What do the record profits of Royal Dutch Shell tell us?

The Anglo-Dutch oil firm Royal Dutch Shell has reported annual profits of £13.9bn, a record for a UK-listed company. Not everyone is pleased, of course! Some trade unions have objected to the level of Shell’s profits at a time when consumers and businesses have to cope with the effects of high oil prices. One union leader described the level of profits in the oil industry as, “quite frankly obscene. Shell shareholders are doing very nicely whilst the rest of us, the stakeholders, are paying the price and struggling.”

But should the shareholders be delighted? Is the firm doing much better?

Industry watchers think that much of the rise in profits is because of high oil prices, which currently stand at about $91 a barrel compared with $57 this time last year. Oil prices are likely to come down at some point. That’s the first clue that the firm might not really be doing fantastically better than before.

The second worry is that there is a suspicion that the firm is pumping oil faster than it’s finding new reserves.

The third issue is the question of profit as opposed to profitability. Take Exxon Mobil, who in 2006 racked up a whopping $39.5bn of net profit. That’s a very, very large sum of money. But Exxon Mobil is nowhere nearly the world’s most profitable company. So what’s the difference?

It all depends how big a firm is. Exxon Mobil is the world’s largest company by revenue. Because of this, you might expect them to make the most profit anyway.

To work out profitability, you need to be ready to do some maths. Exxon Mobil made $377.6bn from selling their products. Net profit was $39.5bn – so their net profit margin measures in at around 10.5% for 2006. That means that out of every $1 of revenue, 10.5 cents was profit.

What about 2005 when they sold $286bn of stuff? In that year, they reported their profits as $36.1bn. Therefore their net profit margin was 12.6%. That’s right. They were more profitable the year before.

This is a big difference if you are an investor or manager. Rather than be distracted by the headline figure, you need to be thinking about what’s behind the numbers. In this case, whilst profits have risen, costs have risen even faster. That’s very significant.

Whilst you’re thinking that through you also might like to ponder: which firms and which industries have profit margins vastly higher than the high cost and relatively low margin oil businesses?