The Professor Who Knew Too Little

It is clear that many people have a very simplistic — but wrong — view of the energy markets. This extends to politicians who believe they can usher in a return to $2 gasoline, as well as those who underestimate the difficulty of replacing oil with renewable energy.

For the average person, gasoline prices go up because oil companies are pulling strings, meeting in secret to set prices, or withholding product from the market. To top it off, we are sending them our tax dollars as subsidies while they are wallowing in cash! That’s the view from the man on the street. Somehow, I would have expected a USC business school professor to have a more sophisticated understanding of the situation — especially if he decided to write an article about it. But I would have been wrong.

Normally, when I read something like the following, I am more prone to just shake my head over the sad state of the person’s energy IQ. But I am making an exception here in the case of Professor Ira Kalb, a marketing professor at USC’s Marshall School of Business. The professor recently wrote the following article for Business Insider:

The Only Reason Gas Is $5-A-Gallon Is Oil Companies Have Convinced Us Prices Are Out Of Their Control

The article is so full of misinformation, red herrings, conspiracy theories, and half-baked notions that it warrants a response, especially since the professor is probably passing on this misinformation to his students. If misinformation like this is not addressed, it simply helps create more generations of people who believe all sorts of energy myths. I attempted to engage the professor in the comments after the article, but his responses were about as informative as his article. As I break down the article I will also address some of our exchanges in the comments.

Marketing or High Oil Prices?

There is so much wrong with the article, I don’t know where to start. The premise of the article is that gasoline prices are flirting with $5/gallon because “oil companies must be marketing geniuses.” Bear in mind, that these same “marketing geniuses” are overseeing plummeting natural gas prices that in many cases are below break even.

Following his introduction, Professor Kalb talks about “Huge Profits” even as “the average price at the pump in the US is expected to hit $5 per gallon by summer’s peak driving season.” The source that he frequently cites for his claims is not the SEC filings of these companies, but rather he relies on the Center for American Progress to put these profits into context for readers. He cites their “energy experts”, which as I point out in the comments: “CAP’s “energy experts” consist of bureaucrats and journalists, and all are openly hostile to the oil industry. Not a single person among them has any experience actually producing energy. Why would you expect them to be able to give an informed, objective opinion about the topic?

Profits vs. Profit Margins

We can agree that oil companies are making large profits. But then I tried to explain to him in the comments why his premise that $5 gasoline is driving oil company profits was wrong. To demonstrate this, all we have to do is look at the profit margins of Tesoro and Valero, the country’s largest pure refiners. If high gas prices are driving their profits, we would expect to see that show up in their profit margins. After all, this current gasoline price spike is not the first one we have seen in the past 5 years, and therefore we should see some pretty hefty profit margins from these pure refiners. But in fact, the profit margin for Tesoro has ranged from -3.83% to +7.91% over the past five years. Their average profit margin was 0.93%. Valero’s profit margin was worse, averaging -1.39% over the past five years. Ah, but they had one great quarter in 2007, when their profit margin skyrocketed to 9.3%. Not quite as impressive as Apple’s 28.2% profit margin of last year’s Q4, but then that’s why Apple trades at double-digit PE ratio and Tesoro and Valero trade at single-digit PE ratios. It is certainly apparent that investors aren’t treating these refiners as money printing machines.

So I tried to explain to the professor that all he had to do was look at the profit margins of the refiners to understand that his basic premise is in error. Refining margins are historically very poor, which leads to poor profit margins and as we have seen, shuttered refineries. But when I and others pointed out that it was actually oil prices that were driving oil company profits, the professor respondedIf it is the price of crude, which is a cost to the oil companies, then how do you explain the profits going up so much?” I don’t have to tell most readers what a bizarre reply that is. Is Professor Kalb unaware that the oil companies that are making big profits are either integrated companies, or merely oil producers and not refiners? Does he know the difference between a refiner — for which oil is indeed a cost — and an oil company? I replied that he appeared to be very misinformed, and that a cursory look at the profit margins of refiners should tell him that it isn’t gasoline prices that were driving profits. He replied: “Why do you think my “misinformed” article talked about refineries? I don’t mention refineries at all. My post is about marketing that supports $5 per gallon gas and subsidies.”

Correlation Between Oil and Gas Prices

So Professor Kalb thinks that refineries have no bearing on his contention that brilliant marketing — and not high oil prices — is behind the rise in the price of gasoline. Perhaps he should test an alternative hypothesis by checking the correlation between gasoline prices and oil prices. In fact, a recent article in U.S. News and World Report explained the correlation:

Why have gasoline prices increased since the start of the year? The simplest explanation is that the price of crude oil has increased. Specifically, the spot price for Brent (North Sea) crude has increased $16 a barrel since January. Given that there are 42 gallons to a barrel, that works out to a 38 cent increase in the price of a gallon of oil. Spot prices for gasoline trade in New York have increased about 41 cents per gallon over the same time frame. So there you go.

The professor’s hypothesis requires us to believe that this brilliant marketing is taking place throughout the entire world (except where gasoline is subsidized) and yet these brilliant marketers can’t seem to use the same marketing techniques to support a higher natural gas price.

Who Needs Crude Oil and Gasoline?

But this isn’t really what his article was about, as evidenced by many of the red herrings Professor Kalb brought up in the article and in his subsequent comments. The professor’s article is really just a misinformed attack on what he feels are unjust profits. I doubt that many readers actually accept that brilliant marketing has anything to do with the high price of gasoline, so let’s move on and address some of the professors other contentions:

Professor Kalb: Most companies generate large profits by creating innovative, unique, or highly-desirable, got-to-have-it brands. Apple devices and Nike shoes come to mind. The gasoline we buy at the pump is not particularly innovative. It is basically the same as the gas we have been buying since we all started driving. It looks, smells, and works the same as it always has.

So the professor’s contention here is that the profits are unjust because they did not require innovation. Yet the oil we are producing today has required significant innovation relative to how oil was produced in previous decades. The same innovative techniques have the U.S. currently awash in natural gas — and consumers benefiting from low natural gas prices as a result. The engineering challenges of building a floating city in the ocean and then drilling miles below the ocean to produce oil — which then has to be refined to increasingly higher environmental standards — are substantial. That iPhone that Professor Kalb believes is creating justifiable profits is dependent on the 1.7 gallons of oil embedded in each device. Oil is a major enabler of those iPhones and Nikes, and yes, it did require substantial innovation.

Professor Kalb: As most economists will tell you, commodities typically sell for less because there is significant price competition and no clear reason for brand loyalty. To have control over price, marketers position their products as unique with no adequate substitutes. The more uniqueness, the more control. If buyers really want or need the product, they have to pay the price because they cannot get the same product somewhere else. Uniqueness, from effective branding, gives marketers a monopoly over the mind-space of buyers. This, in turn, creates an effect similar to that of an inelastic demand curve. With oil, there is very little or no uniqueness – making the high prices at the pump and resultant profits an amazing marketing feat.

With oil, there is little or no uniqueness? OK, name a replacement for the 85 million barrels of day that the world currently consumes. I will give you a hint. At the present time, there is nothing that can actually replace oil. Nothing. I would say that makes oil pretty unique. There is no replacement, and without oil the entire world would swiftly come to a grinding halt. It may not be that way at some point in the future, but it is that way today. Thus, people are willing to pay ever increasing prices for oil. The Chinese and Indians are consuming ever more oil (an “excuse”, according to the professor), even at $100 a barrel. Why should they do this, if there is an adequate, economic replacement?

Fossil Fuel Subsidies

Professor Kalb: More amazing is the fact that the oil companies have been getting tax subsidies from the U.S. government since 1916. In spite of their gargantuan profits, the oil industry has convinced the American public that these subsidies, which currently total $4 billion a year, are necessary to keep their prices lower than they ordinarily would be. If this is not another example of marketing genius, it is hard to fathom what is.

CNN just published a story that cites a CBO report that places the sum total of all fossil fuel subsidies in 2011 at $2.5 billion. The total of all energy subsidies was $24 billion, with most going to renewable energy. I challenged the professor on his subsidy claim in the comments. I asked him to detail these subsidies so we could discuss them. It was plainly apparent that he is just repeating things he has heard, and doesn’t actually know the first thing about these subsidies. He refused multiple requests to detail them. He finally resorted to “You seem to want to argue“. I would think a professor would have done a better job of due diligence in writing an article that he was going to put out there for public consumption. But let’s quickly review (more details can be found here).

Oil Company Subsidies for Apple, Google, and Microsoft

Last year, CNN broke down the oil company subsidies. They identified the single largest subsidy as the Section 199 Manufacturer’s Tax Deduction. It is an income tax deduction, and not any sort of cash subsidy that is being paid to the oil companies. More importantly, not only is it not limited to oil companies, but oil companies have already been singled out for a reduction in the tax credit. Other industries get to take a 9% deduction for Section 199, but oil companies are restricted to 6%. So Apple and their 28% profit margin gets to deduct 9% from their U.S. based manufacturing activities, and Tesoro with their single-digit profit margin gets to deduct 6%. So the question that should be asked is “Why are we giving oil company subsidies to Apple, Google, and Microsoft?” If you want to eliminate Section 199, fine. Just do it for everyone.

The other thing to point out on these so-called subsidies is that if you take his entire $4 billion claim at face value, it is 1). A small fraction of the average annual tax bill paid by the oil industry; and 2). Worth 1.7 cents per gallon of fuel used in the U.S. So why anyone thinks that scrapping these “subsidies” has any significant bearing on either oil company profits or on the price people pay at the pump is beyond me.

Lobbying and Investing in Alternatives

Professor Kalb: The oil companies have said repeatedly that they need high profits to develop alternative energy sources and explore for more oil. They may be doing a lot of the latter but very little, if any, of the former. In fact rather than investing in alternative energy sources, the LA Times reported that the oil companies “used $38 billion, or 28% of annual net income, to repurchase their own stocks and invested in politicians to maintain the policies that led to their enormous profits over the past decade.”

Little, if any of the former? The professor continues to demonstrate his absolute ignorance about the oil industry. He may think he is referencing the LA Times, but that article references the anti-oil Center for American Progress for their information. And he selectively references the article, which also presented a snippet of the other side “California’s pension plans for public employees, for example, had about 4.4% of their investments in the oil industry between 2005 and 2009 and obtained a 17.1% return on them.”

I have addressed these claims in Tis the Season for Oil Company Misinformation. First off, ExxonMobil may make $30 billion a year, but they invest $25-$30 billion a year back into their business. Their 2011 capital budget was $34 billion (but you don’t get that from the Center for American Progress). I can guarantee you that Apple doesn’t have to spend that kind of capital. Second, a 2009 study from the University of Texas (Key Investments in Greenhouse Gas Mitigation Technologies by Energy Firms, Other Industry and the Federal Government: An Update) said that the U.S. oil industry had invested over $6.7 billion in renewable energy over the previous nine years (almost a quarter of all investments in renewable energy by industry and governments).

Finally, with respect to the lobbying, over the past 14 years the pharmaceutical industry spent twice as much money as the oil industry on lobbying, and the insurance industry, electric utilities, business associations, agriculture, and computer and Internet industry all spent more money on lobbying than did the oil industry. So where is the outrage that Apple is lobbying to support their 28% profit margins? But do you wonder why the oil industry even has to lobby? To combat the kind of misinformation that Professor Kalb is spreading.

In the section How do they do it?, he writes:

Professor Kalb: They do their convincing by sending press releases to the news media, which distribute their messages for free via news programs and articles – warning us that prices at the pump are going up to $5 a gallon.

His support there is a link to an article in which industry analysts are predicting higher prices. Apparently, he either does not know the difference between an industry analyst and representatives from the industry, or he thinks the analysts are basing their projections on press releases from the companies. Yet here we have ExxonMobil’s CEO saying he doesn’t believe gasoline is headed to $5 a gallon. I guess he did not get the memo from the secret cabal.

U.S. Oil Companies Are OPEC’s Puppet-Masters?

Professor Kalb: In the press releases, they convince the public that the high prices are the result of supply and demand forces that are out of their control. However, OPEC (an oil cartel) controls the supply and pricing of crude oil so invoking supply and demand, while a clever strategy, is a bit disingenuous.

Wow! So does he think then that U.S. oil companies control OPEC? Bear in mind that in this article, his focus has been U.S. oil companies. And yet here he thinks it is disingenuous to cite supply and demand? OPEC does restrict supply. Unless you believe ExxonMobil can call them up and ask them to pump more crude, then what is disingenuous about citing supply as an issue? Does he actually think this is within the control of U.S. oil companies?

Excuses: Rising Demand, Instability

How else do they do it?

Professor Kalb: Providing believable reasons. They use world events as reasons (cynics might call them excuses) for supply and demand changes and higher oil prices. Typical examples include the following:

  • China, India, and other large global users bidding up the price of oil
  • Instability in the Middle East threatening supply
  • Refinery outages, which seem to occur at the worst possible times
  • Seasonal demand factors from heating, air conditioning, and increased driving
  • Industrial demand factors from a healthy economy

I can’t emphasize just how amazed I am that this is coming from a professor at a business school at a major university. These things may be a complete mystery to the professor, but they aren’t to everyone. First, we actually have data to show just how rapidly demand has risen in India and China. In the past decade, oil consumption in China was up 90%, and it was up nearly 50% in India. I would say those are believable reasons. But excuses? It is as if the professor is totally disconnected from the idea that growing global demand — for which we have actual data — might be a real reason for upward pressure on oil prices. Second, given the importance of the Middle East to global oil supplies, why wouldn’t instability there impact prices? Do you remember the Arab oil embargo of 1973? That should tell you what happens when a large fraction of the world’s oil supply is suddenly unavailable. That is a risk, and that risk is part of the price premium.

Refinery outages “seem” to occur at the worst possible times? You are a professor, why don’t you use your skills to actually track when they occur. I will give you a hint. Refineries have been running at 80-90% utilization rates. But they undergo maintenance in the spring — during the transition to summer gasoline but before summer driving season — and then again in the fall after summer driving season. That is when you will see annual refinery utilization dip. When would you suggest that refineries do their maintenance? Since they “seem” to occur at the worst possible times, can you suggest the best possible time?

As far as the last two points, it is a fact that demand goes up in the summer, and demand goes up when the economy is growing. So you think it is an excuse that prices rise when demand goes up? You teach at a business school for crying out loud!

Conclusion: Not Everything is About Marketing

It is clear that Professor Kalb has zero knowledge of the oil industry outside of the spin he picked up from the Center for Selective Information. And because of his sources, the professor is horribly misinformed, and yet determined to share that misinformation with others. So let’s now summarize a few of the professor’s misconceptions:

  • $5 gasoline is due to great marketing which extends to oil companies around the world, but is nonexistent when it comes to natural gas
  • High gasoline prices are driving oil company profits
  • Profit margins from refiners are irrelevant in the discussion
  • Oil companies are not innovating
  • Oil is not unique
  • Oil companies are not investing in alternative energy
  • Oil companies are not exploring for oil
  • Oil companies are not investing back into their business
  • Oil company analysts get their information from oil company press releases
  • Supply and demand is not a factor, since OPEC controls supply
  • Growing demand in India and China is an excuse
  • Refinery outages occur at suspicious times

The professor seems to be entirely unaware that:

  • Oil companies and refining companies are not the same thing
  • Apple gets “oil company subsidies”
  • Profit margins and not profits are what is important (in the comments, he writesI do not talk about profit margin in my post, I talk about profits and subsidies.”)
  • The level of taxes that oil companies pay is very high relative to other industries (he singles out ExxonMobil’s 2009 tax bill as his example of oil company taxes; if you want to see an analysis of XOM’s 2009 taxes here you go)
  • Gasoline prices are closely correlated with oil prices, which are set in global markets based on how much people are willing to pay
  • Gasoline is not priced in the same way as iPhones or Nikes

When I tried to correct some of Professor Kalb’s misconceptions, he let me know: “I have written books on marketing and many even consider me an expert on marketing. Perhaps you believe I have fooled them.” (He was more than a bit thin-skinned; look at his responses to some of the comments). He would not defend his positions, instead he often just repeated himself. He simply would not be dissuaded from his view. He demonstrated that he has zero experience with the oil industry, and yet was determined to lecture on matters in which he has next to zero knowledge. He could not seem to understand that it wasn’t his knowledge of marketing that was the problem, it was the attempt to relate it to something he didn’t understand, which then resulted in a series of erroneous claims. Marketing is what tries to convince people to pay a nickel more a gallon for Shell’s V-Power gasoline. But marketing is not what is pushing gasoline toward $5/gallon.

My advice to the professor would be to stick to what you know. This is not a marketing problem, and by attempting to turn it into one you are misinforming people about the energy industry.