I recently wrote an article discussing oil-company profits as related to refining economics. I quickly discovered how widely read The Motley Fool is, as my mailbox filled with readers' comments. Most of the comments were well-phrased questions in need of answers. Today I'll try to address these questions.

Who do you work for?
To start, no, I'm not a paid shill for the oil industry. I'm not a paid anything for anybody. As of this writing, I am retired, without the $400,000,000 golden parachute that ExxonMobil (NYSE:XOM) gave Lee Raymond. I'm writing this article with pencils that I'll soon be selling from a tin cup on the street corner. If any PR people from Total (NYSE:TOT), British Petroleum (NYSE:BP), Valero (NYSE:VLO), or Chevron (NYSE:CVX) are reading, please have your people call my people. The title "Mr. Paid Shill" has a certain ring.

It is true that my original article focused almost entirely on refining economics and did not discuss the production segment of the oil industry. This was intentional on my part; I worked in the refining segment, so I have access to a lot of refining knowledge, economics, and expertise. Also, in the oil industry, as in most industries, each part of the company is a stand-alone cost center. The production segment "sells" the raw crude oil to the refining segment. The marketing segment is then responsible for trying to turn a profit after the refining costs. If I, as the author, had been involved with the exploration, production, or marketing segments, I'm sure I would have written the original article from a different perspective.

Is all crude oil sold at the same price?
Market prices for crude oil are usually based on a "benchmark crude," such as West Texas Intermediate crude or Brent crude. For decades, these have been the standard for light, sweet (sweet meaning lower sulfur content) crudes. A Middle East crude, the Dubai blend, is the nearest approximation to a stable Middle Eastern heavy sour crude. (Does that statement remind anyone else of jumbo shrimp?) As prices for the benchmarks vary, so do the relative market prices for other crudes that approximate the characteristics of the benchmarks. Therefore, some oil is less expensive than the spot price.

Generally, the lighter, sweeter crudes produce a higher percentage of more valuable refined products, with less processing, than do the heavier, sour crudes. As of this writing, Brent and WTI are trading about $8 per barrel higher than Dubai, according to Platt's.

The higher-priced crudes produce more saleable high-value products than do the heavier crudes, and do so with lower processing costs. For instance, a light crude may yield 50% of its volume in various gasoline boiling-range products. By contrast, the less expensive heavy crude may yield only 30% gasoline cuts, with 70% diesels, gas oils, and asphalts. Most successful refiners are continually adding processes such as cokers and high-pressure hydrotreaters to upgrade the heavy products into more valuable products. All this comes at a price that generally only a Washington politician can comprehend. You know, a few billion here and a few billion there, and pretty soon you're talking real money.

Every day I drive by a local idled Unocal refinery that was shut down in the late 1970s. This refinery was designed to process only light sweet crude, and could not afford the tremendous upgrading costs to process heavy sour crudes. This was just one of hundreds of United States refineries shut down in the late 70s and early 80s due to lack of profit and capital.

Is there an oil shortage?
Now, let's discuss the exploration and production side. My personal experience in this segment is limited to the three years I spent working on work-over rigs and roughnecking in the derrick of a triple-stand drilling rig. I acquired the rest of my knowledge by osmosis from colleagues with knowledge of the industry, and from research after listening to Bill O'Reilly spinning in the No-Spin Zone.

Ever since the Arab oil embargo of 1973, I've heard people say that there is no oil shortage -- it's just a conspiracy. The story is that oil companies want to keep the prices high, so they purposely do not produce more oil. The people know that to be true, for they see the pump jacks in an oil field idle, operating only occasionally. These self-proclaimed experts know that if the oil companies want to produce more oil, they need only to run the wells longer.

The truth is that the wells are on timers to run as long as necessary to pump the available oil. In the vast majority of mature oil fields, the well will produce only a given amount of oil in a time frame -- say five barrels every six hours. In this case, the pump jack would be programmed to operate long enough to pump five barrels, then shut off for six hours before pumping again. This would allow the casing at the bottom of the well to refill before the pump starts. If it were to run longer, it would not produce any more oil, for the well would be temporarily dry; running dry would ruin the pump and waste an enormous amount of electricity to operate the pump jack.

Once upon a time, Jed Clampett may have become wealthy by finding oil with a misplaced bullet. Those days, as well as the days of the Spindletop Gusher, have gone the way of the Edsel. Most of the oil wells in the United States produce fewer than 50 barrels per day.

You'll find the experts who know of several wells that were drilled, then capped. Another trick by the oil companies, right? Wrong. The viable wells that were capped are capped only until prices rise to the point that makes production practical. If Marathon drilled a wildcat well at a cost of $30 million, but found a reservoir of only one million barrels, the initial finding costs were $30 per barrel. That's before any extra costs, such as leases, royalties, production costs, or operating expenses. These costs could easily increase the expense to $50-$55 per produced barrel. Such a well would probably have been capped until prices rose to a range of about $60 per barrel.

Same thing with "stripper wells" -- wells that produce less than 10 barrels per day. There are many of these presently in operation, producing as little as two to five barrels per day. When oil sold for $10 per barrel, it was not worth the costs to operate the wells. At $60 per barrel, these are once again producing wells. These make up many of the wells that people see running only occasionally. It's necessary to let the well's perforated casing refill between pumpings. Again, there is no sea of oil at the bottom of a well. It's a hard rock formation that contains oil in small pockets, or veins. The oil slowly drains through these veins to the well casing. If production slows, but the producer believes the well still has recoverable oil, they may hire Halliburton or Schlumberger to "fracture" the well, pumping chemicals at very high pressure into the formation in an attempt to reopen the veins of oil.

Big profit for big oil?
Want to really spend some money with some high-stakes gambling? Just start looking for oil offshore, or in some volatile third-world country. In the case of even shallow coastal offshore United States oil, it will cost several hundred million dollars to get the first barrel. Start adding zeros if you need to go drilling in the North Sea. In many countries, the oil companies must also pay homage to the "dictator of the day," who may at any time decide to nationalize the oil production.

In short, it takes extremely deep pockets to find and produce oil. Potential profit is the carrot that encourages oil companies to invest the required money. Still, the overall profit margin in the oil industry is less than that of many other companies. The table below shows data from several companies for the trailing twelve months.


Net Profit


Profit Margin





Microsoft (NASDAQ:MSFT)




Coca-Cola (NYSE:KO)




Procter & Gamble




General Electric
















Billions of dollars. Data provided by CapitalIQ.

This table reinforces my original premise that ExxonMobil posted record profits mostly because of such high volume. The profit margin was one-third that of Citigroup or Microsoft, but its sales numbers were so high that the net profits almost tripled that of Microsoft.

In closing...
Oil companies are presently making a lot of money. They make it by pennies per gallon from refining, and only a little more from production. It's almost impossible to back-calculate the true cost of production or profit per barrel, but the chart above tells me that ExxonMobil's 11% net profit margin on $70 oil would equate to a net profit of $7.70 per barrel, or $0.18 per gallon. That's admittedly a very simplistic way to look at it, but it does tell me that there's no huge rip-off occurring.

Oil prices are set by global supply and demand, and they will continue to rise as long as demand keeps increasing. Global demand has risen from 77.7 million barrels per day (BPD) in 2002 to a projected 85.2 million BPD in 2006. The quickest way to force a price reduction is to reduce demand by easing the regulatory requirements to construct nuclear power plants. If it were not for undue regulatory expense, nuclear power could be so inexpensive that we'd all willingly drive electric cars and use electricity for all possible uses, instead of using fossil fuels. Oil would be used only where absolutely necessary. Then, and only then, would we again see $20 oil.

More oil-related Foolishness:

Microsoft and Coca-Cola are Inside Value recommendations. Total is an Income Investor pick.

Fool contributor Glen Kenney does not own shares in any of the companies mentioned. The Motley Fool has an ironclad disclosure policy.