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May 19, 2007

ExxonMobil Understands Reduced Demand for their Products

Category: Companies,Economics,Editorial,News – Tom Harrison – 5:38 pm

Business Week reported in this week’s issue that ExxonMobil has been using their record profits to buy back stock. They are not using it to build new refineries, finding new sources oil, or (god forbid) researching and developing environmentally sound energy sources.

A stock buyback allows the company to reduce the supply of their shares, thereby driving up the price, which is good for stockholders. But by not expanding their ability to produce more of their product, they simultaneously reduce the supply of their product, which drives up the price. That only works because they know their will competitors do the same thing.

So guess what?

Chevron has also been buying back their stock, and Business Week reports that the other major oil companies are also seeing this is a great way to make profit. To my eyes, the stock buyback represents three important factors in how the oil companies are understanding their business:

  1. Buying back stock suggests there is not a more profitable use of assets
  2. Not investing now ensures profit now and higher prices later
  3. Not investing is an indicator of oligopoly or monopoly power

Oil Companies Don’t Want to Invest

In the 70s, oil companies went on a great investment splurge. While some new assets were found (Prudhoe Bay, for example), much of the investment was in new technologies or sites that didn’t pan out. I can’t say whether in the end the investment then was a good idea for the oil companies. But each new potential source of oil today is more difficult to extract, or more risky for geo-political reasons (e.g. Venezuela, Middle East), so a bigger investment is required to get a given amount of new supply.

More telling still, though, is the decision not to invest in more refining capacity. As I wrote in a post last week, the current record gasoline price is reportedly driven by a shortage of refining capacity. While it is mostly due to refinery maintenance, not just overall shortage of refining capacity, one has to think that in a “normal” market, a company might be willing to take use their huge profits to gain advantage over their competitors. But refineries are long-term investments; they take many years to build, just as are new sources of oil.

What this tells me is that oil companies see the beginning of the end.

Profits Now, and Later (but not forever)

A stock buyback as an alternative to new investment suggests awareness that in the long run, demand will be lower. That’s a little counter-intuitive, (or maybe just wrong), but my reasoning is as follows. Assuming that we’ll run out of oil some time in the future, all other things being the same, reduced supply would drive up prices. If this is the case, then the company able to provide greater supply in the future would benefit — the expectation of higher prices for increased future production makes the current investment an even more worthwhile use of investment.

In other words, it should make sense to find more oil, even if it’s harder, because you’ll get more money later. But that’s not what’s happening.

In Economics, the oft used assumption that “all other things being the same” (Ceteris paribus as the Econ people like to say) is the biggest failing of the (dismal) science. In the future, all other things will not be the same, and I think that’s what is at the heart of ExxonMobil’s investment strategy.

Any sentient being can see that there are a lot of forces at work to reduce demand for oil:

  • Increased awareness and acceptance of global warming
  • Bush and conservatives reduced power
  • “Energy independence” movement, bio-fuels, geo-political instability
  • Pushes towards alternative energy sources
  • Conservation

So if people are going to be needing less oil in the future, why spend a lot of money now to find more? The real answer is probably how much less demand will there be — that’s hard to know, and that makes major investments now quite risky. What’s not risky: buying back stock and making shareholders (even more) happy.

Oligopoly or Monopoly Power

But not investing can only work as long as your competitors are all playing the same game. ExxonMobil and Chevron, two rather large companies, are doing it. And others, according to the Business Week story, are seeing the wisdom and effectiveness of the approach: not all of the oil companies did as well as ExxonMobil and Chevron as fuel prices rose.

But this only works if either your company is big enough to control the market (monopoly power) or if collusion can be counted on because there are a small number of powerful companies (oligopoly power). Monopoly is an overstatement, but oligopoly certainly seems reasonable.

And because of this power, companies like ExxonMobil are able to raise their share price now, avoid risk now, and make more money even as the price of their product rises due to decreased supply. It’s good business all around — the best way out for an industry that sees the writing on the wall.

The End of Oil is coming as expected, and everyone knows it

So the book Paul Roberts wrote in 2004, and which got my attention by 2005, stimulating the original post in this blog is happening as predicted.

The question is, how will we, as a country, respond?

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