A Microeconomic Analysis Of British Petroleum Economics Essay

BP’s (British Petroleum) origins can be traced back to 1901 when William Know tried to explore oil in Persia. The first commercial oil discovery was made in the Middle East by BP in 1908. In 1935, the company prospered and was renamed the Anglo- Iranian Oil Company. The war effort resulted in the British government becoming a shareholder of the company (until 1987). In 1950, Anglo-Iranian expanded into petrochemicals. The Iranian nationalization of the oil industry and subsequent diplomatic solution involving Britain, the US, and Iran led to the emergence of a new consortium involving Anglo-Iranian Oil called The British Petroleum Company (founded in 1954).

1.2 Company Overview

BP is one of the largest vertically integrated oil and gas companies in the world. The company’s operations primarily include the exploration and production of gas and crude oil, as well as the marketing and trading of natural gas, power, and natural gas liquids. BP is headquartered in London, the UK and employs about 92,000 people.

1.3 Why choosing BP for the essay

The company recorded revenues of $361,143 million during the financial year ended December 2008 (FY2008), an increase of 27% over the financial year ended December 2007 (FY2007). The operating profit of the company was $36,347 million during FY2008, an increase of 9.2% over FY2007. The net profit was $21,157 million in FY2008, an increase of 1.5% over FY2007.

1.4 Business Description

BP is one of the world’s largest oil and gas companies. It has presence in more than 100 countries across six continents. The company operates through two reportable business segments: exploration and production; and refining and marketing. The company also operates through a third business segment, other businesses and corporate. Upstream activities involve oil and natural gas exploration and field development and production. The midstream operations involve the ownership and management of crude oil and natural gas pipelines, processing and export terminals, and LNG processing facilities and transportation.

For the FY2008, BP’s worldwide network consisted of some 22,600 locations branded BP, Amoco, ARCO, and Aral. BP’s retail network in the US for the FY2008 comprised approximately 11,700 sites, of which approximately 9,200 were owned by jobbers (who purchase their products directly from the refining companies and either sell them to retailers or directly to the end users) and 900 operated under a franchise agreement. At the end of FY2008, BP’s European retail network consisted of approximately 8,600 sites and had approximately 2,300 sites in the rest of world.

Other businesses and corporate segment of the company comprises treasury (which includes interest income on the company’s cash and cash equivalents) the company’s aluminum asset, the alternative energy business, and shipping and corporate activities worldwide.

1.5 What we will discuss

Not a clue yet.

2. ANALYSIS

2.1 Microeconomic analysis

2.1.1 Consumer demand, price elasticity and BP revenues for FY 2008

We will take one example here to analyse the law of demand and how it applies to BP. For this specific example we will use petrol as product. In general, the law of demand states that the quantity demanded of a good falls when the price of the good rises (assuming other things equal). To represent this change, the demand curve is used. It is a graph that represents the relationship between the price of a product (petrol in this case) and the quantity demanded.

demand.JPG

Figure – The Demand Curve

(image taken from www.freeworldacademy.com)

As you can see in figure1, when the price increased from P1 to P2 the quantity demanded dropped from Q1 to Q2. Changes in the demand curve can be caused by many factors such as the consumer income, the price of substitutes and others.

There are 2 categories of goods though. The ones that the demand doesn’t change a lot when price is changed and those that even a small price change will result in a huge change in the demand. This is called the elasticity of demand. The price elasticity of demand for petrol is inelastic (price elasticity <1) and we can put all the goods necessary to people in this category. This means that even if the price of petrol increases dramatically, people will still continue to buy it as it is necessary for let’s say driving to work.

inelastic.JPG

Figure – Inelastic demand

You can see here that an increase in price (p1 to p2) leads to a decrease in quantity (q1 to q2) that is proportionately smaller. This results in an increase of the total revenue of the company. Let’s see how BP performed.

revenue.JPG

Figure – BP revenue in 2008 (BP annual review)

BP recorded revenues of $ 361.143 million in the year 2008 compared to $ 284.365 million in 2007.

This large revenue increase is partially due to the very high oil price. Peter Sutherland (BP chairman) said in his speech in February 2009: “There are few precedents in history for such a rapid and dramatic change in the business environment. In the space of a few months we went from a record oil price of more than $140 per barrel, and BP reporting two consecutive quarters of record profits for the group”.

This profitability in 2008, in theory can be based to the “price effect” which states that after a price increase, product (petrol) sells at a higher price, which tends to higher revenue. The “sales effect” doesn’t apply here because we are talking about inelastic demand.

2.1.2 Oil Market Structure (supply curve, market equilibrium, total surplus)

It’s difficult and most times inaccurate to try and analyse the supply curve for inelastic products. A supply curve illustrates firms’ willingness to supply at particular prices. But in the oil industry there are exogenous factors that affect the prices. When a factor changes we say we have shifts in supply. That can be anything, for example a change in the number of firm selling petrol, a change in the price of a factor input (oil exploration expenses) or a change in technology. In our case, the supply is not affected by customer’s willingness to buy. Someone will buy petrol at any price in order to cover their needs (e.g drive to work). But in theory, the more quantity requested, the higher the price set by the firm. In the case which the price has reached the level where quantity supplied equals quantity demanded, we use the term “equilibrium”. On a graph, it is the price at which the supply and demand curves intersect. The total surplus refers to the total net gain to consumers and producers from trading in the market. IT is the sum of the producer and consumer surplus. But in practice the things are a little bit different. There is always need for more petrol (or oil products generally). This means that BP and other firms can produce as much petrol as they want. The boundaries here are if the petroleum firms can produce more petrol. It’s clear that the firm that can sell more barrels of oil, they will generate more revenue and gain more market share.

BP’s performance in the last 10 years has been exceptional well. They improve and increase the production every single year and that’s due to increased refining availability.

In the next page (figure4) you can see some of the performance factors.

performance.JPG

Figure – BP’s performance (picture taken from BP’s annual report 2008)

As you can see in the photo, the production was high but a bit lower that the year 2006. This is due to the unstable economy and prices in the last 2 years. BP still managed to increase their profits by improving their processes. The highlights of the year are: replacement cost profit of $ 25.594 million (up 39%), capital expenditure and acquisitions of $ 30.700 million and share price increase. The complete table with data will be attached in the appendix.

2.1.3 Government legislation (competition policy and carbon trading)

The competition policies are different from country to country. We will talk about the policies in England as the BP is a british firm. In the UK there is the role of “Director of fair trading” and their job is to supervise the behaviour of companies. If they think that a firm is doing something is not supposed to do then they can refer those firms to the “Competition Commission” for investigation. The maximum market share that a company can hold is less than 25% of the total market. If it exceeds this limit the Director of fair trading can refer the company to the Competition Commission. Also, firms are not allowed to collude because this way they restrict the competition by setting prices. Also, because many companies operate in Europe or worldwide, there are other organisations that keep an eye on firm’s strategy.

In the oil industry the top 3 competitors are : Exxon Mobil, Royal Dutch Shell and BP. BP is the second largest refining and fuel retailing firm in the UK and third in the world. In their effort to become the largest petroleum and offer high variety of products, BP merged or acquired other firms over the past few years. The company’s key products and services now include the following: Aromatics and acetyls, petrochemical products, oil and gas exploration and production, lubricants downstream derivative products, aluminum coil and other.

To produce their products, firms utilise big amounts of energy. This energy usually comes from burning fossil fuels. For example, oil and coal are used to generate electricity. By burning these fuels, greenhouse gas is emitted in the atmosphere. Carbon dioxide is a pollutant and the European governments have set rules to try to reduce the emissions. The reason the firms don’t care much about pollution is because they maximise profit by reducing their costs. Nowadays though, they have to pay big amounts of money depending how much they pollute the environment (surplus permits).

“BP is helping to meet the world’s growing demand for sustainable and affordable energy, building alternative energy businesses with the potential to grow and compete far into the future”. gas.JPG

It is also impressive how much money BP invests in alternative energy, $ 1.4 billion just in 1 year. The total cost they are willing to invest is $ 8 billion. Alternative sources of energy BP is experimenting with are: Wind (432MW), Solar(162MW) and Biofuels.

Moreover, they are running a project called CCS that stands for Carbon Capture and Storage. What CCS does is capturing the CO2 emitted during the burning and processing of fossil fuel. Then, it is transported and stored in deep geological formations such as gas or oil fields. CCS technology is supported by the government and the target is a worldwide implementation that will help reduce the problem of global warning.

2.2 Macroeconomic Analysis

2.2.1

2.2.2

3. CONCLUSION

Based on your analysis, state your recommendations describing the possible strategies that the firm can consider.