America's Energy Morass


By Christopher Palmeri The world's largest oil companies reported profits last week, and what a quarter it was: Chevron (CVX) was up 12% to $3.6 billion, BP (BP), up 35% to $6.5 billion, and Royal Dutch Shell (RDS), up 68%, to $9 billion. And king of them all, ExxonMobil (XOM), saw profits soar 75%, to nearly $10 billion. That's an astonishing $150 million profit for every working day in the past three months.

It's great when General Electric (GE) or General Motors (GM) make money. That feels good for America. It's a different story when oil companies report profit gushers. That money is coming straight out of our wallets every time we fill up the tank.

The oil companies have been trying to defuse public anger about high gasoline prices all year by running advertisements discussing the supply and demand imbalance in world energy markets and how they are trying to fix it through new technologies and investments in renewable energy.

It's not working. Politicians are denouncing Big Oil on the steps of Congress. One cartoon circulating on the Internet parodies the novelty hit The Monster Mash. It features ExxonMobil's outgoing chairman, Lee Raymond, biting into a barrel of oil like Dracula.

On a more serious note, though, it's worth discussing how the nation got into this energy mess -- and what can be done to remedy it.

Why are gasoline prices so high?

About 44% of the cost of gasoline is the cost of the crude oil needed to manufacture it. An additional 27% of gasoline's cost goes to federal and state taxes. The remaining third is what refiners, distributors, and gas stations earn.

The really big money is made by oil companies on their exploration and production business. Oil prices are high right now -- more than $60 a barrel -- because demand, particularly from China and India, has been much stronger than anticipated.

At the same time, the big energy companies have had a hard time increasing their oil production. ExxonMobil, for example, has boosted its drilling budget by 75% in the past five years, to $12 billion a year. Its production hasn't budged.

Why is that so difficult?

To make a dent in a world that consumes 80 million barrels of oil per day, you have to have really big new fields come online. Existing fields are in a constant state of decline. Large-scale projects can take decades to develop.

Overall, energy outfits have nearly doubled their drilling expenditures over the past five years, to $180 billion, according to industry researcher John S. Herold Inc. So even though oil prices have been shooting up, companies are still playing catch-up on the supply side.

Should the oil companies be spending more on drilling?

In hindsight, yes. The industry went through a period in the 1980s and 1990s when prices were low. To cope, they consolidated, cut staff, and focused more on stock buybacks and dividends than on chasing every barrel they could produce.

That mindset has been difficult to change despite the high prices of the past year or so. Over the past five years oil companies poured 85% of their exploration and production cash flow back into drilling, while the other 15% went to reduce debt, pay dividends, and buy back stock.

In previous eras, companies were spending as much as 100% of their production earnings on drilling. That improved their returns on capital but didn't contribute enough to new oil supply.

What about refineries? Don't we need more of those?

The last new U.S. refinery was built in 1976. There are 148 in the U.S., producing 17.1 million barrels per day. This is down from a high of 324 refineries in 1981, with a capacity of 18.6 million barrels per day.

For much of the past two decades refining has not been a very profitable business. Much of the industry's spending has gone toward meeting environmental requirements, such as cleaner-burning gasoline and low-sulfur diesel fuel.

The recently passed energy bill contained $400 million worth of tax incentives to increase refining capacity. Energy companies are focused on long-term margins, and to that end, improving refining capacity rather than starting from scratch continues to look like the way to go.

Still, Glenn McGinnis, who heads Arizona Clean Fuel, runs a startup and aims to build a $3 billion refinery in remote Yuma, Ariz. After 10 years of planning and getting permits, McGinnis thinks he has a strategy that will work, and he hopes to break ground next year.

What about the big companies? Will they add refining capacity?

Shell is considering major expansions at its three Gulf Coast refineries, which could be like building a whole new plant. But other oil execs, such as BP's John Browne, say it's unlikely they'll build a major new facility in the U.S. They say even with oil priced so high, it's just too costly and time-consuming.

How is it that we avoid gas lines and rationing?

As with crude oil, an increasing amount of our gasoline is imported from other countries, mostly from Europe and Asia. It was a big jump in gasoline imports that brought prices down to $2.60 per gallon today, from more than $3 immediately after Hurricane Katrina.

What is Washington doing about this?

Even die-hard Republicans such as House Speaker Dennis Hastert (R-Ill.) and Senate Majority Leader Bill Frist (R-Tenn.) are bashing Big Oil. They are calling for hearings on price gouging and urging the industry to build new refining capacity.

Among the remedies Washington is considering is a kind of Strategic Petroleum Reserve for gasoline and other refined products. Apart from the logistical challenges, the industry opposes this since they may be asked to administer it themselves.

Hastert has also called for drilling in the Arctic National Wildlife Refuge, a controversial issue, and giving states authority to increase drilling off their coasts, two things the oil industry has been pleading to get for years.

Is there any truth to charges of price gouging?

Federal and state authorities have investigated gouging in the gasoline industry for years. During one of the price spikes earlier this decade, gasoline supplies were found to have been withheld by one of the refiners, but no major evidence of gouging has been found.

Most gas stations in the U.S. are independently operated. After Hurricane Katrina, some independent operators were found to have gouged, but not anything on the scale that brought prices up nationally.

With Eamon Javers in Washington

Palmeri is a correspondent for BusinessWeek in Los Angeles


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