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June 28,1974 The record profits earned by major U.S. oil companies in the wake of the Arab oil embargo have triggered a public outcry against the industry by a number of consumer groups. Coming at a time of shortages and sharply rising consumer prices, the spectacular upsurge in oil profits has aroused suspicions that producers may have taken advantage of the embargo to reap excessive profits. Some of the industry's critics have even suggested that the large com panies deliberately contrived the energy shortage to push up prices and profits, to drive out indepen dent refiners and marketers and to force a relaxation of stringent en vironmental standards. The oil companies categorically deny these charges. They contend that the nation's energy problems are the outgrowth of inadequate investment incentives, that the in dustry's profit gain in 1973 stemmed largely from foreign sales, and that domestic prices for refined products have been raised only enough to compensate for the rising cost of imported and domestic crude oil. Size and performance Some of the criticism levelled against the industry undoubtedly can be traced to its enormous size and economic influence. In terms of sales, the petroleum industry is the third largest business group in the United States, outranked only by the agribusiness and construc tion sectors. The 18 largest U.S. petroleum companies rank among the top 100 manufacturing firms in 1 Digitized for FR A SER the nation in terms of sales, and they account for about one-half of total U.S. crude oil production. Even so, the uniqueness of the in dustry's structure lies not in the size of its corporations nor in its high degree of concentration, which actually is somewhat less than in other basic industries, but rather in its high degree of vertical integra tion. The 18 largest producers are fully integrated and are important forces in all four of the industry's major activities— crude-oil explora tion and production,transportation, refining and marketing. These same companies also account for the bulk of the crude oil produced overseas — in Canada, South America, the Middle East, Africa and the Far East. But in addition to those fully inte grated companies— the so-called majors—the industry embraces other large firms that are partially integrated as well as several thous and smaller "independents." In view of the industry's multi layered structure and international involvements, the task of monitor ing its financial performance is quite difficult. Nonetheless, by any meas ure of profitability, 1973 was a ban ner year for the American petroleum industry. The 97 largest U.S. oil companies boosted their total earn ings 53 percent in 1973 to a record $9.9 billion, and thereby far sur passed the 31-percent annual gain recorded by all of manufacturing (First National City Bank data). The industry's profit performance also was outstanding measured by a 15.6-percent return on net worth. (continued on page 2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. But the bright results achieved in 1973 and early 1974 followed a fouryear period which was perhaps the flattest in the industry's postwar history. During that 1968-72 period, earnings rose at an annual rate of only 1.5 percent, compared with a 5 .2-percent rate for all of manufac turing. Moreover, the industry's re turn on net worth not only moved steadily lower over the period, but averaged only 11.6 percent. The Arab take The oil-profits drama has been played against a background of changing relationships between the major international oil companies and the eleven members of the Organization of Petroleum Export ing Countries (OPEC), who account for about four-fifths of world crude-oil exports. In 1970, Libya took the lead by securing higher taxes and royalties through means of a production cutback. In early 1971 the Persian Gulf countries, through the Tehran agreement, achieved a pattern of higher "posted" prices— reference prices for calculating taxes and royalties— as well as a higher tax rate on profits. In early 1973, Saudi Arabia and two other Gulf states moved into direct ownership, with a 25percent shareholding scheduled to reach 51 percent by 1982. From the host countries' new share of output, specified portions of oil were to be sold back to the companies, with the price of this "buy back" oil to be higher than the cost of their own "equity" crude. Iran and Iraq fully nationalized their operations.2 2 Digitized for FR A SER These agreements served to cloud the 1973 supply outlook— even before the imposition of the em bargo. For that matter, the supply situation already was uncomfortably tight, in part because U.S. produc tion of crude oil had been declining ever since 1970. With demand meanwhile soaring because of the worldwide economic boom, market prices for foreign crude oil began to rise even faster than posted prices, boosting the companies' profit per barrel. The denouement of course came last fall, with the embargo, produc tion cutbacks, and unprecedented price increases, following the deci sion by the Persian Gulf countries to repudiate the 1971 Tehran agreement and to become them selves the sole arbiters of crude prices. By year-end, their actions had raised their revenue to $7.12 per barrel, compared with $1.51 at the start of the year. The Arabs also indicated that the price of "buy back" oil would have to be raised to reflect the sizeable increase in market prices, although the "buy back" price remained undecided throughout 1973, forcing the com panies to estimate this cost in their earnings reports. Yet, despite these actions, the companies' profits con tinued to benefit from soaring worldwide demand. Firming product prices also gave a large lift to profit margins in Euro pean "downstream" operations of refining and marketing— while over seas earnings also benefited from the devaluation of the dollar (which raised the conversion value of foreign profits) plus the rising value of inventories and the strong de mand for petrochemical products. As a consequence, almost two-thirds of major oil company profits last year came from overseas operations. The U.S. return In the United States, the industry benefited from the increased con sumption of refined products, the end of gasoline price wars, and a sharp increase in domestic crudeoil prices. However, price controls prevented domestic prices from soaring to foreign levels. Refiners were allowed to pass on the higher costs of imported crude, so that refined-product prices jumped 39 percent at wholesale, but eventually increases were allowed only once a month, thereby slowing the rise in profits. More importantly, price controls held domestic prices for crude below foreign levels. Recognizing that the differential be tween foreign and domestic prices was encouraging exporting and hoarding, the Cost of Living Council last August freed at least one-quarter of U.S. production from controls — "new" oil, or output in excess of 1972 levels— and also raised the ceiling price on "old" oil. As foreign prices continued to soar, however, the weighted average of U.S. crude prices under this "two-tier" system lagged behind, and the CO LC finally raised the price of "old" oil again. In late December, foreign prices averaged $9.50 per barrel, while the weighted average of U.S. prices stood at $6.50 per barrel. Nonethe less, the doubling of U.S. crude-oil prices during 1973 transformed the prospects for domestic producers and encouraged an upsurge in drilling activity. Sharp increases in worldwide prices for crude and refined products had a significant impact on profits dur ing the first quarter of 1974. Profits for thirty large U.S.-based com panies jumped 78 percent above the year-ago level, partly because of the huge inventory profits earned on foreign oil— one-shot gains made by revaluing earlier purchases of in ventory at today's higher prices. Profits would have been even larger had not the companies established a contingency fund to cover antici pated but unknown costs of foreign "buy back" oil. Even so, the companies contend that they might not be able to maintain this strong profits performance, be cause of the need to acquire new inventory at higher prices and because of nationalization moves abroad. Indeed, the recent "interim agreement" between American firms and the Saudi Arabian govern ment left the latter with a 60-percent (up from 25-percent) participation in Saudi Arabian operations. Agree ments such as this could signal an end to American access to lowcost foreign crude, and over the long-run might even result in the complete elimination of U.S. owner ship rights overseas. Yvonne Levy Digitized for FR A SER @ /a) uoi8umse/v\ • i]Bin • uoSaiQ • epEA9N . oqepi M EM EH • E |U JO ^I|E 3 . BUOZUV BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Amount Outstanding 6 /1 2 /7 4 Change from 6 /5 /7 4 Change from year ago Dollar Percent + + + + + + + + + + + + + + + + + + 12.07 + 14.37 22.35 + 15.02 + 17.44 + 10.38 11.37 + 12.59 + 9.91 + 4.44 — 22.33 + 12.73 1.89 + 32.96 — 4.23 + 46.93 83,476 65,111 1,827 23,070 19,267 9,281 5,162 13,203 78,882 22,480 327 54,825 17,829 27,367 6,897 14,138 Weekly Averages of Daily Figures Week ended 6 /1 2 /7 4 Week ended 6 /5 /7 4 Comparable year-ago period 23 72 49 86 256 170 44 229 -1 8 5 + 1,963 + 1,371 + 626 + + + 575 - + + + — - + — + 876 632 484 67 35 23 14 258 229 671 113 39 29 120 190 174 8,993 8,179 526 3,013 2,861 873 662 1,476 . 7,112 955 94 6,190 344 6,784 305 4,516 Loans (gross) adjusted and investments* Loans gross adjusted— Securities loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities Other Securities Deposits (less cash items)-—total* Demand deposits adjusted U.S. Government deposits Time deposits— total* Savings Other time I.P.C. State and political subdivisions (Large negotiable CD's) Member Bank Reserve Position Excess Reserves Borrowings Net free ( + ) / Net borrowed ( —) - - Federal Funds— Seven Large Banks Interbank Federal funds transactions Net purchases (+ ) / Net sales ( —) Transactions: U.S. securities dealers Net loans ( + ) / Net borrowings ( - ) 904 401 "■Includes items not shown separately. Information on this and other publications can be obtained by calling or writing the Administrative Services Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, California 94120. Phone (415) 397-1137. Digitized for FR A SER • E>|SE|V