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Thursday, July 31, 2008

Large Profits Mean Large Investment and Larger Supply

If you want cheaper gas, then the news that an oil company is reaping record profits should come as welcome news. This is because high profits in an industry cause investment capital to flow to that industry. This investment capital increases supplies in that industry until profit margins begin decreasing. If an industry is unprofitable, the opposite occurs and capital begins flowing out of that industry. In fact, over time the rate of profit tends to be uniform across all industries. This principle is known as the "uniformity of profit principle" and is explained in great detail in Chapter 6, Part A.1 (p.172) of Capitalism: A Treatise on Economics by Dr. George Reisman previously linked here. Such increased capital investment and increased supply will translate to cheaper prices. Or, as Shell CEO Jeroen van der Veer states very succintly:

"If we do less investment there will be less supply for consumers" which would drive prices higher."

"The world needs energy."

Further illustrating this principle in action:

He said the company was reinvesting profits and now expects capital spending of between $35 billion and $36 billion this year, up from the last previous estimate of $24 billion to $25 billion. That figure includes the company's $5.8 billion bid for Canada's Duvernay Oil Corp., launched earlier this month.

Petercam analyst Alexandre Weinberg:

"Though the sentiment toward the majors (major oil companies) has weakened in the past weeks due to the oil price decline, we believe that Royal Dutch Shell will continue to generate massive cash flows," he wrote in a note on the earnings."The following 18 months should see significant production capacity increase," he said, citing a large project on Sakhalin island in Russia expected to begin production at the end of the year.

So, it stands to reason that proposed "windfall profit taxes" on oil companies would decrease their profits, reduce capital spending and therefore reduce future supplies which would translate into even higher prices. Unfortunately, logic and reality will not stand in the way of Congress.

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