There aren’t many targets as favorable today as the big oil companies.  Every time we pull up to the gas pump we’re faced with a major assault on our wallets.  It angers us and we want to strike out at someone or something.  Then every quarter we hear about record profits for the oil companies and we think the fat cats are dining on steak tonight while we’re shopping for sales on hamburger.  Damn them!

Today the executives of the big oil companies were on Capitol Hill to answer to members of the Senate Finance Committee as to why they shouldn’t lose their subsidies.  Subsidies?  You mean we’re giving a subsidy to Exxon Mobil, that made 11 billion dollars last quarter?  Why that’s scandalous!  Or is it?

It seems the big oil companies are reporting record profits every quarter, so are they gouging us?  Are they taking advantage of a crisis to pump up their profits?  Well it would be easy if that was the case.  Crisis love villains and today the Democrats did their best to villainize Big Oil.

Everyone has in their mind that somewhere up in an ivory tower big oil fat cats sit around a table, smoking cigars, and deciding how much to charge at the gas station.  Unfortunately for the oil company haters it has nothing to do with the facts.  So let’s dissect how the price of a gallon of gas is set:

Let’s follow the oil from 3000 feet below the Arabian desert to your gas tank.

First of all there isn’t a treasure map to a producing well.  It often takes years to identify and secure access to oil reserves.  Before the first drop of oil goes into that barrel millions of dollars are spent.  In addition the cost of non-producing explorations must be factored into that barrel as well.  Current technology reduces the amount of unsuccessful test drilling, but as drilling technology has enabled us to go deeper and deeper into the ground or below the ocean floor, the cost of production has gone up.

Once oil is pumped from the ground, it can be sold on the spot market, a last-minute trading arena where oil companies and distributors buy and sell to each other, or straight to refiners.  It would seem to be a simple matter to pump the oil into a tanker ship, bring it to Louisiana and refine it into gasoline, but that’s not how it works.  Oil producing countries control the price of crude oil by regulating production which effects world supply.  When the price falls below a set level, they reduce production to reduce the amount of oil going onto the world market causing an immediate change in price required to purchase oil on the market.  If they believe there will potentially be a threat to delivery or where a portion of production will be off-line, they don’t automatically increase production elsewhere.  Why let a good crisis go to waste? The number one influence on this is the Organization of the Petroleum Exporting Countries (OPEC), a consortium of 13 countries: Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. Together, these 13 nations are responsible for 40 percent of the world’s oil production and hold the majority of the world’s oil reserves.  OPEC controls the price, either directly or indirectly, of all oil purchased from non-domestic sources.  The only way to remove that control is to control the entire supply chain, and that is only possible with oil produced in the U.S.

When you pull up to your local Chevron station you assume you’re buying gasoline refined from oil Chevron pumped out of the ground.  And you may be, or you could be filling up with gasoline that originated from a well drilled by Shell or Exxon or any of several hundred oil production companies.  Remember, all non-domestic oil is coming from one large bucket, the world oil market.  Oil is traded on this market and refiners, whether it be a refinery run by Exxon or some small fuel company, is purchased from the market where the price is varies by current production levels; translation: OPEC.  So does that mean the cost of a barrel of oil produced in Texas is controlled by OPEC, to some extent because such a large percent of our crude oil comes from non-domestic prices.  World oil prices create upwards pressure on U.S. resources as well.  If there was no relationship, U.S. oil producers would simply ship all their oil to the most favorable market.  Most everyone conceptually understands the laws of supply and demand; when something is in plentiful supply it tends to be less expensive and when in shorter supply it will be more expensive.  OPEC dials up or down production of their 13 member countries to regulate the price by keeping demand in excess of supply.  Once a barrel of oil comes out of the ground the first nibble comes from royalty payments to the land owner and/or country involved.  While Exxon might bring a barrel of oil out of the ground in the Arabian desert, Saudi Arabia takes the lion’s share of market price of that oil.  After the Saudis have taken their taste there is barely enough remaining to cover the cost of delivering the oil to a refining facility.  Remember oil doesn’t jump out of the ground and fill barrels.  In many cases the cost of drilling and recovering oil has drastically affected the profit, and while the price of a barrel of oil goes up so does the royalty payment.  And last, but not least, keep in mind that the price netted on a barrel of oil is ever varying, so one month the net profit on a barrel may not be sufficient to cover transportation costs and in order to keep profits stable the only way to do that is to raise the price all the way down the supply chain and you know where that ends? Yup, in your wallet.  Even in the most stable market gasoline prices will vary from week to week by a few cents up or down.

Oil comes in several categories, from light sweet to heavy sour.  The weight refers to the viscosity or thickness of the oil and the flavor represents the sulfur concentration from low (sweet) to high (sour.)  The lighter and sweeter a barrel of crude oil, the less intense the refining process must be to produce gasoline and diesel.  Oil is priced on the market based on the category.  All refiners would love to use only light sweet oils but light sweet supplies are much lower and therefore the cost is much higher.  All this factors into the cost of producing a gallon of gasoline.  The markets know when a tanker ship is going to arrive at a port what the tanker contains, and the oil is delivered to the refiner that has purchased that oil on the market.

Refiners contract with local distribution facilities to provide product via a number of methods, all of which add cost to each gallon.  Local distributors contract with service stations to deliver gasoline to service stations, after bringing the fuel up to the station’s parent company’s additive standards.  Seen those nifty commercials where one oil company touts how their fuel cleans your injectors, makes it run better or reduces sludge build-up?  That’s all in the additives and each gas station chain has their own specifications that each station must adhere to and each distributor must be able to provide to sell to those stations.  Additionally the federal government (EPA) adds blending requirements such as adding certain percentage of ethanol to the fuel.  In some states they have unique blend requirements that must be met for gasoline to be sold in their state.  All these additive and blending requirements add to the cost of a gallon of gasoline. 

The service station takes delivery of gasoline and pays the distributor based on a contracted price with delivery charges.  Localities, states and the federal government apply a tax to every gallon of gasoline.  Depending upon where you live there may be no local tax, but you’ll always find a state and federal tax.  If you have the misfortune of living in an area where every municipality adds a tax, such as in California, you may pay significantly more per gallon than in another state.  This is one of the reasons we see gasoline prices in California routinely leading the country.  Service stations routinely make between 7 and 10 cents per gallon of gasoline.  It’s common for service stations to make more money from the sales of convenience items than gasoline.

So how does the money breakdown?  Let’s dig into the facts versus the rhetoric:

The biggest part of the price of a gallon of gasoline is by no surprise for the raw crude oil.  Oil companies have absolutely no say on the market price of oil.  Do they benefit from higher prices?  Surprisingly no.  Oil companies profits are relatively stable in the range of 3-5 cents per gallon of gasoline sold.  So how do big oil companies make such great profits?  It’s relatively easy: sell more gasoline.  The world demand for oil continues to grow, with China taking a ever-increasing bite out of the world supply.  Also keep in mind that big oil does much more than just produce gasoline.  Because oil is used in a variety of products other than fuel, such as plastics to lubricants, oil companies make money through many different avenues and gasoline is purely a volume profit business.  So how does Exxon Mobil make 11 billion in profits for the first quarter of the year if they’re only making 3-4 cents a gallon?  Lots of gallons of gas, selling producing wells to other producers, selling rather than relocating equipment and reselling product produced at a time of high supply at a time of OPEC-induced supply limits.  Averaged out the net yield remains fairly stable, but by being an active trader oil companies can manage their costs to maintain or improve their margins.

So who is the big beneficiary of rising gas prices? Governments. Governments in the Middle East and Latin America make huge money by leasing land and taking a fixed percent royalty.  In the U.S. the average cost of taxes is 40 cents per gallon to as high as 63.5 cents per gallon in California.  Take a look at this breakdown of the cost of getting gasoline to your tank:

71% of the price is the cost of raw crude.

5% is the cost of refining.

10% is marketing and distribution.

14% is taxes.

Add it all up and it leaves 1% profit for the oil companies.  This means that if the oil companies removed all profit from a gallon of gasoline currently selling for $4.00/gallon it would only lower the price to $3.96/gallon.  Your government pockets a neat 56 cents without so much as lifting a finger and this doesn’t include money the government makes on oil drilling leases.  The cost of refining in the U.S. is captive to capacity.  Without additional refining capacity (which the EPA has prevented us from developing for the past 20 years) the time-to-market remains fixed.  So even if 30 days of oils shows up at the refiners they cannot produce one drop more of gasoline as our refining operations run at near maximum capacity at all time.  That’s a ticking time bomb.  We’re walking a fine line that could end in total economic collapse if we lost a significant portion of our domestic refining capacity.

So how does this all factor into big oil’s need for subsidies?  Lest we forget oil companies are publicly held corporations which must make a profit to continue to operate.  Without subsidies oil companies would have to lower their risk profile which means cutting way back on exploration.  A million dollars spent on exploration which doesn’t yield a profitable well is lost money and if 100% of the cost was born by the oil companies they’d be forced to drastically curtail exploration.  Reduce exploration and you reduce supply.  Reduce supply and the cost of crude goes up.  And as we all know now, when you increase the cost of the raw material for producing gasoline the price goes up all the way down the supply chain.  So if the congress reduces or eliminates the 2 billion a year it spends on oil company subsidies you can certain that that 2 billion will come out of your pocket one way or the other.  Some small oil companies simply could not operate in the black without the subsidies as they could not bring wells into production without them.

The Democrats love to villainize the oil companies.  They do nothing to attack the source of our biggest cost and that’s being hostage to OPEC price gaming.  Without additional production and refining we will play this never ending game where prices are artificially controlled by a committee of countries that, for the most part, aren’t amongst our best friends.

So while the Democrats beat up on Big Oil, the real source of the problem goes unaddressed.  But then again the Democrats aren’t about bringing cost effective energy to the American people.  There game is to find a villain and whenever they’re short of one they can always point at Big Oil.