Industry Insight: Energy's Money Machine

"Industry Insight" is a weekly series that examines sectors through what's known as the five forces of competition, which can help separate the winners from the losers. Come back every Monday at 6 a.m. to see which industries and companies will be put under review.

As the price of gasoline soared to more than $4 a gallon last summer, Exxon Mobil ( XOM) executives took heat for booking $14.8 billion in quarterly earnings. The company, whose annual revenue exceeds the gross domestic product of countries including Belgium and Switzerland, is so profitable not only because of high energy prices, but due to competitive forces that act upon the oil and gas industry. In a way, Exxon Mobil can't help but be so successful. Ratings

Thirty years ago, Michael Porter of the Harvard Business School in Boston famously described five forces that influence competition. The energy industry enjoys a mostly positive mix of these forces. As a result, investors should consider the oil and gas sector as an attractive long-term investment and disregard volatile energy prices. In addition to Exxon Mobil, Chevron ( CVX), BP ( BP) and ConocoPhillips ( COP) also are beneficiaries of these forces.

To give an idea of the scope of the revenue that flows into these massive companies every quarter, consider Exxon Mobil's first-quarter revenue versus that of Proctor & Gamble ( PG), a consumer-products company that's similarly dominant. Exxon Mobil had sales of more than $64 billion, nearly four times that of Proctor & Gamble. In fact, it's even higher than Procter & Gamble and General Electric's ( GE) combined.

Here are the five forces and how they affect the energy industry:

Degree of rivalry: Rivalry is low. Since the product is a commodity, there is little need to create customer loyalty. So branding is out. People will pick the option that has the lowest cost. Some will even drive five miles to save a few cents a gallon. Thus, all players are essentially equal and the market price will be a function of supply and demand.

With relatively few major competitors and individual control over price, much of the profitability for an individual company comes from operating efficiencies and economies of scale. Due to this, Exxon Mobil has an advantage because of its sheer size. After all, revenue almost reached half a trillion dollars last year.

Threat of substitutes: This force will be of increasing importance as the world begins to push for alternative-energy sources to replace fossil fuels. This won't happen soon, though, so there's only a slight risk. Alternative energy is too expensive to compete with oil or natural gas.

Switching costs are also extremely high at this point. Converting homes and cars to accept alternative forms of fuel is too expensive or simply unavailable for most people.

Some players have begun to develop alternative-energy technology in hopes of staying ahead of the curve. Chevron and BP have started solar, wind, biodiesel and geothermal projects. Exxon and ConocoPhillips seem more stubborn to adapt.

Bargaining power of customers: Customer power is an interesting topic in the oil and gas industry. Price sensitivity is extremely high. However, customer dependence is also extremely high. While customers may not enjoy paying high prices for gas for their cars or to power factories, they have no other choice.

Since oil is a commodity, switching costs within the industry is non-existent. This reinforces the fact that oil and gas prices are a simple matter of supply and demand. While customers may claim that price increases will lead to decreased consumption, the actual decrease is far too small to have any real effect on profits, which is illustrated by Exxon's record earnings when oil prices spiked to an all-time high a year ago.

Bargaining power of suppliers: For integrated oil companies, suppliers have little say in the matter. The Earth supplies the primary input, and it's not very demanding in regard to compensation.

Labor is probably the most important and volatile input to be considered by investors. However, oil and gas companies lack the sort of union issues that have plagued the auto industry for years.

Threat of new entrants: Under usual circumstances, highly profitable industries will draw new competitors seeking to achieve similar earnings. But the threat of new entrants to the oil and gas sector is extremely low due to huge capital requirements. From oil fields to drilling apparatus to infrastructure and a disruption to networks, nothing is cheap.

While some small drilling operations may pop up from time to time, large integrated oil and gas companies are an exclusive club, leaving profits for a few players.

The bottom line is that oil and gas companies enjoy an enormous amount of leverage on consumers, leading to outsized profits. Those that can produce the most oil for the lowest cost will be the most profitable. When factoring in forward-looking management choices, Chevron and BP appear to be the strongest "buys" in the category due to their advances in alternative energy, which should position them better once that transition becomes a reality.
Prior to joining Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.