Here’s What the Oil Industry’s Profit Margins Are Telling Us

The economic concept of free trade is a simple one, though economists tend to confuse it with numbers. Reduced to the individual, the logic of unfettered trade becomes very apparent.

To see why, consider what life would be like if as individuals we were reliant on ourselves for all that we desire. If so, we would live lives of unrelenting drudgery.

Since most of us don’t know how to grow, let alone cook food, or how to build secure living spaces, manufacture cars, or design clothes, we rely on others who do. We buy from others the things we don’t know how to produce, and our individual buying power is our own labor that we’re presumably more suited to.  It’s unlikely that  Nike (NYSE:NKE) Chairman Phil Knight could have built the company’s headquarters outside Portland, but his brilliance as an overseer of one of the world’s foremost brands meant that he could exchange the fruits of his productivity with those possessing the skills to create a magnificent coprorate campus.

To paraphrase John Stuart Mill, we trade products for products, and the more profitable our own production, the more that we can buy. And the greater our ability to trade freely, the more likely it is that the number of producers seeking our business will grow, thus bringing down prices all the while increasing our standard of living.

Trade deficits? We happily all run them. Countries don’t trade, thus rendering absurd the notion of country “trade deficits”, but as individuals our trade “deficits” are a mirror image of our trade “surpluses.”

How the above works in practice is that most of us run trade deficits with our landlords, clothiers, restaurants and appliance stores, yet we finance those alleged deficits with the surpluses we run with our employers. Contrary to popular belief about trade “deficits”, the larger they are for us as individuals, the more prosperous we are because the deficits signal major surpluses, or income, from our work.

Looked at more broadly, there’s a very good reason that American businesses have moved away from manufacturing prosaic goods such as socks, t-shirts and televisions. While American companies could doubtless be the best producers of all three, the profit margins aren’t very grand.

As a result the United States as a nation is “sock, t-shirt and television dependent”, but far from a weight on economic growth stateside, our “dependence” is stimulative. Indeed, rather than U.S. firms wasting limited human, financial and mechanical capital on low-value, low-margin work, American companies and workers seek higher-margin work, and trade their productivity for some of life’s necessities, including socks, t-shirts and televisions.

All of which brings us to a recent post by the brilliant host of the Carpe Diem blog, Professor Mark Perry. In analyzing the profits of ExxonMobil (NYSE:XOM), profits thought by many in Washington to be “excessive”, Perry made the essential point that “The 6.1% average profit margin for Exxon’s industry “Major Integrated Oil and Gas” ranks #112 among all industries for the most recent quarter”. In short, for all the media and political hype about price-gouging oil (NYSE:USO) companies enjoying gargantuan profits, the actual truth is that the industry’s margins are rather pedestrian.

Applied to the popular notion of “energy independence”, assuming it’s true that the U.S. is awash in oil, the relatively slim margins revealed by Perry point to the sheer absurdity of the U.S. seeking energy autarky. To do so wouldn’t exactly impoverish us, but it would make us much less prosperous than we presently are.  The human, financial and mechanical resources we’d have to commit to this relatively low margin endeavor would by definition detract from higher value work, and as such, would cripple us economically.

About this, it should be stressed that this writer has no problem with drilling offshore, in Alaska, or anyone else in these fifty states. But for the government to subsidize even one penny of activity that’s not terribly profitable is for it to subsidize our economic decline.

Much as we don’t have national sock, t-shirt or television policies in the United States, we similarly shouldn’t have an “energy policy.” The reality is that once oil surfaces anywhere in the world, that oil is ours if we’re willing to pay the market price for it. The idea of energy embargoes is doubtless good fodder for cable television shows, but in the real world discovered oil is oil sold into the markets, after which there’s no accounting for its final destination.

And as we live in the most economically advanced country in the world, wherever oil is discovered, a lot of it ends up in the U.S. as a reward for our productivity. We trade the fruits of our higher margin work for oil, televisions, socks, t-shirts and everything else not in our interest to produce.

So while it’s certainly possible that we could be “energy independent”, the industry’s profit margins tell us that we’d achieve such a goal at the expense of our lifestyles which even now are the envy of the rest of the world. Our individual profit margins are the currency which affords us lives of plenty, but if policy moves in the direction of subsidizing the prosaic in the form of more domestic oil exploration than would normally occur in a market free of distortions, the end result would be that we’d have reduced production to exchange for our other goods and services such that our consumptive ability would be forced down by an economically bankrupt idea.

Of course the sad reality is that much of today’s oil hysteria has to do with a falling dollar since 2001 that has driven up oil prices, and created the highly false impression that nosebleed oil is a function of not enough drilling stateside. In truth, oil costs much the same as it ever has, an ounce of gold (NYSE:GLD) bought roughly 15 barrels in 1971 just as it does in 2011; oil only “expensive” insofar as the dollar is cheap.

Once that’s understood, once we know that we don’t have a supply problem, that a dollar fix will erase oil-price fluctuations, we can then judge oil as it should be judged; specifically as a simple commodity that the world’s awash in, and that we needn’t discover more of domestically in order to have access to it. Once we’re clear there, Americans should be able to do what’s most profitable for them to do (including working in the oil business) free of subsidy, and should be allowed to exchange the fruits of their labor with anyone in the world.

John Tamny is a senior economic advisor to Toreador Research & Trading, a senior economist with H.C. Wainwright Economics, and editor of RealClearMarkets and Forbes.

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