The story goes that it is “unfair” that the oil companies are “gouging” consumers at the pump while reaping record profits. As one reporter argued, “If ExxonMobil were a country, its 2007 profit would exceed the gross domestic product of nearly two thirds of the 183 nations in the World Bank’s economic rankings.” The oil industry argues that looking at nominal profits is meaningless. What matters, they say, is profit margin, which is materially lower for oil companies than for other major industries. Recently, a third view has surfaced – in no small part as a response to the oil company position - asserting that the key measure is return on equity and “the oil industry as a whole earned a 27 return on equity [in 2007] and that this was 10 points higher than other industries”. Whose view is correct?

Let’s take them one at a time. As one might expect, it is the position taken by the politicians that is completely wrong. As has been made clear in countless articles and columns by competent analysts and economists, looking at nominal profits in a vacuum is of no value whatsoever in assessing the real profitability of a company or industry. I will not rehash the reasoning behind this obvious point here.

Naturally, this means that the oil companies have a much more tenable position when they argue that profit margins examine profitability in context. The oil industry earned about 7.6% of revenues in the fourth quarter of 2007. For comparison purposes, all of US manufacturing (excluding auto manufacturing which took a dive as gas prices rose) earned approximately 9.2% of revenues in the same quarter. These are figures concede even by the industry’s detractors.

One must be careful when looking at such numbers. One quarter does not a trend make and there are those on both sides who will point at specific industries who performed better or worse (depending upon the point of view) in order to make a point. The banking industry, for example, has taken a bath since then (roughly since I took up my current position with a regional bank), but banking has long been an industry that generates higher margins than the average. That’s the point: over the long haul, the oil industry earns profit margins generally lower than most other industries, including other manufacturing industries.

But the response to the emphasis on profit margins – that return on equity (ROE) is a viable indicator of company profitability – has some merit. The question is whether or not such a measure is materially superior to a comparison of profit margins and, further, whether or not such a measurement can indicate whether or not the industry has reaped a “windfall”. The answer to both questions is: no.

First of all, while the dismissal of nominal profits as unrelated to underlying investment has merit, the dismissal of profit margin on the same grounds does not. While looking at nominal revenue growth would be equally useless, the profit margin, by extension, reflects the outlay (expenses) necessary to generate those profits. While expense outlays are a step removed from shareholder investment, the connection between spending and profits is far more immediate than between capital holdings and earnings in any particular period.

Nor is the use of ROE as a measure without problems. One must remember that these are accounting measures that are designed to represent, as well as possible, real world conditions. Understanding those real world conditions is so important that literally dozens of alternative measures have been developed to refine the concept (ROA, ROCE, ROGIC, RAROC, etc.).

Then, of course is the (deliberate) distortions in the use of these measures. The statement about the oil industry being “10 points above” all other industries is factually wrong. For the period (a point I’ll come back to), the oil industry’s return was 10 points higher than all other manufacturing industries. Further, the manufacturing figure included the automotive industry whose returns were so poor during the quarter that its losses depressed the profit margins for the entire US manufacturing sector from the 9.2% mentioned above to a mere 5.8%.

The argument is then made that these ROE figures have been higher during the period of rising prices, just as they were when prices rose in the early 1980s. Rather than demonstrating a “windfall”, however, this merely demonstrates a material flaw in using ROE as measure of assessing profitability over the short run. It should hardly come as a surprise to anyone that periods of rapidly rising prices can easily outstrip the pace at which a company can attract capital. The differential is not some wonderful bonus for the company but an indication of how much more a company must spend to acquire additional capital. That is, because funds must be obtained more rapidly in comparison to other investment alternatives, a premium must be paid to investors to attract needed capital away from those alternatives. Such conditions are particularly prevalent in industries that a particularly capital intensive – and you’d be hard pressed to find many more so than the oil industry – and have historically low profit margins because thinner margins mean greater investment risk.

In the final analysis, higher returns on equity during a period when costs, and thus dependent prices, are rising rapidly are not evidence of a windfall, but nothing less than an informed observer should expect.

In such an environment, assessing a windfall profits tax is particularly foolhardy. Not only is it attempting to recoup a benefit that does not exist – and “recoup” is a further misnomer as there is never any intent to return it to those consumers supposedly harmed when it can, instead, simply be added to the public treasury to buy still further votes – but it reduced capital in an industry that, for reasons that should now be obvious, is in desperate need of additional capital to finance the greater expense burden. The inevitable result of such a move is to increase the cost of funds to the industry and place further upward pressure on prices and downward pressure on production. The results of the original “windfall profits tax” signed by Jimmy Carter was no fluke. Prices surged still further and the problem was simply made worse.

It was up to Ronald Reagan, who as his first official act deregulated oil prices, to return sanity to the energy market and allow prices to fall to the point that the real price of a gallon of gas didn’t return to similar levels for more than a quarter century.