Thursday, July 30, 2009

The sky is falling... or so CNN would have us believe

It’s all kicking off in the media with doomsday reports that Shell, BP, ExxonMobil, and ConocoPhillips have all reported dramatic losses in their Q2 financials. Why does a blogging expat in Norway care about this? A few reasons – mainly because I love a good media frenzy. Also, Husband’s company is related to oil and gas services, so I like to pre-worry if Armageddon has arrived and the whole thing is going up in smoke. Another reason is that I am a professor in a business school, and they kind of like the faculty to at least pretend to understand these kinds of stories. Finally, I care because I live in an oil town and many of my expat friends are employed by the aforementioned companies, and I know that lower profits will translate in some way to expat contracts getting cut and me having one (or ten) less friends in town.

So I decided to do a little digging as that’s the kind of gal I am. Mind you, it was already established that I was rubbish at economics, but here’s my assessment of the situation.

Oil companies are reporting lower profits because the price of oil is declining.

Overly simplistic perhaps, but I did not see it mentioned in any of the articles I read. Famine, illiteracy, the impending resurrection, and Obama were all named culprits, but the simple fact that oil companies make money based on how much they can get for a barrel was painfully overlooked.

Have a look at the graph* below – it tracks Shell’s gross profit against the oil price**. (I use Shell as an example as I was too lazy to look at more than one company’s annual reports, but I suspect the trend is similar.)

See how the two trend together? So it should not be causing a media meltdown that Shell is down 70% in CCS (current cost of supplies) between Q2 09 and Q2 08. The media should actually be noting that these earnings are to be expected since we see the same trend in oil prices. But that’s not sexy enough. Frankly, if oil prices were trending down and Shell’s profits were trending up or staying the same, that would mean that an oil company is making money from something other than oil. Perhaps they invested in shares of Google back in the early days or have been quite judiciously investing their weekly allowance from dad.

The other issue is that 2008 was somewhat of an outlier in terms of profits, so we all got a little spoiled thinking the Golden Age would last forever. But Gatsby always dies at the end no matter how many times you read the book, and what we are seeing now is, for lack of a more astute phrase, a very sharp correction in the market.
Oil prices of $100 and more were not sustainable in the long run, and we saw those prices in part because 2008 saw a decline in the dollar, which is how oil commodities are priced. This decline in base currency meant OPEC had to raise oil prices in order to maintain existing profit margins. Throw in some unrest in major oil producing countries and increased demand from some larger national markets and you’ve got yourself an expensive barrel of black gold.

In fact, if you perform a trend analysis on gross profits in the same example used above, gross profit is still on a steady upswing.

I am not denying that we are in economic decline. However, I think this should be tempered with a little ‘big picture’ thinking and a recognition that these things are cyclical. So take a deep breath and resist the urge to run for the hills or sell out the portfolio. I don’t think we have to pawn the good china just yet. Perhaps someone should call CNN and let them know.
*Apologies for the fuzzy graph. Frankly, I was pleased to get it from Excel into Blogger, so I'm not going to look a gift horse in the mouth.
**A few disclaimers about the graph. The numbers being thrown about in the media are CCS, but I used gross profit as this gives a little bit broader perspective. Second, the oil prices are annual averages adjusted for inflation, and Shell's gross profit is stated in millions. Third, Shell's gross profit for 2009 is simply GP for the first six months of 2009 multiplied by 2. This is most definitely not a FASB-approved accounting method, but, frankly, any other treatment required a lot of assumptions and even more math, and I have some West Wing to watch.

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