Energy & Entrepreneurs #6                                                                                       

Economics 101: Price and Profits

by Raymond J. Keating

When prices rise and profits increase for energy companies, many politicians and activists protest, and proclaim that something must be done.  By something being down, of course, they are talking about government intervention, such as through various forms of regulation, mandates, subsidies, price controls and/or taxes.

These folks need a brief refresher on the role prices and profits play in a market economy.

Prices and profits serve as the signals that the market system uses to allocate resources to their highest and best uses based on the preferences of consumers. 

On the demand side, increasing energy prices serve as a conservation measure, as consumers reduce demand when prices rise. While demand for gasoline and electricity, for example, can be fairly inelastic, consumers still respond to varying degrees.

On the producer side, increased profits provide incentives to boost energy exploration and development. Profits show that resources are being used to produce goods of value, and that value exceeds the costs of production.  Also, higher energy prices provide added incentives to develop alternative energy sources.

But does the market really work when it comes to energy? The answer is yes.

First, let's put energy earnings in perspective. This volatile industry experiences extremes in profitability over time. Consider some data from the American Petroleum Institute:

• In 2006, net income as a share of sales registered 9.5% for the oil and natural gas industry, which compared to 8.2% for all manufacturing. Factor out the dismal performance by the automobile industry, and manufacturing in general matched the oil and gas industry's 9.5% earnings.
• As for return on investment, from 2000 to 2005, oil and gas production averaged 16.7% and U.S. refining and marketing came in at 12.3%, versus 10.4% for the S&P Industrials. However, a longer term view points to a different story. For example, the average over the past 10 years was 13.5% for oil and gas production and 10% for refining and manufacturing, but 14.7% for S&P Industrials. Go back over 25 years, and oil and gas came in at 9.9% and refining and marketing at 6.8%, as opposed to 12% for the S&P Industrials.

So much for supposedly the greedy, oligopolistic energy industry.

Now, getting back to how the market responds to higher prices and profits, note the following from recent API reports:

• "U.S. first quarter 2007 drilling estimates hit a 21-year high and were nearly twice the level of first quarter drilling activity recorded during the 1990s."
• A chart in a report titled "Putting earnings into perspective" reveals how strikingly new oil and natural gas investment has tracked with earnings from 1992 to 2006. It was noted in the report: "New investment last year (2006) in the U.S. alone reached more than $174 billion (a 29 percent increase from 2005), and between 1992 and 2006, the U.S. industry invested more than $1.25 trillion in a range of long-term energy initiatives compared to net income of $900 billion." Investment has accelerated dramatically from about $40 billion in 2002 to that $174 billion in 2006.

This is exactly what one would expect given changes in prices and profits over the past few years.

If policymakers considered the actual economics at work, they'd realize that profits are a good thing, not bad.  Responding to increased profitability for energy companies by further raising those companies' costs through taxes and regulation makes no sense as market signals would get distorted. After all, reducing profitability by hiking costs sends a clear signal for less investment, exploration and development. That does nothing positive for consumers, businesses and the economy in general.

Instead, our elected officials should be working diligently to reduce unnecessary governmental costs imposed on the energy sector. In addition, they should lift limits or restrictions on domestic energy exploration - such as offshore, and in ANWR and other federal lands - that artificially restrict supply and work to push up energy prices.

Prices and profits are far better guides for running the energy sector of our economy, than is pandering politics.

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Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.