Where the Oil Profits Went

Oil prices have risen 58% since late March and are now trading at all-time record highs well above $90 a barrel.

Still, over this period, nearly every major oil and gas company saw their income results deteriorate. What gives?

The answer is simple. Like any business, profits in the oil and gas business aren't determined by the industry's cost of inputs. Rather, profits for oil companies are determined by the spread between their cost of goods sold and the price of their finished products. The greater the spread, the more the companies profit.

For oil companies like Exxon Mobil(XOM Quote), Chevron (CVX Quote), ConocoPhillips(COP Quote), British Petroleum (BP Quote) and Royal Dutch Shell (RDS.A Quote), the product that they sell is not crude oil.

Rather, they sell products made from crude oil like motor gasoline, jet fuel and chemicals.

Most oil companies drill for oil themselves. After refining and marketing that oil, profits are calculated by subtracting the costs of finding and developing the oil from the final price that the company earns from selling the product.

Finding and development costs range widely depending on location, technical difficulty of extraction, taxation and subsidies. These expenses are about $2 a barrel in Saudi Arabia and reach as high as $40 a barrel in the oil sands of Alberta, Canada.

However, most companies don't produce enough oil to cover the demand for the refined products that they make. Thus, oil companies must buy additional crude from the global market in order to fill that void. The remainder mostly comes from the major producing countries like Saudi Arabia, Russia, Canada and Iran.

In the first quarter of 2007, the average price that oil companies had to pay to buy crude from the marketplace was around $58 a barrel. In the third quarter, this number was closer to $75 a barrel. In this situation, the sales price of refined products must keep up with the rising price of crude oil if profit margins are to hold steady.