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The Impact of Commodity Prices
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As you might guess, commodity prices have a huge influence on the industry's health and how it operates. For oil companies, the amount of oil pumped from the ground in any given day is largely fixed, but the value of that black gold is highly variable. In addition, with a large percentage of operating costs also fixed, the oil business carries a large degree of inherent operating leverage.

Consider an oil company that can get oil from the ground to a refiner at an average cost of $iy a barrel. This cost is largely fixed, regardless of the price of crude. If crude is at $18 a barrel, the oil company makes S3 a barrel in profits. However, if oil takes off to $30 a barrel, the company makes $15 per barrel, or five times as much as it did at $18 a barrel, even though its revenue has less than doubled.

Figure 25.I summarizes how commodity oil prices impact profits. Although other factors can come into play, the fact remains that commodity prices are the biggest influence on the sector's financial health at any given moment.

Not all oil, and not all oil companies, are created equal. For example, some crude in the Middle East can be brought to market for well under $10 a barrel. Meanwhile, some Canadian oil extracted from oil sands costs twice as

much to produce. When oil prices are high, oil companies can afford to produce in areas that might otherwise be uneconomical. Beyond dramatically im­pacting the oil company's financial statements, commodity prices also greatly influence how and where oil is produced.

Refining profit margins are much less dependent on commodity prices. High crude prices raise the cost of the refiners' raw goods, but some of this can be passed along to consumers. How much can be passed along is a function of the health of the global economy, as well as how much or little excess refining capacity there is at any given moment.

Though such a heavy reliance on commodity prices can make profits of energy firms highly variable from one quarter to the next, the average long- term profitability is very handsome. It's no coincidence that of the seven global companies that made more than $8 billion in profits in 2OOI, three were oil companies. If the long-term economics of the business were not attractive, the industry would not be as huge as it is today.

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