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Sunday, May 25, 2008

"Excessive" Oil Corporation Profits Explained

The blame for increasing gasoline prices is being incorrectly placed on oil corporations. The blame properly belongs with the Federal Reserve. If you print more money, prices go up. Rising gasoline prices are 90%+ due to an increase in the money supply.

Suppose that the price of oil were $100/barrel and oil corporations make a profit margin of 10%. Their profit will be $10/barrel.

Suppose that the price of oil doubles to $200/barrel and oil corporations make a profit margin of 10%. Their profit will be $20/barrel.

If the price of oil doubles, then the oil corporation's profits *SHOULD* double. Why does this make sense? Suppose oil corporations didn't double their profits when the price of oil doubled. In this case, their profit margin would shrink to 5% from 10%. Now, the oil corporation is a stupid investment. It would make sense to sell off the oil corporation business and invest the proceeds somewhere else.

When the price of oil doubled from $100/barrel to $200/barrel, inflation was 100%. (Part of the increase in the price of oil is due to increased demand and decreased supply (oil gets used up, unlike gold), but the primary factor is money supply inflation. If you consider the price of oil/gold, and correct for manipulation of the gold price, then the price of oil is relatively unchanged.) The value of all assets doubled. The value of the oil corporation also doubled. If it wasn't allowed to double its profits, then its investors would be better off selling and investing the proceeds elsewhere. If an oil corporation isn't allowed to double in value when inflation is 100%, then an oil corporation is a bad investment.

The key point is: WHEN INFLATION CAUSES PRICES TO DOUBLE, CORPORATE PROFITS *SHOULD* DOUBLE. When prices double, all asset prices should double and all corporate profits should double.

Oil corporations have an oligopoly. They have a State-granted monopoly/oligopoly. I can't say "Oil corporate profits are excessive. I'll start an oil company!" There are too many restrictions. This makes it tempting to blame oil corporations for rising oil prices. They are a beneficiary of rising oil prices, but they have *NO CHOICE* given the rules of the US economic system. Many oil corporation executives are paid via stock options. They are the recipients of a massive windfall when there is inflation. The value of this windfall isn't free; it's paid by all the holders of dollars in the form of inflation, and by other shareholders of the corporation in the form of dilution of their ownership. The other shareholders don't complain much about stock options, because their shares are also skyrocketing due to inflation.

Oil corporation executives are being interrogated by Congress. It's a charade to distract attention from the real issue. Price inflation is nearly 100% caused by money supply inflation.

If you print more money, prices go up. It's that simple! For other products, people don't notice as much, because money supply inflation doesn't lead to uniform price inflation. Plus, people have bad memories. People remember that they used to pay less than $10 for a tank of gas and they're paying $50+ now. It's hard to maintain the illusion "Inflation is only 2%-3%!" when gasoline prices are skyrocketing. The "core CPI" removes inflation due to rising energy prices.

Gasoline prices rise nearly 100% in lockstep with money supply inflation. The demand and supply of gasoline are relatively inelastic. Therefore, money supply inflation is almost immediately reflected in gasoline prices.

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