for the major integrated oil companies,
compared to 2003, which itself was a strong year for industry profit performance, and
rose by an even greater amount compared to 2002. Only ExxonMobil (17.8%)
experienced a gain of less than 20%, and only Marathon (-4.5%) experienced lower
net income in 2004 than in 2003. Five of the companies in this group posted net
income gains in excess of 50% for 2004, while the average gain in net income was
approximately 40%. Comparing 2004 to a 2002 base, the gains in net income totaled
over 175% for the major integrated oil companies.
Total revenue growth for 2004 compared to 2003 was 35% for the group, which
was less than the 44% growth in net income, suggesting that possibly the greater
profitability of the major oil companies in 2004 did not arise solely from the higher
price of crude oil. Compared to 2002, revenue growth for 2004 was approximately

70%, less than the 175% growth in net income for the same period.

The profit rate on sales for this group of oil companies, based on the totals of
revenue and net income reported in Table 2, were 7% for 2004, 6.5% for 2003, and
4.3% in 2002. The growth in the profit rate experienced by these companies
suggests that the stronger underlying market fundamentals in the crude oil and oil
product markets were successfully translated into increased performance by the

Table 3 shows the upstream (exploration, development, and production)
performance of the major integrated oil companies in 2004. This segment of the
firms’ business accounted for approximately 60% of the net income for the group.
Table 3. Upstream Financial Performance of the Major
Integrated Oil Companies, 2004
(millions of dollars)
Net incomeOil production(000 b/d)Gas production(MM cf/d)
2004 %Change 2004 %Change 2004 %Change
Exxon Mobil$16,67530.32,5712.29,864-2.5
BP 19,759 21.7 2 ,531 19.3 8 ,503 -1 .3
Royal Dutch/Shell9,6646.12,253-5.38,808-0.5
Chevron Texaco9,49049.21,710-5.43,958-7.8
Conoco Phillips5,70232.5905-3.13,317-5.8
Marathon 1,696 7.3 170 -12.4 999 -8 .9
Amerada Hess75582.4246-5.0575-15.8
Occidental 3,544 33.0 434 3.6 637 5.1
Murphy 513 69.3 9 7 16.9 140 -34.9
To tal $51,123 26.1 8 ,346 1.9 26,937 -3.1
Source: Oil Daily, Profits Profile Supplement, vol. 55, no. 39, February 28, 2005, p. 8.
As shown in Table 3, increased net income was not derived from large increases
in oil and gas production for most companies. For 2004, more than half of the
companies produced less oil during this year of high prices than they did in 2003.
The total increase in oil production by the group of 1.9% was largely attributable to
the 19% increase of one company, BP. The production results for natural gas are
even more uniform. Every company, except one, Occidental, produced less natural
gas in 2004 than in 2003, yielding a total 3.1% decrease in production from the group
as a whole.
Table 4 reports the downstream (refining and marketing) results for the major
integrated oil companies. This sector accounts for approximately 23% of the total
net income earned by these companies. Data in Table 4 show that net income from
this sector increased by almost 100% in 2004, compared to 2003, but production
increased by only 1.5%. Again, consistent with the upstream results, it seems the
integrated oil companies derived increases in net income from price increases with
little support from increased production in the short term.

Table 4. Downstream Financial Performance of the Major
Integrated Oil Companies, 2004
(millions of dollars)
Product sales
Net income(000 b/d)
2004% Change2004% Change
Exxon Mobil$6,25677.98,2103.2
BP 5,603 78.2 6 ,398 -4 .3
Royal Dutch/Shell6,530107.57,6002.1
Chevron Texaco3,250178.53,9084.5
Conoco Phillips2,743115.62,6641.8
Marathon 1,406 71.7 1 ,400 3.2
Amerada Hess45137.94282.1
Occid e ntal NA NA NA NA
Murphy 82 NA 339 27.9
To tal $20,065 96.7 22,737 1.5
Source: Oil Daily, Profits Profile Supplement, vol. 55, no. 39, February 28, 2005, p. 8.
NA = Not Available.
The recent record of the major integrated oil companies in expanding production
of crude oil and oil products may be the result of several factors. Unfavorable
geologic and political factors might have inhibited output expansion. While the
decision to expand oil and gas production in the United States is generally based on
the underlying market economics, the geology of many producing regions in the
United States may not support large increases in output, especially without financial
investment in new technologies. Many U.S. oil and gas fields have either peaked or
are in decline, making it difficult to expand production, irrespective of the available
price incentives. Overseas, oil and gas production decisions may reflect the policies
of the host governments, the Organization of Petroleum Exporting Countries (OPEC)
quotas, or host nation’s tax policies.
Another possible explanation for the relatively slow production response by the
major integrated oil companies in reaction to high oil prices might be that significant
investments are required and that the resulting time lags might be long enough to
delay the appearance of additional supply on the market. The major oil companies
have been active in international investment, although a good part of that investment
has been in new product technologies, such as gas to liquids and liquefied natural
gas. These projects, requiring multi-billion dollar investments, take up to five to
seven years to complete. This could be one explanation why little additional output
of gasoline and other refined products has appeared to result from higher prices in the
short term.

Oil companies are owned by shareholders and managerial performance is
evaluated in terms of corporate earnings. It is possible that because of limitations on
the ability of the firms to invest in additional oil and gas production in the short term,
profits have been returned to investors in the form of dividends, or the buy back of
shares to enhance the market capitalization of the companies.
Independent Oil Company Profits
The profit picture for the independent oil and gas producers with respect to net
incomes and total revenues in 2004 was, in some ways, similar to that of the major
integrated companies. However, some features of their performance differed from
that of the major companies. Table 5 presents data for ten independent producers.
Aggregate net income for the group of 10 independent oil and gas producers in
2004 rose by approximately the same rate, just below 40%, as that of the major
integrated oil companies. Similarly, revenues grew by over 25%. The major
difference in the picture for the independent oil and gas producers is that they raised
output during 2004 by a multiple of the amounts registered by the major companies.
Oil production was up by over 12.5% and natural gas production rose by almost 4%.
This increased production may, however, be partly the result of asset acquisition by
the independent companies. Over the past several years the major integrated oil
companies have sold off smaller producing fields and facilities which have been
acquired by the independent companies. For this reason, it is possible that the
increased production in this sector as well as the small production increases recorded
by the major companies might be related, and reflect an ownership transfer of
existing assets.

Table 5. Financial Performance of Independent Oil
Companies, 2004
(millions of dollars)
Net incomeRevenuesOil production(000 b/d)Gas production(MM cf/d)
2004% Change2004% Change2004% Change2004% Change
o n $2,176 25.3 $9,189 25.0 279 21.3 2,433 2.8
1,208 87.9 8,204 26.0 159 -0.6 1,510 -14.4
o 1,601 24.4 6,067 18.4 230 -0.4 1,741 -1.2
iki/CRS-RL33021t on 1,527 27.1 5,618 30.3 151 36.0 1,914 0.8
s.or1,663 49.0 5,333 27.3 242 12.6 1,235 1.5
://wikie rr-McGee 404 84.5 5,179 23.8 159 5.3 921 21.2
http 614 46.5 2,271 30.1 33 22.2 1,036 7.8
T O 508 76.4 1,948 63.7 30 57.9 835 20.0
313 -23.8 1,847 43.5 69 19.0 685 18.4
312 56.0 1,353 33.0 21 23.5 666 9.3
$10,326 37.3 $47,009 27.4 1,373 12.6 12,976 3.8
: Oil Daily, Profits Profile Supplement, vol. 55, no. 39, February 28, 2005, p. 8.

Independent Refiners and Marketers
Independent refiners and marketers are typically only involved in the
downstream activities of the oil industry. They typically purchase crude oil, process
it in their refineries, and market the resulting petroleum products either directly to
consumers or wholesale the products to other firms. As shown in Table 6, the
financial performance of this sector was the strongest of any in the petroleum
industry, surpassing even the downstream performance of the major integrated oil
companies that are among their major competitors.
Table 6. Financial Performance of Independent Refiners
and Marketers, 2005
(millions of dollars)
Product sales
Net incomeRevenues(000 b/d)
2004 %Change 2004 %Change 2004 %Change
Valero $1,791 187.9 $54,619 43.9 NA NA
Suno co 605 93.9 25,508 41.6 903 19.8
Premcor 478 308.5 15,335 74.2 NA NA
T eso ro 328 331.6 12,262 38.6 604 8.4
Ashland 101 197.1 2 ,177 12.4 1 ,414 4.4
Frontier 7 0 2 ,233.3 2 ,862 31.8 166 0.0
To tal $3,737 189.8 $112.763 45.0 3 ,087 9.0
Source: Oil Daily, Profits Profile Supplement, vol. 55, no. 39, February 28, 2005, p. 8.
NA = Not available.
As shown in Table 6, these firms did expand their product sales in response to
the high prices of 2004. The 9% expansion in product sales by these firms in 2004
was about six times the magnitude of the increase in production generated by the
major integrated oil companies in their comparable downstream business, although
the independent’s production base was smaller.9 The 9% increase in product sales
translated into a 45% increase in revenues which resulted in a 190% increase in net

9Not all the increase in product sales was necessarily due to expanding production. Over
the past decade, the oil industry has experienced asset churning. The major oil companies
have sold producing fields, refineries, and other assets as a result of merger and acquisition
requirements, inadequate returns from smaller fields and refineries, or changes in business
focus to a more international stance. These assets have typically been acquired by the
independent oil and gas producers and the independent refiners and marketers. These asset
transfers might bias the major integrated oil companies’ production totals downward, while
the independents’ production totals rise. The net effect might just be a reallocation of
existing productive capacity.

income, with every company in the reporting category, except one, achieving at least
triple digit increases. This performance, coupled with the downstream profitability
of the major integrated oil companies, gives some support to the viewpoint that, in
addition to high oil prices, conditions in the petroleum product markets, especially
gasoline, decoupled from their traditional linkage to crude oil and generated
independent market tightness and higher prices.
Key profit indicators in the refining industry are the gross and net refining
margins.10 Table 7 presents data for the twenty four firms included in the EIA’s set
of major energy companies.11
Table 7. Refining Margins, 1996-2004
(dollars per barrel)
1995 1997 1998 1999 2000 2001 2002 2003 2004
Gross Refining7.204.406.535.827.347.946.3610.7013.82
Net Refining0.971.611.631.172.322.760.192.06 —
Source: Energy Information Administration, Performance Profiles of Major Energy Producers 2003,
Table B-32, p. 101, and Financial News for Major Energy Companies, updated March 9, 2005, Table
For the years 1996 through 2002, the net refining margin averaged $1.44 per
barrel of refinery throughput. The value of the gross refining margin in 2003 was
approximately 7 times the average for the previous seven years. The gross margin
increased by a further 29% in 2004 compared to 2003. With domestic refinery
throughput approximately 13.5 million barrels per day, and the gross refining margin
approaching $14 per barrel, the source of the profit performance of the oil companies
downstream operations and the independent refiners and marketers is clear.

10The gross profit margin is defined as the revenue achieved from petroleum product sales
minus the cost of crude oil, the primary input. When a further deduction in operating costs
is made, the result is the net margin. These margins are usually expressed on a per barrel
11The EIA publishes aggregated financial data for both major and independent energy
producers. Company specific data on refining profitability is proprietary. The firms
included in Table 7 are: Amerada Hess Corporation, Andarko Petroleum Corporation,
Apache Corporation, BP (only U.S. operations), Burlington Resources, Inc., Chesapeake
Energy Corporation, ChevronTexaco Corporation, CITGO Petroleum Corporation,
ConocoPhillips Inc., Devon Energy Corporation, Dominion Resources, Inc., EOG
Resources, Inc., Equitable Resources, Inc., ExxonMobil Corporation, Kerr McGee
Corporation, Lyondell Chemical Company, Marathon Oil Corporation, Occidental
Petroleum Corporation, Premcor, Inc., Royal Dutch Shell Group(only U.S. operations),
Sunoco, Inc., Tesoro Petroleum Corporation, Unocal Corporation, Valero Energy
Corporation, Williams Companies, Inc., XTO Energy, Inc.

The gross refining margins of 2003 and 2004, which increased by a greater
percentage than the price of crude oil, are a likely indication that tightness in the
gasoline market, which is linked to a refining sector running at nearly full capacity,
has led to profits that increased by a larger percentage than the price of crude oil.
Another indication of tightness in the refining sector is that imports of finished
gasoline, as well as gasoline blending components, have been increasing and were
at record levels in 2004. It is also true that the number of operating refineries in the
United States has declined to 149 from a peak of 324 in 1981. No significant new
refineries have been constructed in the United States for a quarter of a century. The
refining capacity growth that has occurred in the United States since 1990 has been
largely due to improvements made at existing facilities, called capacity creep.
Use of Oil Profits
Refinery Investment
An expansion of refinery capacity in the United States might alleviate the
portion of petroleum product price increases not due to the high price of crude oil.
Construction of new refineries in the United States would add stability to the supply
of gasoline and other petroleum products; the current capacity is stretched nearly to
the limit to accommodate growing petroleum product demand. In addition, the
growing U.S. dependence on imported gasoline and petroleum products would be
reduced. Re-investing profit into a growing, profitable business is also a normal
business strategy. However, current conditions may limit potential expansion.
The key factor in determining whether new refinery capacity will be constructed
in the United States is the underlying economics. An oil company seeking to meet
gasoline demand in the U.S. market can do that in any of three ways. The company
can either expand existing refineries, build a new refinery, or import additional
gasoline from overseas. The economics dictate that companies choose the cheapest
alternative, given that all gasoline will sell for the same price, irrespective of source.
In 2005, it is likely that the cheapest source of gasoline is through imports. Europe
is thought to have surplus gasoline capacity as their vehicle fleet is in transition to
diesel fuel, and refineries are still largely oriented toward now excess gasoline
production.12 Expansion of existing refineries is likely the next cheapest source of
product. Expansion of existing refineries avoids many, or all, of the fixed costs
associated with a new refinery and allows firms to benefit from economies of scale
in the refining process. Construction of new refineries is likely the most expensive
source of new product.
As shown in Table 7, not only have the returns to refiners been low, on average,
but they have also been volatile. Even recent profit performance has not been
uniformly good. Although returns in 2004 and 2003 were favorable, 2002 was a year
of very low return. As a result of the observed volatility in returns, the industry
might question whether the current increases in profitability are the beginning of a

12Oil and Gas Journal, Europe Sees Growing Diesel-Gas Mismatch, vol.103, Issue 8,
February 28, 2005, pp. 5-8.

new era of profitability, or an upward aberration that will be reversed with the next
market correction.
Related to the uncertainty with respect to the permanence of high refining
returns is a longer term projection for the price of crude oil. Supply increases up and
down the oil supply chain are normally linked to investment. Based on net present
value analysis, investment is likely to take place only if the long term, forecasted
price of crude oil is high enough to generate projected cash flows sufficient to justify
the multi-billion dollar costs of major petroleum projects. If the companies use
projected oil prices in the $25 to $35 per barrel range in investment planning
decisions, limited extra investment and supply expansion can be expected to develop.
One oil analyst has asserted that prices might need to remain in the $50 to $80 per
barrel range for a sustained period for investment to occur in sufficient volume to
build up a comfortable cushion of spare oil production capability.13
A reluctance to invest based on current price levels might reflect historical
experience with the price-investment-supply dynamic of the oil market. As a result
of the rise in the price of crude oil associated with the Iran-Iraq War of 1979-80,
supply from non-OPEC sources increased and demand declined. Prices during this
period reached real values (corrected for inflation) of between $50 and $80 per barrel,
and then declined to a nominal value of $11 per barrel by 1985. Investments
undertaken early in the decade based on an expectation of continued high prices
would have likely not been profitable in the market conditions that actually evolved.
Refinery investment trends over the past two decades have been influenced by
environmental compliance requirements. EIA has studied the effect of refinery
investment required by environmental regulations, and its relationship to profitability.
The EIA report found that return on investment in the refining industry was reduced
by 42% from 1996 to 2001 as a result of mandated investment expenditures.14 The
industry is currently preparing to expand and introduce low sulfur gasoline and diesel
fuels. These investment requirements may claim a share of the companies capital
budget and reduce returns, in parallel with past experience.
The permitting process has been identified by some as an impediment to refinery
investment in the United States. Critics contend that even if it is possible to assemble
all of the necessary permits to construct a refinery, the long time line required for
approvals will tend to make the investment less attractive. One example that has
been cited concerning the length of the time required for the permitting process
associated with the possible construction of a new, grassroots refinery, is the facility
planned to be constructed near Yuma, Arizona. The refinery has an estimated cost
of $2.5 billion, a capacity of 150,000 barrels per day and is to be located on vacant
desert land owned by the federal government. The refinery is planned by Arizona
Clean Fuels, formerly Maricopa Refining. The refinery is scheduled to process
imported Mexican crude oil. The refineries output of gasoline is to be marketed in

13Piotrowski, Matt, “Higher Prices Needed to Spur Capacity Outlays”, Oil Daily, vol. 55,
no.51, March 16, 2005, p. 1.
14Energy Information Administration, The Impact of Environmental Compliance Costs on
U.S. Refining Profitability 1995-2001, May 2003, pp. 1-10.

southern California, an area which has a tight product market because of limited
pipeline access to major U.S. refineries on the Gulf coast as well other factors.15
The company first applied for an air permit in 1999 at another Arizona site. The
application was withdrawn in 2004. Local groups opposed the project based on
possible health and environmental risks. The U.S. Environmental Protection Agency
decided not to object to an air permit for the refinery on March 21, 2005. The
company awaits an air permit from the Arizona Department of Environmental
Quality, expected to be issued in 2005. After that permit is obtained approximately
two dozen additional permits need to be obtained, ranging from a county permit for
zoning approval to a presidential permit from the U.S. State Department to allow the
importation of Mexican crude oil.16
The tight petroleum products market in California, with the resulting high
prices, as well as the generally good returns to refining since 2000 have maintained
interest in this project. The long delays in construction start-up might have led to the
project being cancelled if the underlying economics, especially in the California
market, had not been so strong in recent years.
Mergers and Acquisitions
The oil industry of today has evolved to its current structure partly through years
of mergers, acquisitions, and joint ventures. In May 2004, the Government
Accountability Office (GAO) released a study on the effects of mergers and the
restructuring of the U.S. petroleum industry.17 GAO found that between 1991 and

2000 there were over 2,600 mergers, acquisitions, and joint ventures in the U.S.

petroleum industry. A majority of the transactions took place in the last five years
of the decade. The transactions took place at all stages in the chain of production,
from exploration and production, through refining and marketing. These transactions
included deals among the very largest oil companies. For example, in 1999 Exxon
Corporation acquired Mobil Oil; in 1998 British Petroleum and Amoco formed BP-
Amoco, which acquired ARCO in 2000; and in 2001 ChevronTexaco was formed.
Merger activity is again on the rise in the U.S. petroleum industry. In April
2005, ChevronTexaco made a $17 billion stock and cash bid to acquire Unocal, the
number 9 oil company in the United States, ranked by reserves of crude oil. Unocal
was also targeted for takeover by CNOOC Ltd., a company majority-owned by the
Chinese government, in a bid that has since been withdrawn.18 In the same month,

15“Arizona Firm Close to Building New Refinery”, Oil Daily, vol. 55, no. 55, March 22,

2005, p. 1.

16Piotrowski, Matt, “EPA Does Not Object to Air Permit for New Arizona Refinery”, Oil
Daily, vol. 55, no. 56, March 23, 2005, p. 2.
17United States General Accounting Office, Energy Markets: Effects of Mergers and Market
Concentration in the U.S. Petroleum Industry, GAO-04-96, May 2004.
18Manimoli Dinesh, CNOOC Seeks Quick US Review of Unocal Bid, Oil Daily, vol. 55,
no.127, July 5, 2005, p. 1.

Valero Energy Corp. bid to acquire Premcor Inc., to form the largest refining
company in the United States in a $6 billion deal.
As a result of the profitability of the last year, companies with large cash
reserves on their balance sheets are searching for ways to better position themselves
on the world oil market, increase their crude oil reserves and other assets, and create
economies of scale and cost savings. Individually, they are able to accomplish these
goals through mergers and acquisitions. In addition, a large amount of accumulated
profits is returned to investors, usually at a premium price, through these transactions.
Although these transactions may improve the market position of the firms
involved and imply the expenditure of billions of dollars of accumulated profit, they
do little to improve the nation’s demand and supply balance with respect to oil and
petroleum products in the near term.
Dividends and Share Purchases19
The firms that make up the oil industry are private firms that use shareholder
capital to engage in business operations. When they make profits they are obliged
to return those profits to shareholders, unless management deems it likely that
business opportunities exist such that reinvestment will yield even larger future
profits for shareholders.
The major oil companies have increased dividends for shareholders, but in
general, by less than increases in available funds. For example, ExxonMobil
increased quarterly dividends by $0.02 per share during 2004, an increase of about

8%. However, during the last quarter of 2004 earnings per share increased by $0.42,

an increase of about 47%. For the years 2002 through 2004, earning per share
increased from $1.68 to $3.89, an increase of approximately 130%, but dividends,
the amount actually paid out to shareholders, increased by only about 15%.
ExxonMobil did however reduce the number of shares outstanding over the period
by about 300 million, to 6.4 billion from 6.7 billion. If a company re-purchases its
shares, the value of shares outstanding is likely to increase and the company may
choose to re-sell them on the market if it needs capital in the future. ExxonMobil
also held over $18 billion in cash at the end of 2004, an increase of 75% over the
A similar dividend strategy was in place at ChevronTexaco, where quarterly
dividends increased by $0.03 per share during 2004, an increase of about 8%, while
earnings per share almost doubled compared to levels attained in the last quarter of
2003. For ChevronTexaco, earnings per share increased over the period 2002 to
2004 by an approximate factor of 10, from $0.54 to $6.28, while yearly dividends per
share increase from $1.40 to $1.53, an increase of about 9%. The number of
ChevronTexaco shares outstanding declined by about 29 million.

19Financial data used in this section was obtained at [http://www.hoovers.com], viewed on
June 21, 2005.

ConocoPhillips, over the period 2002 through 2004 increased yearly dividends
from $0.74 per share to $0.90 per share, an increase of about 21%. However,
earnings per share increased from a loss of $0.31 in 2002 to $5.81 in 2004.
ConocoPhillips increased the number of shares outstanding over the period by about

34 million.

Limited dividend payouts, coupled with a modest expansion of investment in
relation to profit has left oil companies highly liquid and well positioned to take
advantage of future market opportunities.
Since oil price increases began in 2004, the oil industry has earned increased
profits. These profits might have resulted from other factors in addition to the
increased price of oil. A key factor in increased profitability might be the tightness
in the U.S. gasoline market, a factor related to the lack of enough refinery capacity
to meet U.S. demand for petroleum products.
If oil and petroleum product prices are to decrease, supply will likely have to
increase relative to demand. Expanded supply results from investment in the various
stages of the oil industry production process, from exploration and development of
new oil fields to increased refinery capacity. If the underlying economic parameters
and the regulatory environment are not encouraging, investment might not be
undertaken. Historically volatile prices and profit levels coupled with a tight
regulatory environment contribute to industry uncertainty.
Other legitimate uses for earned profits include paying higher dividends and
retiring outstanding shares, acquiring assets through merger and acquisition, and
investing in new product areas. These uses of profit may benefit shareholders and
strategically position the firm in the global market, but they do less to expand the
supply of oil and products on the market and thereby reduce prices for consumers.
As a result of significant time lags that tend to occur in the oil industry, it may
be too soon to know whether or not investments in the industry, if taken, will result
in the increased supply of oil and petroleum products needed to reduce prices and
consumers’ costs.

Appendix: Measuring Profit
In a market economy, a firm’s key measure of success is its ability to earn a
profit. Profit is important to firms because it is a signal to the financial markets and
investors that the firm is worthy of funding either through debt or equity capital.
Firms that earn less profit than expected by the market have difficulty funding
investment opportunities with negative implications for growth. Firms that
consistently earn less than adequate profits tend to experience slow growth,
stagnation, and ultimately, failure.
Profit is seemingly a simple concept. Total cost is subtracted from total
revenue, leaving a residual, total profit. In this approach, profit is measured in
dollars. For the oil industry, the simple total revenue minus total cost approach is
complicated by the difficulty in neatly separating the revenue-generating outputs of
the firms from the cost-creating production inputs. For any given oil company, crude
oil price changes may affect both the revenues and costs of the company. If the
company is an upstream producer and sells crude oil, the production of crude oil is
revenue generating. However, downstream operations, notably refining and
marketing, make use of crude oil as a raw material, and for them, the acquisition of
crude oil is a cost. As a result, it is not always clear that an increase in the price of
crude oil will raise, or lower, profits for firms with differing positions in the upstream
and downstream segments of the industry.
Another key factor in the profit calculation is how easily the increase in the cost
of crude oil can be passed on to consumers in the form of higher prices for gasoline
and other refined products without suffering a more than proportionate decrease in
sales. If cost increases can be passed on to consumers, and the firm has significant
upstream business interests, then it is more likely that an increase in the price of
crude oil will yield increased profits.
A simple way to rank companies, for comparative purposes, is by total profit.
However, this type of simple ranking is likely to provide a misleading picture of the
relative performance of the companies in the oil industry.
While the total dollar value of profit is important, it may be equally important
to know the value of the resources, or assets, at a firm’s disposal that were used to
earn a given dollar level of profit. The size of the firm relative to the level of total
profit is important, especially for investment analysts. For this reason, the most
commonly used measures of profit in investment analysis are expressed as
percentages, or rates, independent of specific magnitudes. The use of percentages
allows meaningful comparisons to be made between companies of different sizes and
differing access to resources.
Profit also can be measured to include or exclude special, non-recurring items
that may temporarily affect a company’s revenues and costs. For example, if a
company incurs substantial costs and legal penalties associated with an
environmental cleanup due to an oil spill at one of its facilities, its profit performance
for the relevant time period might well be negatively affected. However, profit
numbers that include the costs resulting from the spill may tell potential investors

and other interested parties little about the real, continuing, business performance of
the company.20 Profits from continuing operations, excluding one-time charges (or
revenues), may be more informative for some purposes.
All stakeholders in a company do not necessarily have an interest in the same
conceptual definition of profit. Accountants are interested in profit calculations that
meet generally accepted accounting practices and are consistent with the tax code.
Economists use profit as a signal to judge the efficiency of resource allocation
decisions and include opportunity costs in their calculations.21 Potential investors in
the company’s stocks and bonds may choose to evaluate profit from a still different
perspective, comparing profit to a measure of the assets management had available
for business purposes relative to the risk the company faced.
The Profit Rate
Even once the efficacy of using a profit rate is determined, measurement issues
still need to be addressed. Since profit as a rate, or percentage, must be expressed
relative to some base, an appropriate base must be specified. Three possible bases,
widely used in business analysis, are sales, assets, and net worth, or shareholder
equity. Each is useful in answering particular questions about the operation of the
business, but none necessarily serves as an all-purpose profit measure.
The profit margin on sales uses the total sales revenue of the business as the
base and expresses profit, or net income, as a percentage of sales revenue. Profit
rates expressed in this manner can answer questions as to whether increasing sales
become more or less profitable as the business grows.22 This profit measure can also
lead analysts to basic questions as to whether the businesses’ prices were too low or
too high, or whether adequate cost controls were in place as the business expanded.
A variation on this profit measure results from replacing net income in the
calculation with operating income.23
Profits based on assets, or the return on assets, divides profit, or net income, by
the value of the total assets of the business. This measure allows analysts to
determine how well management uses the asset base of the company to generate
profits for investors. If the asset base represents the tools available to management

20A large, non-recurring expense might, however, affect a company’s financial condition.
21Opportunity costs are the value of the returns that could be earned in the next best
alternative. For example, if a firm earns $100,000 in profits according to the tax laws, but
could earn $150,000 from liquidating the firms resources and applying them to another
activity, an economist would observe that the firm lost $50,000 by engaging in its current
activities rather than having made $100,000 in profit.
22The answer to this question requires a set of profit results over time, as sales have
presumably grown. In general, it is more revealing to have a time dependent set of profit
data, rather than one data point, so that trends may be ascertained.
23Operating income is defined as gross profit minus operating expenses. It is profit before
the payment of interest and income taxes. It is considered to be a measure of how well the
firm has succeeded in making money from the sales of goods and services, before financial
and tax obligations are considered.

to carry out business activities, the return on assets gives an indication of how
effective management has been in using those tools. This approach has been
criticized by some because certain “intangibles” important to the functioning of the
business may not receive adequate weight in this measure.
A profitability rate popular with potential investors is the return on equity, or the
return on net worth. This measure divides profit, or net income, by the value of
shareholders equity in the firm. Since the fundamental accounting identity, Assets=
Liabilities + Owners Equity, must always hold, for every business, this profit rate is
generally greater than, and at least equal to, the return on assets.24 This measure is
especially interesting to investors who might plan to buy shares of stock in the
business. While this profit measure may be revealing to potential investors, care
should be exercised in its use. If two businesses have the same asset value and the
same level of profits, differences in return on net worth can arise solely as a result of
the amount of debt financing on the firm’s balance sheet, a difference purely of
financial structure, unrelated to a firm’s ability to efficiently produce goods and earn
revenues from selling goods. This can generate misleading conclusions about the
strength of the firm’s performance, because the choice of financial structure for a
business is not generally related to its current profitability from continuing
Another measure, sometimes identified with profitability, is earnings per share.
This measure divides profit, or net income, by the total number of shares of common
stock outstanding. Earnings per share provides the prospective maximum of
dividends per share that might be paid by the firm. However, it is not a relevant
measure to evaluate profit. Like the return on net worth, it is affected by the capital
structure of the company, the division between equity and debt financing. Earnings
per share can also be directly affected by strategic management decisions. Firms may
decide to buy back shares of common stock and retire them, holding them as treasury
shares. This type of strategy raises earnings per share by decreasing the number of
outstanding shares over which any level of net income is divided. This strategy
might well be viewed negatively by financial analysts, who might interpret it as a
signal that the firm does not have, or recognize, profitable investment opportunities
available, and hence chooses to return to shareholders the money they had invested
in the company.
An important factor in analyzing profit data is that in many cases it is more
informative to use comparative analysis. Comparisons can be made over time, with
other companies in the same industry, or with other companies that bear the same
level of risk.
Time-based comparative profit analysis may be helpful because it suggests the
direction the company is heading, or the direction of market trends. A particular rate
of profit might be viewed as favorable if it was embedded in a trend of rising profit
rates, or unfavorable if embedded in a trend of falling profit rates. Time trends might
also help to identify correlations between profit and other factors which influence

24In the case where a firm has no debt, assets must equal owner’s equity and the two profit
measures will be identical.

profits. In addition, key lags that affect profit are also more likely to be identified in
a time trend.
Standing alone, any rate of profit might be difficult to evaluate. Comparisons
can be drawn with other firms in the same, or closely related, lines of business to
determine whether a particular firm is a profit leader, average, or a low profit earner
within its industry cohort. Barring special circumstances, which should be clearly
reported in the company’s financial statements, if two firms in the same line of
business, with approximately the same asset base, report very different profit rates,
it is possible that this differential might suggest that one or the other firm’s
management strategy is superior. Looking at profit rates of different sized firms
within the same industry allows the analyst to assess whether growth of the firm to
a larger scale may imply any advantage or disadvantage with respect to profit.
In some cases, particularly for investment decisions, the most relevant
comparison is with firms with a comparable level of risk, independent of the line of
business in which the firms are engaged.25 This approach is appropriate for
prospective investors because they may have less interest in what business activity
a firm undertakes, than the results of that activity in terms of profits earned and risk
borne. In many cases, profits can be expressed in comparison to an index of firms
designed to show average, or market, returns and risk.

25Risk is defined as the dispersion of the rate of return for the company. In terms of the
stock market, risk is usually measured, somewhat incompletely, to reflect the dispersion in
the movement of share prices, without accounting for variations in dividends.