Profit analysis may be carried out using total profits and their yearly growth, or with profitrates. Total profit analysis is useful in evaluating the effect of the industry's profitability onexpenditure flows within the economy as well as the potential command over resources held bycompanies in the industry. Yearly growth of profits can show whether the industry is becomingmore or less of a factor in over-all expenditure flows in the economy. Profit analysis based on profit rates is useful in examining the effectiveness of the firm'smanagement in using available resources. Profit rate analysis is also useful in making comparisonsbased on the relative performance of firms in the industry and is widely used by investment analysts. In this report, the focus is on total profits and the growth of profits within the oil industry andthe likely uses of profits by the industry, specifically the potential ability of the industry to invest inoil supply related projects. (4) Profits in the oil industry have been volatile over the past three decades, reflecting oil pricechanges as well as other market effects. For example, net income for the major energy companies,as defined by the Energy Information Administration (EIA), increased almost threefold by 1981,compared to 1977, on the oil price increases associated with the Iran-Iraq war. By 1986, net incomesof the major energy companies had sunk below 1977 levels. Profits peaked and declined at leastthree other times during the period 1987-2002. (5) Volatility in the price of oil, which leads to volatility in profits,makes investment planning risky. Investments which might qualify for implementation if a high oilprice is assumed may not qualify if a lower price of oil is assumed. This uncertainty may havecontributed to the cyclical nature of investment and capacity expansion in the industry. Oil industry profits are widely identified as related to world oil price levels. Figure 1 showsthe movement of the monthly price of WTI crude oil at Cushing, Oklahoma from 2003 through2005. (6) Figure 1. Spot Price of WTI, 2003-2005 Upward pressure on the price of WTI, which began in 2003, strengthened during the summerof 2004, leading to peak price levels in October 2004. The daily peak price for the year, $55.17 perbarrel of WTI, occurred in late October. The average price of WTI for the second half of 2004,$46.01 per barrel, was 25%, or almost $10 per barrel, higher than the average price for the first sixmonths of the year, which was $36.79 per barrel. If the profit performance of the oil industry wasbased, or related, only to the price of oil, given normal lags in the production chain betweenproducing crude oil and distributing petroleum products, it might have been expected that profitsmight have risen late in 2004 and into 2005. Table 1. Refiners Composite Acquisition Cost of Crude Oil,2003-2005, Quarterly (dollars per barrel) Source: Energy Information Administration, Petroleum Marketing Monthly, June 2005, Table 1, p.5. Although the price of WTI attracts the most headlines through its association with both thefuture and spot market prices, a more reliable measure of the real cost of crude oil to the nation'srefiners is the refiner's acquisition cost of crude oil as shown in Table 1 for 2003 through 2005. Thiscomposite cost measure is a weighted average of the cost of domestic and imported crude oils usedby refiners and also reflects the mix of various qualities of crude oils used in refineries. Refineries of different levels of technological complexity can use different mixes of crudeoil to produce varying mixes of petroleum products within technological limits. This ability to varythe production mix can be used to enhance profitability when price differentials between sweet lightand heavy sour crude oils or between light and heavy product mixes change. Figure 2 shows thedifference between light and heavy crude oils was generally less than $10 per barrel during theperiod 1992 to 2002. The spread increased in 2004 and into 2005. The average monthly differencebetween light and heavy crude oil in 2003 was approximately $7 per barrel. The average differenceincreased to over $10 per barrel in 2004, approaching $15 per barrel at times. For the first threemonths of 2005, the differential remained at approximately $12 per barrel. (7) Figure 2. Real Price Difference Between Light Crude Oil and Heavy Crude Oil,1978-2003 Source : Energy Information Administration, Performance Profiles of Major Producers 2003, March2005, Figure 31, p. 31. Figure 3 shows the movement of the monthly spot market price of reformulated regulargasoline at New York harbor during 2003 and 2004. (8) Figure 3. U.S. Spot Market Price for Reformulated Regular Gasoline, New YorkHarbor, 2003-2005 After a relatively stable year in 2003, gasoline prices peaked twice in 2004, reaching recordnominal levels. The first peak, of almost $1.41 per gallon, occurred in May, before the summerdriving season began in the United States. The second peak, of almost $1.38 per gallon, occurredin October. The timing of these peaks are similar to those observed in the crude oil market. Pricescontinued to be high in 2005, with a peak price of over $1.52 per gallon attained in April 2005. The high gasoline prices of 2004 also brought what some identified as a partial decouplingof the oil and gasoline markets. Fears related to limited refinery capacity, low inventory levels, andstrong demand growth in China and other parts of the world led some analysts to conclude that gasoline prices might remain high even if crude oil markets weakened. These conditions might beexpected to yield high margins for refiners. Table 2 reports the basic financial performance of the major integrated oil companies from2002 through 2004. Table 2. Financial Performance of the Major Integrated Oil Companies, 2002-2004 (million of dollars) Source : Oil Daily , Profits Profile Supplement, vol. 55, no. 39, February 28, 2005, p. 8; andFinancial Data by Company at http://www.Hoovers.com . Aggregate net income rose in 2004 for the major integrated oil companies, compared to 2003,which itself was a strong year for industry profit performance, and rose by an even greater amountcompared to 2002. Only ExxonMobil (17.8%) experienced a gain of less than 20%, and onlyMarathon (-4.5%) experienced lower net income in 2004 than in 2003. Five of the companies in thisgroup posted net income gains in excess of 50% for 2004, while the average gain in net income wasapproximately 40%. Comparing 2004 to a 2002 base, the gains in net income totaled over 175% forthe major integrated oil companies. Total revenue growth for 2004 compared to 2003 was 35% for the group, which was less thanthe 44% growth in net income, suggesting that possibly the greater profitability of the major oilcompanies in 2004 did not arise solely from the higher price of crude oil. Compared to 2002,revenue growth for 2004 was approximately 70%, less than the 175% growth in net income for the same period. The profit rate on sales for this group of oil companies, based on the totals of revenue andnet income reported in Table 2, were 7% for 2004, 6.5% for 2003, and 4.3% in 2002. The growthin the profit rate experienced by these companies suggests that the stronger underlying marketfundamentals in the crude oil and oil product markets were successfully translated into increasedperformance by the companies. Table 3 shows the upstream (exploration, development, and production) performance of themajor integrated oil companies in 2004. This segment of the firms' business accounted forapproximately 60% of the net income for the group. Table 3. Upstream Financial Performance of the MajorIntegrated Oil Companies, 2004 (millions of dollars) Source : Oil Daily , Profits Profile Supplement, vol. 55, no. 39, February 28, 2005, p. 8. As shown in Table 3 , increased net income was not derived from large increases in oil andgas production for most companies. For 2004, more than half of the companies produced less oilduring this year of high prices than they did in 2003. The total increase in oil production by thegroup of 1.9% was largely attributable to the 19% increase of one company, BP. The productionresults for natural gas are even more uniform. Every company, except one, Occidental, producedless natural gas in 2004 than in 2003, yielding a total 3.1% decrease in production from the groupas a whole. Table 4 reports the downstream (refining and marketing) results for the major integrated oilcompanies. This sector accounts for approximately 23% of the total net income earned by thesecompanies. Data in Table 4 show that net income from this sector increased by almost 100% in2004, compared to 2003, but production increased by only 1.5%. Again, consistent with theupstream results, it seems the integrated oil companies derived increases in net income from priceincreases with little support from increased production in the short term. Table 4. Downstream Financial Performance of the MajorIntegrated Oil Companies, 2004 (millions of dollars) Source : Oil Daily , Profits Profile Supplement, vol. 55, no. 39, February 28, 2005, p. 8. NA = Not Available. The recent record of the major integrated oil companies in expanding production of crude oil and oil products may be the result of several factors. Unfavorable geologic and politicalfactors might have inhibited output expansion. While the decision to expand oil and gas productionin the United States is generally based on the underlying market economics, the geology of many producing regions in the United States maynot support large increases in output, especially without financial investment in new technologies.