A central motive of energy policy-making in the US is anger at oil companies. The sentiment expresses itself in bills passed this year by both houses of Congress. A Senate bill would make oil prices found to be “unconscionably excessive” a target of criminal prosecution. A House bill would sharply raise taxes on the oil industry.
The anger results only partly from the oil price increases of the past few years. When confronted with explanations for the prices-rising demand, limited supply, hurricanes-angry observers typically note that oil-company profits reported when prices are high are what really peeve people.
For companies that sell crude oil and its derivatives, of course, profits are hard to avoid when commodity and product prices jump. The increases raise revenue if sales volumes hold steady or rise. And the revenue increases lift profits if costs hold still. That so many Americans find this arithmetic outrageous is perplexing. That the outrage so readily influences politics is even more so.
In fact, policy mistakes born of anger outlast price-swollen profits, which inevitably get whittled by rising costs. It’s happening now.
As the story on p. 22 reports, second-quarter profits for a group of producers and refiners fell from the same period last year even as revenue increased. For 71 companies based in the US, net income fell 9.6% on total revenue up 2.6%. Fifteen of the companies reported net losses. For a sample of Canadian oil and gas companies, second-quarter earnings dropped by more than 20%.
Profits can decline when revenues rise for many reasons. But the common factor in second-quarter financial reports will surprise no one in the oil and gas business: surging costs.
Contemporaneous industry data on operating costs are scarce. But various proxies make clear that oil field costs have been zooming. For example:
- In a July report, Adam Sieminski of Deutsche Bank, using data from the US Energy Information Administration, estimated that worldwide finding and development costs increased 15%/year in inflation-adjusted terms during 2005-07. He projected the rate of increase at 7.5%/year or more during 2008-10, when the average finding and development cost would reach $18-20/bbl.
- The annual Joint Association Survey on Drilling Costs published by the American Petroleum Institute last April showed average drilling costs per well and per foot, adjusted for activity and inflation, nearly doubled for all US wells during 2000-05. The 2004-05 increases, however, were less than 1%.
- A new index of capital costs-which don’t immediately affect profits but rise for many of the same reasons operating costs do-reflects a surge that its producers call “dramatic.” For the 6 months ending last Mar. 31, the IHS/CERA Upstream Capital Costs Index, published by Cambridge Energy Research Associates, was up 79% from 2000. The indicated annual rate of project inflation for the period was 14%, down from 30% in 2006 in a trend CERA said might foreshadow a plateau as early as next year.
Everyone in the oil and gas business knows how costs have risen and why: competition for workers, materials, and services. The increases were predictable. Oil and gas price increases since 2001 did more than raise industry revenues and restore profitability, which in the 1990s had become elusive for many companies. They also stimulated activity in an industry with work capacities shrunken by years of financial trouble, an industry suddenly needing to compete with other active businesses for the ingredients of expansion.
So costs have jumped and are eroding profits. The development should begin to comfort industry antagonists who think oil and gas companies ought not to make money. It should, but it won’t. The antagonists will just replace anger over profits with the strangely ineradicable suspicion that companies curb supply to drive up oil prices.
Yet behavior consistent with that suspicion is nowhere to be seen. While US profits were falling in this year’s second quarter, operators were completing what API estimates to have been the highest number of wells in 21 years, and refiners were working up to their highest rate of gasoline output in history.