Wednesday, June 11, 2008

Why are oil companies so profitable?

Last semester, four of my classmates (Matt Hess, Derek Schmidly, Steven Hinkle, Jimmy Fan) and I performed analysis of ExxonMobil and the industries it participates in to find out why oil companies are so profitable.

Intro

ExxonMobil (XOM) is the largest U.S. company in the world and it participates in three very profitable industries: Mining/Crude-Oil industry, Petroleum Refining, and Chemicals. First, the profitability of the industry is determined by comparing the three industries’ profitability with the S&P 500 median’s profitability. Second, Porter’s Five Forces are examined to determine the attractiveness of the industry with a focus on super majors (i.e., companies that integrate upstream and downstream activities). Finally, the attractiveness of the industry is summarized to explain why oil companies are so profitable.

Background

ExxonMobil’s business and products include 1) upstream activities of oil and natural gas exploration, development, and production, 2) downstream activities of refining and marketing of petroleum products, and 3) chemical businesses tightly integrated with the downstream refining operations. ExxonMobil produces gasoline, energy, and raw materials for plastics and chemicals. ExxonMobil had revenue of $404.552 billion in 2007. Their business is a commodity-based business. This means that everyone sells the same product to the market and there is no product differentiation among suppliers. In order to gain profit in a commodity industry, the seller has to focus on “reducing unit cost and improving efficiency through technology improvements, cost control, productivity enhancements and regular reappraisal of their asset portfolio”.

Profitability of the Industry

All three of the industries Exxon participates in are more profitable than the S&P 500 median. Specifically, the Mining/Crude-Oil industry (i.e., Exxon’s upstream activities) is ranked first with a 26.6% return on revenues (i.e., most efficient operations), ranked eleventh with an 8.2% return on assets, and ranked tenth with a 21.8% return on equity. The Petroleum Refining industry (i.e., Exxon’s downstream activities) is ranked twentieth with a 7.3% return on revenues, ranked second with a 13.2% return on assets (i.e., second best productivity of assets), and ranked third with a 30.7% return on equity (i.e., third greatest power of equity). The Chemicals industry (i.e., Exxon’s Chemical businesses) is ranked twenty-sixth with a 6.6% return on revenues, ranked seventeenth with a 6.6% return on assets, and ranked twelfth with a 20.9% return on equity. Charts generated using Fortune 500’s Most Profitability Industries of 2006 show how ExxonMobil's industries rank in comparison to the top five industries:




Porter’s Five Forces

Threat of New Entrants. The threat of new entrants is low because barriers to entry include high capital cost, economies of scale, distribution channels, proprietary technology, environmental regulation, geopolitical factors, and high levels of industry expertise needed to be competitive in the areas of exploration and extraction. In addition, fixed cost levels are high for upstream, downstream, and chemical products. Thus, it is very hard for new players to enter the market.

Business Rivalry. Business rivalry (i.e., competition) is high because of the commodity-based nature of the business. In addition, there is competition with other industries that supply chemical, energy, and fuel for both industrial and individual consumers. The industry growth rate (based on the global demand for petroleum) is estimated to be 1.9% in 2008 and does not pose a threat or an opportunity. Further, since the oil industry is a commodities market, the competitive advantage is primarily derived from the ability to produce products at a lower cost via operational efficiencies. The significant number of competitors include ExxonMobil, BP, Chevron, Conoco Philips, and Royal Dutch Shell.

Supplier Power. The suppliers are the oil mining and extraction firms (includes Exxon). Supplier power is high because OPEC controls 40% of world’s supply of oil and, thus, has a strong influence on the price of oil. OPEC’s influence on oil prices is a threat because Exxon purchases oil on the open market. In addition, unstable countries that host Exxon oil reserves are a threat because they can seize Exxon’s assets at any time. For example, Venezuela recently seized one of Exxon’s major projects.

Buyer Power. Buyers are both industrial consumers and individual consumers. Industrial (i.e., downstream) buyer power is low because upstream suppliers have an incentive to limit supply and keep prices high as is evidenced by the shrinking downstream margins. Individual buyer power is low because of the high volume of demand as is evidenced by the fact that energy prices are continuing to rise despite slowing economic growth worldwide. Further, oil demand is expected to increase in 2008, although not as much as originally predicted.

Threat of Substitutes. The threat of substitutes is low and comes from nuclear power, hydroelectric, biomass, geothermal, solar, photovoltaic, and wind. Nuclear and hydroelectric energy sources are not a threat within the next decade because of government regulation, environmental concerns, and a high barrier to entry. Further, photovoltaic sources are limited by technological issues and geothermal sources are limited by geographic availability. The only potential threat could be biomass. However, efficiency levels of biomass have yet to be proven competitive to oil/natural gas. Finally, coal could prove to be a threat to oil consumption as an energy source should technological advancements in coal liquefaction techniques advance to a level that would provide clean, stable oil molecules from the largely abundant domestic coal reserves.

Attractiveness of the Industry: Why are Oil Companies so Profitable?

The Mining/Crude-Oil industry, Petroleum Refining, and Chemicals industries as a group are very attractive because the threat of new entrants is low, buyer power is low, supplier power is high (which is good because most of the big industry players are both suppliers and buyers), and the threat of substitutes is low. The attractiveness of the industry is reduced because business rivalry is high.

However, analysis of Porter's Five Forces does not tell the entire story. One reason why oil companies are so profitable is because of their high volume of goods sold. The following charts demonstrate that the oil companies are not profitable because of profit margins. Specifically, most companies (S&P 500 median) experience much higher profit margins than oil companies. The oil companies low profit margins suggests that oil companies are not making as much money per gallon as the average consumer assumes and that throughput is their key to profits.

In addition, oil companies are profitable because of their operational efficiencies as is illustrated by the following activity ratios. ExxonMobil's high inventory turnover (i.e., ability to produce and sell oil quickly) is a big reason why it is the industry leader and a very profitably company. Specifically, ExxonMobil achieves its cost leadership by competing through technological and operational efficiencies in the areas of exploration, extraction, and refining.

Critics of oil companies cite price gouging as source for their exceptional profits. True or not, price gouging practices can not account for the long-term sustained profitability of oil companies. Instead, analysis of ExxonMobil illustrates that oil companies' dominant position within Porter's Five Forces, high volume of goods sold, and operational efficiencies are what make them so profitable.

4 comments:

  1. Your research was very useful.
    Thanks.
    Roza.

    ReplyDelete
  2. real good research........very useful for me..

    ReplyDelete
  3. great analysis. Thanks for sharing and keep up the good work

    ReplyDelete